Monetarism is a macroeconomic thought that emphasizes the role of money supply in the growth and stability of an economy. The monetarism theory implies that monetary policy, including the central bank’s position, is more effective for an economy than fiscal policy or government spending and taxation.
Monetarists believe that changes in money circulation create severe impacts on price levels and living standards. Milton Friedman promoted the concept in his book A Monetary History of the United States, 1867 -1960. He and Anna Schwartz argued that monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc. objectives are the best when targeting the money supply growth rate.
Table of contents
- Monetarism is a macroeconomic theory which states that a nation’s money supply plays a critical role in its economic growth and stability.
- The concept describes how monetary policy is more influential than a fiscal policy for stabilizing an economy and controlling inflation.
- According to the theory, by controlling the interest rates, one can control the amount at which individuals borrow and spend, subsequently affecting the money supply.
How Does Monetarism Theory Work?
The monetarism theory became popular in the 1970s when countries like the United States and the United Kingdom were suffering from the economic effects of inflationInflationThe rise in prices of goods and services is referred to as inflation. One of the measures of inflation is the consumer price index (CPI). Rate of inflation = (CPIx+1–CPIx )/CPIx. Where CPIx is the consumer price index of the initial year, CPIx+1 is the consumer price index of the following year.. The concept came about in criticism of the previously dominant macro-economic theory called Keynesian EconomicsKeynesian EconomicsKeynesian Economics is a theory that relates the total spending with inflation and output in an economy. It suggests that increasing government expenditure and reducing taxes will result in increased market demand and pull up the economy out of depression..
According to monetarism, the central banks are a more persuasive authority on the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society. than the government. The reason for this is that central banks control the money supply. The money supply in a country refers to the entire pool of currency in a given economy, such as cash, coins, and savings.
The market monetarism theory implies that changes in money supply directly affect other economic factors such as inflation and unemployment. When the money supply increases, aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices. increases since individuals now have more money to spend. When the money supply decreases, aggregate demand also decreases. Monetarist policies can reduce expectations of higher inflation that boosts demand for more wages.
Monetarism can work in two ways:
- And Expansionary
The monetarism concept works in theory when the central banks, or Federal Reserve (FED), control the money supply through interest rates. According to the idea, if the FED were to increase interest rates, the cost of borrowing would increase, resulting in people spending less and saving more. As people spend less, there will be less money supply in the economy. This is the contractionary policyContractionary PolicyContractionary monetary policy is the type of economic policy that is basically used to deal with inflation and it also involves minimizing the fund’s supply in order to bring an enhancement in the cost of borrowings which will ultimately lower the gross domestic product and moderate or decrease inflation too..
However, if the FED were to lower interest rates, people would be more willing to borrow and spend money. The additional spending can increase the total money supply in an economy and is an expansionary policyExpansionary PolicyExpansionary policy is an economic policy in which the government increases the money supply in the economy using budgetary tools. It is done by increasing the government spending, cutting the tax rate to increase disposable income etc..
One can observe many of monetarism’s concepts through the quantity theory of moneyQuantity Theory Of MoneyThe Quantity Theory of Money is an economic theory that defines the relationship between the money supply and the price of products. It states that an increase or decrease in the money supply will result in inflation or deflation, respectively. equation, which is:
Now you can Master Financial Modeling with Wallstreetmojo’s premium courses at special prices
Best Financial Modeling Courses by Wallstreetmojo
Financial Modeling Course
* 12+ Hours of Video
Financial Modeling & Valuation
* 25+ Hours of Video
* Certificate of Completion
* 12+ Hours of Video
Milton Friedman and Monetarism
Milton Friedman is an American economist who is primarily credited with the development and popularization of monetarism theory. Friedman and other economists began writing monetary theory in the 1950s. But it was not until 1967, when Friedman delivered a presidential address to the American Economic Association, that the idea came to light. His findings were published in 1968 as The Role of Monetary policy.
