Monetarist

What is a Monetarist?

The term monetarist is used to refer to an economist who values the theory that the overall money supply plays a primary role in affecting the demand in an economy. Furthermore, a monetarist believes that the regulation of the money supply can impact the performance of an economy. The foundation of such a belief comes from the idea that the regulation of the money supply allows for the regulation and control of inflation.

Understanding Monetarism

Monetarism, which gained popularity during the 1970s and the 1980s, is a theory in macroeconomics that emphasizes the importance of controlling the sum of money in circulation. Monetarist hypothesis attests that disparities in the money supply cause notable short-term impacts on national output and significant long-term effects on price levels.

One fundamental aspect of monetarism is the equation of exchange. Monetarists believe that an increase in the money supply at a constant velocity will result either in an increase in the average prices of goods and services or an increase in the quantity of goods and services being produced.

Where:

• M – Money supply
• V – Money turnover velocity
• P – Average price levels
• Q – Total quantity of goods and services produced

Also, following the equation of exchange, an increase in price levels would mean that there may be no increase in the quantity of goods and services being produced. An increase in the quantity of goods and services being produced would indicate constant price levels. The equation of exchange reinforces the concept that changes in the money supply result in a direct long-term impact on price levels, production levels, and employment.

Furthermore, monetarists argue that in order to encourage economic growth and stability, governments should increase the money supply with a steady annual rate, which should be linked to the expected growth in the gross domestic product (GDP). The rate should be quoted as a percentage.

Constant growth in the money supply (in theory) would result in low inflation and steady economic growth. However, the theory was proven to be inaccurate during the 1980s, as developments in bank product offerings made it challenging for economists to calculate money supply, with savings being an important variable in its computation.

Understanding Money Supply and Interest Rates

The relationship between money supply and interest rates is a negative one.

An increase in the money supply would result in the lowering of interest rates. An expansion in the money supply means that there’s more money for banks to lend to consumers, thus enabling lower rates for borrowing. The low interest rates encourage consumers to borrow money to make asset purchases (land and buildings or motor vehicles) and other household goods.

Similarly, a decline in the money supply would result in higher interest rates. It increases the cost of borrowing for consumers and causes a decline in consumer spending, adversely affecting the economy.

The Role of the Federal Reserve and Other Central Banks

Central banks are able to regulate the money supply by making use of a repo rate (or a Federal Funds rate). The rate can be defined as the rate at which other banks (such as commercial banks) borrow money from the central bank. It affects all other interest rates.

Other monetary tools can include the reserve requirements set forth by the central banks, say, the Federal Reserve in the U.S. The reserve requirement provides an indication to banks on how much money they should keep in their reserves at the close of business each night.

The central banks can regulate inflation rates by either increasing or decreasing the rate at which it borrows from other banks. Making use of a contractionary monetary policy, the central bank can increase the rate, which results in higher interest rates, thereby decreasing the money supply.

In a careful attempt to not delve into a recession, central banks make use of expansionary monetary policy and decrease the repo rate (or the federal funds rate) to encourage an increase in the money supply.

Limitations of Monetarism

Because monetarism heavily emphasizes the importance of the money supply, it is important to note that money supply computations do not take financial assets, such as equity and stocks, into account. Individuals are likely to invest their money into instruments that are promising and offer possible returns. The money supply does not provide a measurement for such asset classifications.

A rise in the stock market encourages consumer spending because it makes people believe they’ve gained wealth. The increase in spending results in an increase in demand, which, in turn, encourages economic growth.

Related Readings

CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA®) certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Inflation Targeting
• Contractionary Monetary Policy
• Negative Interest Rate Policy (NIRP)
• Federal Funds Rate
• See all economics resources