Monetarism

The monetarist theory states that variations in the money supply have major influences on national output in the short run and on price levels over longer periods. Monetarists assert that the objectives of monetary policy are best met by targeting the growth rate of the money supply rather than by engaging in discretionary monetary policy.

Monetarism is mainly associated with the work of Milton Friedman, who was an influential opponent of Keynesian economics, criticising Keynes's theory of fighting economic downturns using fiscal policy (e.g. government spending). Friedman and Anna Schwartz wrote an influential book, A Monetary History of the United States, 1867–1960, and argued that inflation is "always and everywhere a monetary phenomenon".

Although opposed to the existence of the Federal Reserve, Friedman advocated, given its existence, a central bank policy aimed at keeping the growth of the money supply at a rate commensurate with the growth in productivity and demand for goods. Money growth targeting was mostly abandoned by the central banks who tried it, however. Central banks struggled to identify stable relationships between traditional monetary aggregates and inflation, though some researchers argue that theoretically grounded measures like Divisia aggregates may reveal more consistent patterns. Starting in the early 1990s, most major central banks turned to direct inflation targeting, relying on steering short-run interest rates as their main policy instrument.

Important monetarist views were integrated into the new neoclassical synthesis which appeared in macroeconomics around 2000.

Description

Monetarism is an economic theory that focuses on the macroeconomic effects of the supply of money and central banking. Formulated by Milton Friedman, it argues that excessive expansion of the money supply is inherently inflationary, and that monetary authorities should focus solely on maintaining price stability.

Monetarist theory draws its roots from the quantity theory of money, a centuries-old economic theory which had been put forward by various economists, among them Irving Fisher and Alfred Marshall, before Friedman restated it in 1956.

Monetary history of the United States

Monetarists argued that central banks sometimes caused major unexpected fluctuations in the money supply. Friedman asserted that actively trying to stabilize demand through monetary policy changes can have negative unintended consequences. In part he based this view on the historical analysis of monetary policy, A Monetary History of the United States, 1867–1960, which he coauthored with Anna Schwartz in 1963. The book attributed inflation to excess money supply generated by a central bank. It attributed deflationary spirals to the reverse effect of a failure of a central bank to support the money supply during a liquidity crunch. In particular, the authors argued that the Great Depression of the 1930s was caused by a massive contraction of the money supply (they deemed it "the Great Contraction"), and not by the lack of investment that Keynes had argued. They also maintained that post-war inflation was caused by an over-expansion of the money supply. They made famous the assertion of monetarism that "inflation is always and everywhere a monetary phenomenon."

Fixed monetary rule

Friedman proposed a fixed monetary rule, called Friedman's k-percent rule, where the money supply would be automatically increased by a fixed percentage per year. The rate should equal the growth rate of real GDP, leaving the price level unchanged. For instance, if the economy is expected to grow at 2 percent in a given year, the Fed should allow the money supply to increase by 2 percent. Because discretionary monetary policy would be as likely to destabilise as to stabilise the economy, Friedman advocated that the Fed be bound to fixed rules in conducting its policy.

However, the effectiveness of such monetary rules may depend critically on how money is measured and incorporated into macroeconomic models. Traditional simple-sum monetary aggregates, which treat all monetary assets as perfect substitutes, may provide misleading signals for monetary policy, particularly during periods of financial innovation. Studies using theoretically-grounded Divisia monetary aggregates have found more stable relationships between money growth, inflation expectations, and economic activity, suggesting that properly measured money can provide clearer guidance for monetary policy implementation. Moreover, incorporating money into forward-looking macroeconomic models with proper measurement can enhance the transmission mechanism of monetary policy and improve the effectiveness of rules-based approaches.

Opposition to the gold standard

Most monetarists oppose the gold standard. Friedman viewed a pure gold standard as impractical. For example, whereas one of the benefits of the gold standard is that the intrinsic limitations to the growth of the money supply by the use of gold would prevent inflation, if the growth of population or increase in trade outpaces the money supply, there would be no way to counteract deflation and reduced liquidity (and any attendant recession) except for the mining of more gold. But he also admitted that if a government was willing to surrender control over its monetary policy and not to interfere with economic activities, a gold-based economy would be possible.