Monetarism

QUANTITY THEORY OF MONEY

FISCAL AND MONETARY POLICY

LATE TWENTIETH-CENTURY EMPIRICAL EVIDENCE ON MONETARISM

BIBLIOGRAPHY

Monetarism is an economic school of thought that emphasizes minimal government intervention into the marketplace and the importance of the money supply in explaining economic fluctuations. Modern-day monetarism, as advanced by the American economist Milton Friedman in the late 1940s and 1950s, was presented as a theoretical challenge to the emerging Keynesian paradigm that began to gain popularity in the aftermath of the Great Depression and World War II. Keynesians viewed the Great Depression as evidence that the prevailing classical school of thought in which all unemployment was voluntary and markets self-correct was considered seriously flawed. With the unemployment rate in the United States reaching a peak of 25 percent during the Great Depression, it became painfully obvious there was insufficient demand and involuntary unemployment was an issue for policymakers to address. Upon the recommendation of the English economist John Maynard Keynes in 1936, the Roosevelt administration undertook an aggressive expansionary fiscal policy approach in the implementation of the New Deal programs to promote spending in the United States. While Keynesians viewed the decline in consumption and investment as the cause of the Great Depression, Friedman thought it could be attributed to the Federal Reserve’s inability to provide enough liquidity to the economy. Rather than restrict the money supply, the Federal Reserve should have increased the money supply especially given the deflationary environment.

In light of the Keynesian focus on the role of fiscal policy to remedy insufficient demand in the private sector, monetarism reestablished the importance of the quantity theory in explaining economic fluctuations. The monetarist position rests on several fundamental propositions with respect to the role of money and economic activity. First, the money supply is the most important factor in the determination of nominal income. In particular, changes in the money supply cause changes in nominal income whereby the money supply is determined largely by the central bank. Second, in the long run changes in the money supply only influence the price level and nominal variables whereas real variables are determined by labor, capital, and the level of technology with the economy operating at or near full employment output. Third, contrary to the long run impact of the money supply, changes in the money supply can influence real variables in the short run. Fourth, monetarists view the economy as relatively stable with government policies destabilizing the economy rather than stabilizing it.

QUANTITY THEORY OF MONEY

The quantity theory of money provides the theoretical underpinnings for the proposition that the money supply is the most important factor in the determination of nominal income. The basis of the monetarist approach begins with the equation of exchange M × V = P × Y, where M is the money supply, V is velocity of money (the turnover rate of the money supply), P is the price level, and Y is real output. As it stands, the equation of exchange is an identity; however, monetarists assume that velocity is stable in the short run and if this assumption is taken to the extreme fixed (stable) as well.

Hence, the equation of exchange is transformed to the quantity theory of money as follows: M × V̄ = P × Y, where V̄ denotes velocity as fixed. The above equation states that changes in the money supply will affect nominal income, P × Y. Moreover, monetarists would contend that changes in the money supply cause changes in nominal income.

With respect to the long run consequences associated with changes in the money supply, monetarists believe that the economy is always operating near or at full employment determined by the markets for labor, capital, and technology. Indeed, if the economy is operating at its potential, the quantity theory of money in the long run can be stated as follows: M × V̄ = P × Y_P, where Y_Pdenotes potential real output. Thus, the long run changes in the money supply will only affect the price level.

While the changes in the money supply will only affect the price level in the long run, changes in the money supply in the short run can have real effects. Monetarists assert that in the short run, changes in the money supply can influence real variables such as output and employment. The rationale stems from the rigidities in prices and wages. Prices and wages may not fully adjust in the short run due to the presence of wage and price controls, implicit contracting, and the degree of unionization. Therefore, changes in the money supply will affect both prices and real output in the short run.

