Monetarist Theory

What It Means

Monetarist theory, or monetarism, is an approach to economics that centers on the money supply (the amount of money in circulation, including not just coins and bills but also bank-account balances). The basic idea behind monetarist thinking is that the size of the money supply is more important than any other factor affecting the economy.

In the 1970s governments guided by the then-dominant school of economic thought, Keynesian economics (based on the writings of British economist John Maynard Keynes), were battling high inflation (the rising of prices across the economy that causes money to lose value) and conditions of economic stagnation. Monetarists, led by American economist Milton Friedman, maintained that the Keynesian approach was flawed and that inflation could be brought under control by restraining the growth of the money supply. Under the influence of monetarist theory, the United States’ central bank, the Federal Reserve System (commonly called the Fed), was successful at reining in inflation, and in the 1980s economists and government leaders accordingly embraced the school of thought in large numbers. But subsequent changes in the economy seemed to disprove an exclusive focus on the money supply, and the doctrine’s influence waned. Although monetarism remained influential into the twenty-first century, it was in a modified form that took other variables besides the money supply into consideration.

When Did It Begin

Monetarist theory arose in reaction to Keynesian theory, the mainstream school of economics in the United States from the 1930s to the 1970s, which was based on the ideas of the British economist John Maynard Keynes. Keynes had provided a blueprint for recovery from the Great Depression (the severe crisis affecting the world economy in the 1930s), suggesting that governments could stimulate their ailing economies by cutting taxes and spending money, even if they had to go into debt. The money they spent (on public projects and on aid to the poor, the unemployed, and the elderly, for instance) would put money in people’s pockets so that they would be able to buy the products they needed and wanted. This increased consumer demand would give companies an incentive to expand their operations and hire new workers, which would increase demand still further. The United States and other countries did, in fact, pursue such policies, and their recovery from the Depression seemed to validate Keynes’s theories. Keynesian economics continued to dominate in academia and government in the following decades, as governments generally attempted to promote economic stability through tax and spending policies.

The founder and most prominent proponent of monetarism, American economist Milton Friedman, emerged as an opponent of this approach in the 1950s. Friedman’s views were at first seen as extreme, but they began to gain the attention of prominent economists with the publication of A Monetary History of the United States 1867-1960 (1963). In this book Friedman and coauthor Anna J. Schwartz analyzed the role of the money supply in U.S. history, arguing that it was the most important factor in the country’s economic fluctuations. Friedman further believed that Keynesian attempts to fine-tune the economy through tax and spending policy did more harm than good. He believed that governments could play a role in stabilizing the economy but that the only effective tool they had for doing so was monetary policy (control over the money supply). Friedman predicted that Keynesian economic policies could eventually lead to an unprecedented situation in which inflation (the general rising of prices, which causes money to lose value) and unemployment (the percentage of people who want to work but cannot find jobs) could both rise at the same time. When this phenomena, which became known as stagflation (a combination of economic stagnation and inflation), occurred during the 1970s, economists and government leaders turned away from Keynesianism and toward Friedman and monetarist theory.

More Detailed Information

The theoretical basis for monetarism is a mathematical equation known as the equation of exchange: MV=PQ. M, in this equation, represents the money supply, and V represents the velocity of money, or the rate at which the basic unit of currency (such as a dollar) changes hands. P stands for the level of prices in the economy, and Q for the quantity of goods and services in the economy. In other words, the left side of the equation accounts for all of the money circulating in the economy and for the speed at which it is circulating, and the right side of the equation accounts for the entire output of the economy (the price of all goods and services multiplied by the quantity of those goods and services).

Monetarists use this equation to argue that as M increases (if V remains constant), then either P or Q will increase. It follows, then, that the size of the money supply has a direct relationship to both prices and production and also to employment, since the number of people who have jobs will vary according to how much companies are producing and how much money they can charge for the items they are producing.

P, or prices, is a particularly important factor, since inflation poses one of the most persistent threats to any economy. Though inflation is a natural part of the economy, if it gets out of hand, the level of wages that people bring in will be insufficient to pay for their needs and wants, and they will be likely to demand higher wages. This can force inflation still higher (since companies will likely compensate for the increased wages they are paying workers by raising the prices of their goods) without solving the basic problem, and the devaluation of money continues.

According to monetarist theory, inflation is always caused by there being too much money in circulation. Money, like other products for sale in the economy, is subject to the forces of supply and demand. When there is too much money in circulation, the demand for money is low, and it loses value. When there is not enough money in circulation, the demand for money is high, and it gains value.

Monetarists believe that if a government’s central bank can keep the supply and demand for money balanced, then inflation can be controlled. A central bank could theoretically do this by setting a strict rate of increase in the size of the money supply relative to Gross Domestic Product (GDP), a figure that represents the total value of all the goods and services produced in the economy. In other words, as the amount and value of the products generated by the economy increases, the money supply should increase proportionately. If this happens, then inflation will remain low.

Monetarists argue that whereas the effect of the money supply on the economy is direct and verifiable, the effects of fiscal policy (government spending and tax programs) are much less controllable. Monetary policy can reliably be counted on to have specific economic effects, but fiscal policy is inefficient, and it creates more problems than solutions. Monetarists argued, therefore, that governments should stop trying to manage the economy through fiscal policy and adopt, instead, a strictly monetary approach.

Recent Trends

After the onset of stagflation, which Friedman had predicted, U.S. government leaders turned increasingly to monetarist theory. In 1979 President Jimmy Carter nominated a monetarist, Paul Volcker, as chairman of the Fed, and Volcker made it his mission to battle inflation by decreasing the size of the money supply. Between 1981 and 1983 the reduction in the money supply, coupled with falling oil prices, led to the rate of inflation dropping from 13.5 percent to 3.2 percent. It remained low through the early twenty-first century under Volcker’s successor, Alan Greenspan, who was also a proponent of monetarist theory.

Monetarism was most completely embraced during the administration of President Ronald Reagan (1981-89). Changes in the economy during the 1980s seemed to disprove monetarist theory, however. After inflation had been cut so drastically, people were slower to spend money. (When money is losing value quickly due to high inflation, people want to spend it quickly so as to get the maximum value for their dollars; when money maintains its value, this urge is muted.) Therefore, the velocity of money (V in the equation of exchange, the speed with which the average dollar changes hands) decreased greatly, diminishing the effects of increasing the money supply. Also, new forms of bank accounts made it harder to calculate the money supply (the money supply consists not just of coins and bills but also of bank-account balances). Together, these developments pointed out the shortcomings in a strict monetarist focus. Nevertheless, the Federal Reserve and other central banks continued, into the twenty-first century, to follow modified forms of monetarism when it came to making decisions about the money supply.