Monetarism

What is 'Monetarism'

Monetarism 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.

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.

BREAKING DOWN 'Monetarism'

Monetarism is an economic school of thought that 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. However, in the long-term, the increasing demand will eventually be greater than supply, causing a disequilibrium in the markets. The shortage caused by a greater demand than supply will force prices to go up, leading to inflation.

Monetary policy, an economic tool used in monetarism, is used 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. On the other hand, 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.

Due to the inflationary effects that can be brought about by excessive expansion of the money supply, Milton Friedman, whose work 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 1867 - 1960, Friedman proposed a fixed growth rate called Friedman’s k-percent rule, which suggested that money supply should grow at a constant annual rate tied to the nominal GDP growth and expressed as a fixed percentage per year. This way, 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.

Central to monetarism is the Quantity Theory of Money, 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 = PQ

Where M = Money supply

V = Velocity – rate at which money changes hands

P = Average price of a good or service

Q = Quantity of goods and services sold

Monetarist theorists view velocity as constant, implying that the money supply is the major factor of GDP growth or economic growth. Economic growth is a function of economic activity (Q) and inflation (P). If V is constant and predictable, then an increase (or decrease) in M will lead to an increase (or decrease) in either P or Q. An increase in price levels denotes that the quantity of goods and services produced will remain constant, while an increase in the quantity of goods produced means that the average price level 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.

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. Keynesian economics states that aggregate demand is the key to economic growth and supports any action of central banks to inject more money into the economy in order to increase demand. As stated earlier, this runs contrary to monetarist theory which asserts that such actions will result in inflation.

Proponents of monetarism believe that controlling an economy through fiscal policy is a poor decision. Excessive government intervention interferes with the workings of a free market economy and could lead to large deficits, increased sovereign debt, and higher interest rates, which would eventually force the economy into a state of destabilization.

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 economists, and 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.