How Milton Friedman’s Theory of Monetarism Works

A fundamental economic theory that focuses on the importance of the money supply as a key economic force

Written by CFI Team

What is Monetarism?

Monetarism

Monetarism (also referred to as “monetarist theory”) is a fundamental macroeconomic theory that focuses on the importance of the money supply as a main driver for economic growth. Subscribers to monetary economics 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.

Most central bankers prescribe to monetarist theory by using their key policy rate in an attempt to control money supply, thereby controlling inflation and economic growth. This is commonly referred to as monetary policy, as opposed to fiscal policy, which aims to target government taxes and/or control government spending.

Key Highlights

The monetarist theory, as popularized by Milton Friedman, asserts that money supply is the primary factor in determining inflation/deflation in an economy.
According to the theory, monetary policy is a much more effective tool than the fiscal policy for stimulating the economy or slowing down the rate of inflation.
Monetarism is the primary alternative macroeconomic theory to Keynesian economic theory; monetarists believe in extremely limited government economic intervention, while Keynesians argue for active government intervention.

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.

Milton Friedman

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 policies – 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.

K-Percent Rule

In his book with Schwartz, Friedman also proposes a rate of money growth called the K-percent rule, an idea that requires central banks to increase the money supply irrespective of the condition of the economy.

Friedman proposed that policy makers should boost the money circulating in the economy by a certain fixed percentage (“k” variable) every year for controlling inflation in the long term. The K-percent rule suggests fixing the growth rate of money supply at the growth rate of actual GDP.

This way, money growth is moderate so that businesses and consumers are able to anticipate changes to the money supply every year and plan accordingly. Thus, the economy will grow at a steady rate, and inflation will remain at low levels.

The Rise and Wane of Monetarism

Monetarism gained in import during the 1970s when the US experienced high and increasing inflation and slow economic growth. After inflation peaked at 20% in 1979, the Federal Reserve enacted a monetarist strategy in an effort to tamp down inflation. The government policy actions of the Federal Reserve and the Bank of England were responsible for bringing down inflation in the United States and the United Kingdom.

However, in the decades that followed, monetarism fell out of favor with many economists, as the relationship between money supply and inflation proved to be less direct than initially believed, as was evidenced in the failure of monetary economics in the late 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.

Nowadays, most central banks follow a policy of direct inflation targeting rather than adopting monetary targets.

How Does the Policy Rate Impact Monetary Policy?

The central bank of a country can expand or contract the money supply through the manipulation of interest rates, most commonly through their policy rate, and this relationship between money supply and interest rates is a negative one.

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

When the Federal 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 and the money supply increases, thus boosting spending and stimulating economic growth.

However, with increases in the money supply, this can also lead to higher inflation as the amount of money available increases while the amount of goods or services available in the economy remains the same. Hence, the nominal amount of money required to purchase a good or service should theoretically increase – the definition of 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, such as the Federal Reserve, as the central bank is usually the entity responsible for money creation in an economy by exercising direct control over policy rates to control credit flow and liquidity.

Is It Just Controlling Policy Rates?

Apart from directing controlling policy rates and impacting interest rates, central bankers can also steer monetary conditions by changing the amount of reserves that commercial banks must hold against deposits, the risk weightings against their assets, and lending and directly printing more or less money.

Central banks may also choose to buy securities in an attempt to reduce interest rates, increase the money supply and drive more lending to consumers and businesses, commonly called Quantitative Easing, or QE.

Expansionary Policy

Expansionary monetary policy is one wherein the central bank increases the money supply, most commonly by lowering interest rates, to promote credit availability and liquidity in an economy. It means that the cost of borrowing decreases, which enables people to borrow more and consequently spend more.

As rates are lower, investors are also less inclined to keep money in bank deposits or the bond markets, increasing the amount of riskier assets they purchase in order to maximize returns. This drives them into buying stocks and other risk assets, such as real estate.

Thus, expansionary policy increases the money supply and can stimulate the economy. However, proponents often cite easy monetarism as a risk of creating asset bubbles, such as we saw during Federal Reserve Bank Chairman Alan Greenspan’s time in office.

Contractionary Policy

Under the contractionary monetary policy regime, the central bank either maintains high levels or hikes interest rates in an economy, as well as purchasing 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, impacting economic growth by making lending more expensive, driving down asset prices, and helping combat inflation.

For example, in 2022-2023, the Open Market Committee of the Federal Reserve Bank hiked their Fed Funds Rate aggressively a total of 11 times from essentially 0% up to a range of 5.25%-5.5% in the span of less than 16 months in an effort to control rising inflation.

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 can be quite complex due to its expansion and refinement by recent economists, the basic equation is expressed as follows:

MV = PQ

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 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.

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 and the money supply, 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.