monetarism

monetarism An economic theory which is opposed to Keynesian demand management, as it holds that increases in the money supply always lead to inflation but never affect the level of employment. This is because a government can never know the equilibrium that is determined by the market alone, so that it will only realize that demand has been sufficiently increased once it has outstripped supply. In the short run, excess demand can only be met by higher prices, for which workers will seek compensation through higher wages. As a result, employers will not seek to increase output, so that the level of employment remains unaltered even though inflation has occurred. Crucially, monetarism assumes that the market is perfect. Any disequilibrium or economic crisis that occurs is the result of constraints imposed on the market from outside. Social benefits distort the market, for instance, if they raise the price of labour beyond its natural market rate. In a monetarist economy, all the government can do is to hold the money supply constant using the interest rate, and to eliminate market constraints. Then, assuming that all individuals have perfect information, the market will be in perfect equilibrium with no inflation and only a small, ‘natural’ rate of unemployment. By contrast, Keynesians argue that it is precisely because individuals do not always have perfect information about the economic consequences of their actions that distortions in the market occur.

Monetarism was developed by Milton Friedman and his colleagues at the University of Chicago starting in the 1950s, but it came to prominence only during the 1970s, when Keynesian methods of regulating the economy seemed unable to overcome the unprecedented price and unemployment levels caused by the oil price shocks of 1973 and 1979. Since then, most governments have accepted the control of inflation as a central economic objective, though they have been reluctant to carry out the more radical implications of monetarism such as the dismantling of the welfare state.

Keynesianism; Thatcherism