Friedman had several prominent ideas that eventually became known as “monetarism.” Some of the main ideas of Friedman monetarism includes:
- Monetary policy (central banks) is more important than fiscal policyFiscal PolicyFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. (government spending & taxation.)
- Opposition to government intervention. Permission of existence for free marketsFree MarketsA free market refers to an economic system free from government interventions and controlled by privately owned businesses..
- Keeping the money supply steady, increasing each year to match GDPGDPGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period..
- Controlling the money supply in an economy with interest rates. (Higher interest rates = less spending, Lower interest rates = higher spending.)
Friedman blamed the U.S government and the Federal Reserve (FED) for their role in the devastating Great DepressionGreat DepressionThe Great Depression refers to the long-standing financial crisis in the history of the modern world. It began in the United States on October 29, 1929, with the Wall Street Crash and lasted till 1939. that shook the U.S economy. He explained how the Federal Reserve did the exact opposite of what it should have done in the situation and thereby caused more havoc on the economy.
Instead of expanding the money supply, the FED had decided to raise interest rates in a move to protect the value of the U.S Dollar. According to the theory, increasing interest rates decreases the money supply, making it harder for individuals to borrow and boost spending in the economy.
In 2002, Federal Reserve Board of Governors member Ben Bernanke said that the FED’s mistakes led to the “worst economic disaster in American history.”
Both the United States and the United Kingdom have utilized and enacted Friedman’s Monetarism theory with somewhat mixed results.
For example, in the United States, monetarism was gaining popularity during the 1970s as the Federal Reserve took measures to control the money supply to help curb inflation and rising unemployment.
In 1979, Paul Volcker became the FED chief and took it upon himself to fight inflation and control what has been holding back the economy from growing. He took measures to control the money supply and provide stability to the economy. He did this by raising the federal funds rate to 20 percent in 1980.
Although these actions by the FED helped control inflation, they also led to higher unemployment levels. It was eventually responsible for a short recession in the economy that lasted until 1982. People began to blame the monetarism policies enacted by the FED, saying it was the cause of the recession.
As the money supply was rapidly increasing in the U.S and other parts of the world, it became a complex measurement to track as it was not merely savings accounts anymore. This made the macroeconomic theory harder to understand, and many people even claimed the idea can be proven otherwise.
Several prominent critics of the theory claim that monetarism simply doesn’t have enough evidence to back up the claims. Here are a few common problems people have with the monetarism theory:
- Any given economy is subject to periods of instability. Having a specific money supply target can be dangerous.
- After Paul Volcker gained control of the money supply and inflation in 1980, it led to a severe recession.
- When monetary policy changes are put in place, the effects are not typically immediate; it may take months or even years to observe some of their impacts on an economy.
- The money supply has changed over the years, which has had profound effects on the underlying theory.
- The monetarism model overestimates the link between money supply and inflation.
- Indirectly targeting inflation can encourage recession and increase unemployment.
Frequently Asked Questions (FAQs)
Monetarism is a macroeconomic theory that argues that controlling money circulation can increase the growth rate of an economy rather than focusing on fiscal policies or government taxation and spending.
Monetarism was introduced as a refusal for some key parts of the Keynesian economic model, which persisted before that. Unlike the Keynesian model that argued that a nation’s fiscal policies alone could stimulate its economy, monetarists rejected this idea stating that emphasis should be given to controlling money circulation. They believed that central banks could create more influence on the economy than government policies.
Over the years, monetarism started to get some criticisms, and many began to point out the problems with the monetarist way of thinking. Theoretically, monetarism presented many loopholes, while in the application, the model did not bring much solid evidence that could prove its effectiveness. For example, monetarism does not account for the plausible instabilities in the economic factors that can create unpredictable outputs that may solely prove the ineffectiveness of the theory.
This has been a guide to Monetarism and its definition. Here we discuss how Monetarism works along with an example and its problems. You may learn more about financing from the following articles –