FISCAL AND MONETARY POLICY

Unlike the Keynesian position that the private sector is inherently unstable, monetarists view the private sector as inherently stable. Well functioning markets in the private sector serve as a stabilizer, self-adjusting in response to the instability created by the destabilizing forces associated with government intervention. The instability generated by government intervention could be the result of discretionary monetary policy actions, wage and price controls, or excessive bureaucratic costs and social programs, in which the price mechanism in the allocation of resources is disrupted. Thus, unlike the Keynesian view, monetarists do not look upon fiscal policy as a viable stabilizing force in the economy.

Contrary to the Keynesian view that both discretionary monetary and fiscal policies are useful in stabilizing the economy, the policy recommendations advocated by monetarists are rules oriented with minimal government interference. First, because monetarists believe that the money supply is the main factor in explaining nominal output in the short run and the price level in the long run, monetarists argue that monetary authorities should follow a rules oriented policy approach rather than a discretionary policy approach. This policy stance stems from the monetarist assertion that the economy is inherently stable, always adjusting toward full employment, and that discretionary monetary policy actions by the central bank will often times destabilize the economy. The money growth rate rule would have the central bank target the growth rate of money to equal the growth rate of real output. This rules oriented policy would ensure that the money supply would grow at the rate of real output and prevent inflationary pressures in the economy. With respect to fiscal policy, monetarists do not advocate government intervention in the marketplace, trusting instead the functioning of free markets and the operation of automatic stabilizers within the economy to minimize the impact of spending shocks on the economy.

LATE TWENTIETH-CENTURY EMPIRICAL EVIDENCE ON MONETARISM

The empirical support for the monetarist position has been rather mixed. In an attempt to control the accelerating inflation rate throughout the 1970s, the Federal Reserve embarked on what some economists called the “monetarist experiment” in targeting money growth from 1979 to 1982 under Federal Reserve chairman Paul Volcker. However, during the 1980s and into the 1990s the velocity of money became unstable. The instability in velocity severed the relationship between the money supply and nominal income. This instability was largely attributed to the deregulation of the banking industry and the increase in financial innovations, which induced instability in the demand for money. The stability of velocity was the cornerstone to monetarism’s reliance on the quantity theory to argue that changes in the money supply explain movements in nominal output in the short run and the price level in the long run. Once the stability of velocity came into question, the monetarist paradigm also came under greater scrutiny.

Though monetarism has not regained its popularity, the monetarist view that the money supply is an important factor in explaining economic fluctuations has had an impact on the economics discipline. Rapid money growth beyond what is sustainable at full employment will lead to price instability and inflation. This observation is substantiated, for example, by the hyperinflation episodes in several European countries in the 1920s and the ongoing battle with inflation in several Latin American countries.

SEE ALSO Banking; Economics, New Classical; Expectations; Expectations, Rational; Friedman, Milton; Inflation; Interest Rates; Money; Phillips Curve; Policy, Monetary

BIBLIOGRAPHY

Edwards, Sebastian. 1995. Crisis and Economic Reform in Latin America. New York: Oxford University Press.

Friedman, Milton. 1948. A Monetary and Fiscal Framework for Economic Stability. American Economic Review 38: 245–264.

Friedman, Milton. 1956. The Quantity Theory of Money: A Restatement. In Studies in the Quantity Theory of Money, ed. Milton Friedman. Chicago: University of Chicago Press.

Friedman, Milton. 1968. The Role of Monetary Policy. American Economic Review 58: 1–17.

Friedman, Milton, and Anna J. Schwartz. 1963. A Monetary History of the United States, 1867–1960. Princeton, NJ: Princeton University Press.

Hicks, James. 1937. Mr. Keynes and the Classics: A Suggested Interpretation. Econometrica 5: 147–159.

Judd, John P., and John L. Scadding. 1982. The Search for a Stable Money Demand Function: A Survey of the Post-1973 Literature. Journal of Economic Literature 20: 993–1023.

Keynes, John M. 1936. A General Theory of Income and Employment, Interest, and Money. Cambridge, U.K.: Cambridge University Press.

Sargent, Thomas J. 1982. The Ends of Four Big Inflations. In Inflation: Causes and Effects, ed. Robert E. Hall. Chicago: University of Chicago Press.

