Monetarism

What is Monetarism?

The term monetarism refers to a macro-economic concept, according to which government intervention in the economy in the form of the management of money supply is key to economic stability. The premise of monetarism lies in the idea that the total amount of money in circulation in an economy determines the rate of economic growth of that economy. In the long term, however, demand outgrows supply, which causes disequilibrium in the price markets and hence leads to inflation.

What is Monetary Policy?

The most important economic tool under the regime of monetarist economics is monetary policy. It is controlled by the central banks of a sovereign country. The central bank is the entity responsible for money creation in an economy.

Also, it increases the money supply in an economy by purchasing government bonds, and vice versa. It also exercises direct control over interest rates in the economy, which enables it to control credit flow and liquidity.

1. Expansionary Monetary Policy

Expansionary monetary policy is one wherein the central bank lowers interest rates to promote credit availability in an economy. It means that the cost of borrowing decreases, which enables people to borrow more and consequently spend more. Thus, increasing the money supply can stimulate the economy.

2. Contractionary Monetary Policy

Under the contractionary monetary policy regime, the central bank maintains high levels of interest rates in an economy and purchases little to no amounts of government debt. Thus, it drives up the cost of credit, which disincentivizes borrowing and, consequently, spending.

Thus, a contractionary monetary policy decreases the money supply in the economy, drives down asset prices, and helps combat inflation. Also, it can negatively impact economic growth.

Quantity Theory of Money

American economist Milton Friedman is considered to be the pioneer of the school of economics called monetarism. Other proponents of the theory include Alan Walters, Allan Meltzer, Anna Schwartz, David Laidler, Karl Brunner, and Michael Parkin. They used the Quantity Theory of Money to conclude that the manner in which a government can allow the natural growth of an economy is by keeping the money supply fairly steady.

The supply can be gradually increased every year, thus allowing for economic growth. A focus on the growth rate of the money supply is considered necessary in order to combat inflation triggered by excessive expansion.

According to the theory, the level of expenditures in an economy can be achieved by multiplying the money supply with the rate at which overall money is spent in the economy per year. Thus, MV = PQ.

Here, (M) denotes the money supply, (V) denotes the rate at which money changes hands (also known as the velocity of money), (P) is the average price of a good or service, while (Q) denotes the total quantity of goods and services sold.

Thus, M is considered to be in the independent variable under the control of the central banks. It means that any changes in the money supply affect the whole equation. V is considered to be constant, and thus, M is directly proportional to inflation and production. It means that an increase in the money supply leads to an increase in either the prices or the quantity of goods and services produced in an economy.

If P increases, Q will be relatively constant, and if Q increases, P is more or less constant. Thus, a change in the money supply impacts prices, production levels, and employment levels, which makes it the primary driver of economic growth.

The Failure of Monetarism

However, the connection link between money supply and price levels seems to have been overestimated, as was proved in the failure of monetary economics in the last 1970s and early 1980s. Also known as the Federal Reserve’s Monetarist Experiment, the monetary tightening was not able to curb short-term inflation during this period.

There was also a growing skepticism regarding the actual stability of money demand. Many believed that money demand was pretty volatile, even on a quarterly level. Since a significant time lag is observed in the actual effects of monetary policy changes, monetarism started losing credibility.

Currently, most central banks stick to inflation targeting rather than adopting monetary targets.

Additional Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Aggregate Supply and Demand
• Monetary Base
• Quantity Theory of Money
• Inflation Targeting
• See all economics resources