Picture yourself as the host of an economists' dinner party where no one is having any fun (perhaps not a hard thing to imagine). There are two competing schools of thought on what should be done to fix the party. The Keynesian economists in the room would tell you to break out the party games and snacks, and then force people into a rousing game of Twister. Meanwhile, Milton Friedman and his monetarist pals have a different solution. Control the booze, and let the party take care of itself.
Of course, the economy is slightly more complicated than a dinner party gone bad. But the fundamental question is the same: Is it better to intervene when things go wrong, or attempt to prevent problems before they start? This article will explore the rise of the laid-back monetarist approach to controlling inflation, touching upon its proponents, successes and failures.
The Basics of Monetarism
Monetarism is a macroeconomic theory borne of criticism of Keynesian economics. It was named for its focus on money's role in the economy. This differs significantly from Keynesian economics, which emphasizes the role that the government plays in the economy through expenditures, rather than the role of monetary policy. To monetarists, the best thing for the economy is to keep an eye on the money supply and let the market take care of itself. In the end, the theory goes, markets are more efficient at dealing with inflation and unemployment.
Milton Friedman, a Nobel Prize-winning economist who once backed the Keynesian approach, was one of the first to break away from commonly accepted principles of Keynesian economics. In his work "A Monetary History of the United States, 1867-1960" (1971), a collaborative effort with fellow economist Anna Schwartz, Friedman argued that the poor monetary policy of the Federal Reserve was the primary cause of the Great Depression in the United States, not problems within the savings and banking system. He argued that markets naturally move toward a stable center, and an incorrectly set money supply caused the market to behave erratically. With the Bretton Woods system's collapse in the early 1970s and the subsequent increase in both unemployment and inflation, governments turned to monetarism to explain their predicaments. It was then that this economic school of thought gained more prominence.
Monetarism has several key tenets:
- Control of the money supply is the key to setting business expectations and fighting inflation's effects.
- Market expectations about inflation influence forward interest rates.
- Inflation always lags behind the effect of changes in production.
- Fiscal policy adjustments do not have an immediate effect on the economy. Market forces are more efficient in making determinations.
- A natural unemployment rate exists; trying to lower the unemployment rate below that rate causes inflation.
Quantity Theory of Money
The approach of classical economists toward money states that the amount of money available in the economy is determined by the equation of exchange:
M = the amount of money currently in circulation over a set time period
V = the "velocity" of money (how often money is spent or turned over during the time period)
P = the average price level
T = the value of expenditures or the number of transactions
Economists tested the formula and found that the velocity of money, V, often stayed relatively constant over time. Because of this, an increase in M resulted in an increase in P. Thus, as the money supply grows, so too will inflation. Inflation hurts the economy by making goods more expensive, which limits consumer and business spending. According to Friedman, "inflation is always and everywhere a monetary phenomenon." While economists following the Keynesian approach did not completely discount the role that money supply has on gross domestic product (GDP), they did feel that the market would take more time to react to adjustments. Monetarists felt that markets would readily adapt to more capital being available.
Money Supply, Inflation and the K-Percent Rule
To Friedman and other monetarists, the role of a central bank should be to limit or expand the money supply in the economy. "Money supply" refers to the amount of hard cash available in the market, but in Friedman's definition, "money" was expanded to also include savings accounts and other on-demand accounts.
If the money supply expands quickly, then the rate of inflation increases. This makes goods more expensive for businesses and consumers and puts downward pressure on the economy, resulting in a recession or depression. When the economy reaches these low points, the central bank can exacerbate the situation by not providing enough money. If businesses - such as banks and other financial institutions - are unwilling to provide credit to others, it can result in a credit crunch. This means there is simply not enough money to go around for new investment and new jobs. According to monetarism, by plugging more money into the economy, the central bank could incentivize new investment and boost confidence within the investor community.
Friedman originally proposed that the central bank set targets for the inflation rate. To ensure that the central bank met this goal, the bank would increase the money supply by a certain percentage each year, regardless of the economy's point in the business cycle. This is referred to as the k-percent rule. This had two primary effects: It removed the central bank's ability to alter the rate at which money was added to the overall supply, and it allowed businesses to anticipate what the central bank would do. This effectively limited changes to the velocity of money. The annual increase in money supply was to correspond to the natural growth rate of GDP.