James E. Payne

Monetarism. The economic theory known as monetarism holds that the money stock exerts an important influence on economic activity and prices. Economists who embrace monetarism hold that changes in the quantity of money are crucial in increasing aggregate income and productivity in the short run, and the inflation rate in the long run. The University of Chicago economist Milton Friedman (1912–) was the most prominent twentieth‐century proponent of monetarism, but the theory's intellectual origins extend back more than two centuries to the quantity theory of money of classical economics. According to such theories, changes in the money stock or the velocity of the circulation of money (the ratio of total spending to the money stock) determine nominal spending. Because velocity changes less over the longer run than the total money stock, the effects of the latter dominate.

Friedman and Anna Schwartz offered important empirical support for monetarism in A Monetary History of the United States, 1867–1960 (1963). They showed that since the Civil War, fluctuations in the rate of monetary growth led the peaks and troughs of all U.S. business cycles. Moreover, they associated especially severe economic downturns, such as 1929–1933, with large monetary contractions. While money powerfully affected the economy in the short run, its long‐term effect was less predictable. This fact underlies another precept of monetarism: Rather than actively using monetary policy to smooth business cycles, as Keynesians advocate, the monetary authority (in the United States, the Federal Reserve System) should adhere to a fixed rule such as maintaining a constant rate of growth of the money supply.

While changes in the money supply may affect the physical volume of output in the short run, over the long run nonmonetary factors determine economic growth. Monetary changes primarily affect the price level. Hence, monetarists argue, inflation or deflation are directly related to the rate of growth of the money supply.
See also Banking and Finance; Depressions, Economic; Economic Development; Keynesianism; Monetary Policy, Federal.

Bibliography

Milton Friedman , A Program for Monetary Stability, 1960.
Neil DeMarachi and and Abraham Hirsch , Milton Friedman: Economics in Theory and Practice, 1990.

John A. James

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

monetarism An economic theory which posits that the whole economy of a country can be managed through control of the money supply, that is, money in circulation or the cost of credit. The main policy levers are central bank operations to put more or less money in circulation; interest-rates, which are raised and lowered to discourage or encourage credit purchases and bank loans; and direct government control over the volume of lending by banks and other financial institutions. Economists disagree as to the relative effectiveness of monetarist policies—as compared, for example, with fiscal policy—in regulating the level of economic activity. They also differ as to the priority to be given to the cost of credit, credit controls, and the quantity of money in circulation, as the focus of monetarist policies.

monetarism A school of economics that emerged mainly in the 1960s and 1970s, with US economist Milton Friedman (1912– ) as its leading exponent. It is a revival of the classical (pre-Keynesian) approach to macroeconomics. Monetarist models assume that money, prices, and wages are flexible but that aggregate output and employment will automatically tend towards an optimal equilibrium. Therefore government policy should concentrate on achieving and maintaining the stability of the price level, which monetarists believe depends on proper management of the money supply mainly through monetary rather than fiscal policy.

monetarism Economic and monetary theory that argues changes in monetary stability are the principal causes of changes in the economy. It asserts the importance of controlling the money supply as the means of achieving a non-inflationary, stable economy capable of supporting high employment and economic growth. This theory is associated particularly with the theories advanced by Milton Friedman in the 1950s and 1960s. Monetarism exerted great influence on government policy in the UK and the USA during the 1980s.

monetarism economic theory that monetary policy, or control of the money supply, is the primary if not sole determinant of a nation's economy. Monetarists believe that management of the money supply to produce credit ease or restraint is the chief factor influencing inflation or deflation, recession (see depression ) or growth; they dismiss fiscal policy (government spending and taxation) as ineffective in regulating economic performance. Milton Friedman was the leading modern proponent for monetarism.

mon·e·ta·rism / ˈmänitəˌrizəm; ˈmən-/ • n. the theory or practice of controlling the supply of money as the chief method of stabilizing the economy. DERIVATIVES: mon·e·ta·rist n. & adj.