Monetarist Theory

What is the Monetarist Theory?

The monetarist theory (also referred to as “monetarism”) is a fundamental macroeconomic theory that focuses on the importance of the money supply as a key economic force. Subscribers to the theory believe that money supply is a primary determinant of price levels and inflation.

Increasing money supply, according to the theory, inevitably leads to higher prices and inflation, while decreasing the money supply leads to deflation and risks, causing a recession.

Changes in the money supply also affect employment and production levels, but the monetarist theory asserts that those effects are only temporary, while the effect on inflation is more long-lasting and significant.

History of the Monetarist Theory

While economist Clark Warburton initially posited much of the monetarist theory immediately following World War II, Milton Friedman is recognized as the primary advocate of modern-day monetarism. The monetarist theory was expounded by Friedman in a book he co-wrote with Anna Schwartz, “A Monetary History of the United States, 1867–1960,” and in a 1967 speech at the American Economic Association.

Interestingly, while the monetarist theory is essentially a guide for central bank policies, Friedman was opposed to the whole idea of central banks, such as the Federal Reserve Bank in the United States.

In fact, Friedman blamed much of the Great Depression of the 1930s on the Federal Reserve, arguing that the Fed tightened the money supply at the very moment that it should have been expanding it to stimulate economic growth.

Given that central banks do exist, Friedman argued that monetary policy – the expansion or contraction of the money supply – is a much more effective tool for influencing the economy than fiscal policy – the government’s taxation and spending activities.

How Money Supply Affects the Economy

The central bank of a country can expand or contract the money supply through the manipulation of interest rates.

For example, in the United States, the Federal Reserve can change the Fed Funds Rate – the interest rate at which banks can lend money overnight to other banks. The Fed funds rate affects all other interest rates in the economy.

When the Fed funds rate is higher, interest rates increase overall. It decreases the amount of money lent to businesses and consumers, thus reducing spending and economic growth. Conversely, lowering interest rates increases borrowing by consumers and businesses, thus boosting spending and stimulating economic growth.

The Underlying Equation

There is an underlying equation that forms the foundation of the monetarist theory. It is known as the “equation of exchange” (also referred to as the “quantity theory of money”). Although the equation’s become quite complex due to its expansion and refinement by recent economists, the basic equation is expressed as follows:

Where:

• M is the money supply
• V is the velocity of money (the rate of turnover at which a single unit of currency – e.g., one dollar – is spent in one year)
• P is the average price level for transactions in the economy (the purchase of goods and services)
• Q is the total quantity of goods and services produced – i.e., economic output or production

According to the monetarist theory, V (the velocity of money) remains relatively stable. Therefore, it changes M (the money supply) that primarily affects prices and economic production.

Monetarism – Main Points

There are several main points that the monetarist theory derives from the equation of exchange:

• An increase in the money supply will lead to overall price increases in the economy.
• Increased money supply will result in only short-term effects on economic output (i.e., Gross Domestic Product – GDP) and employment levels.
• The best monetary policy for a central bank to follow is to peg the money supply’s growth rate to match the rate of growth of real GDP – it is the best policy to support continuing economic growth and keep the rate of inflation relatively low.

The last point is the key to the monetarist theory. Monetarist economists believe that the central bank’s manipulation of the money supply should be restricted. They believe that a central bank that more actively attempts to change the money supply is more likely to harm the economy than to benefit it.

However, this contention may be heavily tied to the monetarists’ basic distrust of central banks as an institution. The idea runs counter to the Keynesian Economic Theory, which favors active, unrestricted intervention by the central bank.

Monetarist Theory vs. Keynesian Economics

Monetarism, as espoused by Friedman, stands in contrast to the Keynesian Economic Theory, which rose to popularity in the 1930s. While monetarism focuses on monetary policy, Keynesian theory concentrates on fiscal policy.

Friedman argued that the errant monetary policy of the Federal Reserve was a primary cause of the Great Depression. Keynes believed that the fiscal policy of the government – increasing government spending – is the key factor in stimulating an economy that is in a recession.

Overall, Keynesian economists believe in active central bank and government intervention in the economy, while monetarists – such as Friedman – believe that free markets self-adjust in terms of prices and employment to provide the maximum benefit to the economy.

Monetarists are opposed to government intervention in the economy except on a very limited basis (believing that it typically does more harm than good), while Keynesian economists see the government and the central bank as primary drivers of economic well-being.

More Resources

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Neoclassical Economics
• Supply and Demand
• Macroeconomic Factor
• Recession
• See all economics resources