Governments had their own set of expectations. Economists had frequently used the Phillips curve to explain the relationship between unemployment and inflation, and expected that inflation increased (in the form of higher wages) as the unemployment rate fell. The curve indicated that the government could control the unemployment rate, which resulted in the use of Keynesian economics in increasing the inflation rate to lower unemployment. During the early 1970s, this concept ran into trouble as both high unemployment and high inflation were present.
Friedman and other monetarists examined the role that expectations played in inflation rates; specifically, that individuals would expect higher wages if inflation increased. If the government tried to lower the unemployment rate by increasing demand (through government expenditures), it would lead to higher inflation and eventually to firms firing workers hired to meet that demand bump. This would occur any time the government tried to reduce unemployment below a certain point, commonly known as the natural unemployment rate.
This realization had an important effect: monetarists knew that in the short run, changes to the money supply could change demand. But in the long run, this change would diminish as people expected inflation to increase. If the market expects future inflation to be higher, it will keep open market interest rates high.
Monetarism in Practice
Monetarism rose to prominence in the 1970s, especially in the United States. During this time, both inflation and unemployment were increasing, and the economy was not growing. Paul Volcker was appointed as chairman of the Federal Reserve Board in 1979, and he faced the daunting task of curbing the rampant inflation brought on by high oil prices and the Bretton Woods system's collapse. He limited the money supply's growth (lowering the "M" in the equation of exchange) after abandoning the previous policy of using interest rate targets. While the change did help the inflation rate drop from double digits, it had the added effect of sending the economy into a recession as interest rates increased.
Since monetarism's rise in the late 20th century, one key aspect of the classical approach to monetarism has not evolved: The strict regulation of banking reserve requirements. Friedman and other monetarists envisioned strict controls on the reserves held by banks, but this has mostly gone by the wayside as deregulation of the financial markets took hold and company balance sheets became ever more complex. As the relationship between inflation and the money supply became looser, central banks stopped focusing on strict monetary targets and more on inflation targets. This practice was overseen by Alan Greenspan, who was a monetarist in his views during most of his near-20-year run as Fed chairman from 1987 to 2006.
Criticisms of Monetarism
Economists following the Keynesian approach were some of the most critical opponents to monetarism, especially after the anti-inflationary policies of the early 1980s led to a recession. Opponents pointed out that the Federal Reserve failed to meet the demand for money, which resulted in a decrease in available capital.
Economic policies, and the theories behind why they should or shouldn't work, are constantly in flux. One school of thought may explain a certain time period very well, then fail on future comparisons. Monetarism has a strong track record, but it is still a relatively new school of thought, and one that will likely be refined further over time.
EconomicsThis interest rate forecasting model has helped central banks around the world adjust their rates to balance out inflation.
EconomicsThere's a debate over which policy is better for the economy. Find out which side of the fence you're on.
Personal FinanceLearn about the tools the Fed uses to influence interest rates and general economic conditions.
Personal FinanceFind out how the Fed manages bank reserves and this contributes to a stable economy.
EconomicsThe Federal Reserve doesn't interfere with the economy every time it flounders. Find out more here.
Wealth ManagementDiscover what the most important factors are that affect mortgage interest rates. Factors range from inflation and economic growth to Federal Reserve activity, .
InvestingAfter October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
InvestingWhile stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
Investing BasicsLearn why interest rates are one of the most important economic variables and how every individual and business is affected by rate changes.
EconomicsAfter the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
The Reserve Bank of India, or RBI, manages currency in India. The bank's additional responsibilities include regulating the ... Read Full Answer >>
Generally speaking, inflation occurs if M2 money supply expands faster than the rate of productive growth in the overall ... Read Full Answer >>
Transfer pricing refers to prices that a multinational company or group charges a second party operating in a different tax ... Read Full Answer >>
The Canada Pension Plan protects pension holdings against inflation and adjusts its annual rates for inflation. The Canada ... Read Full Answer >>
Investment timing decisions are among the most challenging faced by investors as they have a significant impact on ultimate ... Read Full Answer >>
One of the most significant challenges faced by 401(k) account owners is the creation of an investment plan that can withstand ... Read Full Answer >>