Monetary Theory: Overview and Examples of the Economic Theory

What Is Monetary Theory?

Monetary theory is based on the idea that a change in money supply is a key driver of economic activity. It argues that central banks, which control the levers of monetary policy, can exert much power over economic growth rates by tinkering with the amount of currency and other liquid instruments circulating in a country's economy. 

Key Takeaways

  • Monetary theory posits that a change in money supply is a key driver of economic activity.
  • A simple formula, the equation of exchange, governs monetary theory: MV = PQ.
  • The Federal Reserve (Fed) has three main levers to control the money supply: the reserve ratio, discount rate, and open market operations.
  • Money creation has become a hot topic under the “Modern Monetary Theory (MMT)" banner.

Understanding Monetary Theory

According to monetary theory, if a nation's supply of money increases, economic activity will rise, too, and vice versa. A simple formula governs monetary theory: MV = PQ. M represents 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 number 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 monetary theory.

In many developing economies, monetary theory is controlled by the central government, which may also be conducting most of the monetary policy decisions. In the U.S., the Federal Reserve Board (FRB) sets monetary policy without government intervention.

The FRB operates on a monetary theory that focuses on maintaining stable prices (low inflation), promoting full employment, and achieving steady growth in gross domestic product (GDP). The idea is that markets function best when the economy follows a smooth course, with stable prices and adequate access to capital for corporations and individuals.

Types of Monetary Theories

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

  • 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.
  • Discount rate: The interest rate the Fed charges commercial banks that need to borrow additional reserves. A drop in the discount rate will encourage banks to borrow more from the Fed and therefore lend more to its customers.
  • Open market operations (OMO): OMO consists of buying and selling government securities. Buying securities from large banks increases the supply of money while selling securities contracts money supply in the economy.

Monetary Theory vs. Modern Monetary Theory (MMT)

The core tenets of monetary theory have attracted plenty of support under the “Modern Monetary Theory" (MMT) banner. The likes of Alexandria Ocasio-Cortez and Bernie Sanders have been championing money creation, describing it as a useful economic tool, while disputing claims that it leads to currency devaluation, inflation, and economic chaos.

MMT posits that governments, unlike regular households, should not tighten their purse strings to tackle an underperforming economy. Instead, it encourages them to spend freely, running up a deficit to fix a nation’s problems.

The idea is that countries such as the U.S. are the sole issuers of their own currencies, giving them full autonomy to increase the money supply or reduce the effect of expansionary monetary policy through taxation. Because there is no limit to how much money can be printed, the theory argues that there is no way that countries can default on their debts.

Criticisms of Monetary Theory

Not everyone agrees that boosting the amount of money in circulation is wise. Some economists warn that such behavior can lead to a lack of discipline and, if not managed properly, cause inflation to spike, eroding the value of savings, triggering uncertainty, and discouraging firms from investing, among other things.

The premise that taxation can fix these problems has also come under fire. Taking more money from paychecks is a deeply unpopular policy, particularly when prices are rising, meaning that many politicians are hesitant to pursue such measures. Critics also point out that higher taxation will end up triggering a further increase in unemployment, destroying the economy even more.

Japan is often cited as an example. The country has run fiscal deficits for decades now, with mixed results. Critics regularly point out that continual deficit spending there has forced more people out of work and done little to boost GDP growth.