Monetarist Theory: Economic Theory of Money Supply

What Is Monetarist Theory?

The monetarist theory is an economic concept that contends that changes in money supply are the most significant determinants of the rate of economic growth and the behavior of the business cycle. When monetarist theory works in practice, central banks, which control the levers of monetary policy, can exert much power over economic growth rates.

The competing theory to the monetarist theory is Keynesian economics.

Key Takeaways

  • According to monetarist theory, money supply is the most important determinant of the rate of economic growth.
  • It is governed by the MV = PQ formula, in which M = money supply, V = velocity of money, P = price of goods, and Q = quantity of goods and services.
  • The Federal Reserve controls money in the United States and uses three main levers—the reserve ratio, discount rate, and open market operations—to increase or decrease money supply in the economy.

Understanding Monetarist Theory

According to monetarist theory, if a nation's supply of money increases, economic activity will increase—and vice versa.

Monetarist theory is governed by a simple formula: MV = PQ, where M is the money supply, V is the velocity (number of times per year the average dollar is spent), P is the price of goods and services and Q is the quantity of goods and services. Assuming constant V, when M is increased, either P, Q, or both P and Q rise.

General price levels tend to rise more than the production of goods and services when the economy is closer to full employment. When there is slack in the economy, Q will increase at a faster rate than P under monetarist theory.

In the U.S., the Federal Reserve (Fed) sets monetary policy without government interference. The Fed operates on a monetarist theory that focuses on maintaining stable prices (low inflation), promoting full employment, and achieving steady gross domestic product (GDP) growth.

Controlling Money Supply

In the U.S., it is the job of the Fed to control the money supply. The Fed has three main levers:

  • The reserve ratio: The percentage of reserves a bank is required to hold against deposits. A decrease in the ratio enables banks to lend more, thereby increasing the supply of money.
  • The discount rate: The interest rate the Fed charges commercial banks that need to borrow additional reserves. A drop in the discount rate will encourage a bank to borrow more from the Fed and therefore lend more to its customers.
  • Open market operations: Open market operations consist of buying and selling government securities. Buying securities from large banks increases the supply of money, while selling securities contracts decreases the money supply in the economy.

Example of Monetarist Theory

Former Federal Reserve Chair Alan Greenspan was a proponent of monetarist theory. During his initial years at the Fed in 1988, he increased interest rates, decreasing growth and raising inflation rates, which almost touched five percent.

The U.S. economy tipped into recession during the early 1990s. In response, Chair Greenspan boosted economic prospects by commencing on a rate-cutting spree that resulted in the longest period of economic expansion in the history of the U.S. economy. A loose monetary policy of low interest rates made the U.S. economy prone to bubbles, culminating in the 2008 financial crisis and the Great Recession.

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