What Is Monetarism?

Monetarism is a macroeconomic theory, which states that governments can foster economic stability by targeting the growth rate of money supply. Essentially, it is a set of views based on the belief that the total amount of money in an economy is the primary determinant of economic growth.

Key Takeaways

  • Monetarism is a macroeconomic theory stating that governments can foster economic stability by targeting the growth rate of money supply.
  • Central to monetarism is the "quantity theory of money," which states that the money supply (M) multiplied by the rate at which money is spent per year (V) equals the nominal expenditures (P * Q) in the economy.
  • Monetarism is a branch of Keynesian economics that emphasizes the use of monetary policy over fiscal policy to manage aggregate demand, contrary to most Keynesians.

Understanding Monetarism

Monetarism is an economic school of thought, which states that the supply of money in an economy is the primary driver of economic growth. As the availability of money in the system increases, aggregate demand for goods and services goes up. An increase in aggregate demand encourages job creation, which reduces the rate of unemployment and stimulates economic growth.

Monetary policy, an economic tool used in monetarism, is implemented to adjust interest rates to control the money supply. When interest rates are increased, people have more of an incentive to save than to spend, thereby reducing or contracting the money supply. Contrarily, when interest rates are lowered following an expansionary monetary scheme, the cost of borrowing decreases, which means people can borrow more and spend more, thereby stimulating the economy.

Monetarism is closely associated with economist Milton Friedman, who argued, based on the "quantity theory of money," that the government should keep the money supply fairly steady, expanding it slightly each year mainly to allow for the natural growth of the economy. Due to the inflationary effects that can be brought about by excessive expansion of the money supply, Friedman, who formulated the theory of monetarism, asserted that monetary policy should be done by targeting the growth rate of the money supply to maintain economic and price stability.

In his book, A Monetary History of the United States 18671960, Friedman proposed a fixed growth rate called the K-percent rule, suggesting that money supply should grow at a constant annual rate tied to the growth of nominal gross domestic product (GDP) and be expressed as a fixed percentage per year. This way, the money supply will be expected to grow moderately, businesses will be able to anticipate the changes to the money supply every year and plan accordingly, the economy will grow at a steady rate, and inflation will be kept at low levels.

The Quantity Theory of Money

Central to monetarism is the "quantity theory of money," which monetarists adopted from earlier economic theories and integrated into the general Keynesian framework of macroeconomics. The quantity theory of money can be summarized in the equation of exchange, formulated by John Stuart Mill, which states that the money supply multiplied by the rate at which money is spent per year equals the nominal expenditures in the economy. The formula is given as:

MV=PQwhere:M=money supplyV=velocity (rate at which money changes hands)P=average price of a good or serviceQ=quantity of goods and services sold\begin{aligned} &MV = PQ \\ &\textbf{where:} \\ &M = \text{money supply} \\ &V = \text{velocity (rate at which money changes hands)} \\ &P = \text{average price of a good or service} \\ &Q = \text{quantity of goods and services sold} \\ \end{aligned}MV=PQwhere:M=money supplyV=velocity (rate at which money changes hands)P=average price of a good or serviceQ=quantity of goods and services sold

A key point to note is that monetarists believe that changes to M (money supply) is the driver of the equation. In short, a change in M directly affects and determines employment, inflation (P), and production (Q). In the original version of the quantity theory of money, V is held to be constant, but this assumption was dropped by John Maynard Keynes and is not assumed by the monetarists, who instead believe that V is easily predictable.

Economic growth is a function of economic activity (Q) and inflation (P). If V is constant (or at least predictable), then an increase (or decrease) in M will lead to an increase (or decrease) in either P or Q.

An increase in P denotes that Q will remain constant, while an increase in Q means that P will be relatively constant. According to monetarism, variations in the money supply will affect price levels over the long-term and economic output in the short-term. A change in the money supply, therefore, will directly determine prices, production, and employment.

Monetarism vs. Keynesian Economics

The view that velocity is constant serves as a bone of contention to Keynesians, who believe that velocity should not be constant since the economy is volatile and subject to periodic instability. Instead, Keynes' liquidity preference theory emphasizes how changes in money demand (and thus velocity) influence the price level and aggregate demand.

Monetarism builds on the Keynesian theory by assuming the same macroeconomic framework and integrating the equation of exchange (with V swinging cyclically as Keynes argued), but instead focuses on the role played by money supply. Because they believe that V can be relatively easily predicted, monetarists argue that the equation of exchange could be resuscitated as an approach to stabilization policy and favor the use of monetary policy to do so.

Proponents of monetarism generally believe that controlling an economy through fiscal policy is a poor decision because it necessarily introduces microeconomic distortions that reduce economic efficiency. They prefer monetary policy as a tool to manage aggregate demand in a way that will be more neutral microeconomically and avoid the deadweight losses and social costs that fiscal policy creates in markets.

History of Monetarism

Monetarism had its heyday in the early 1980s when economists, governments, and investors eagerly jumped at every new money supply statistic.

In the years that followed, however, monetarism fell out of favor with many economists, as the link between different measures of money supply and inflation proved to be less clear than most monetarist theories had suggested. Many central banks today have stopped setting monetary targets and instead have adopted strict inflation targets.