Monetarism is an economic theory which focuses on the macroeconomic effects of a nation’s money supply and its central banking institution. It focuses on the supply and demand for money as the primary means by which economic activity is regulated. Formulated by Milton Friedman, it argued that excessive expansion of the money supply will inherently lead to price inflation, and that monetary authorities should focus solely on maintaining price stability to maintain general economic health. Monetarism proposes that the growth of the money supply should be regulated to increase parallel to the potential growth of the Gross Domestic Product (GDP), and that this will stabilize prices, ensuring healthy economic growth with low inflation. Most followers of monetarism believe that government action is at the root of inflation, and view the former United States gold standard as highly impractical. While monetarism provided a foil to the previously Keynesian approach, by arguing that "money matters," it became apparent that controlling the money supply was not enough for economic health. The economic system of human society can be likened to a human body that has suffered ill-health, including the collapse of several banking systems, currencies, with out-of-control inflation, and catastrophic depressions. As humankind develops greater maturity, learning to live for the sake of others not exploiting or harming them, and a peaceful world of harmony and co-prosperity is established, our understanding of the factors that are essential to economic health will become clearer. The development of the monetarist approach can be seen as an important step in that process, although not the final one.
The monetarist theory draws its roots from two almost diametrically opposed ideas: the hard money policies which dominated monetary theory in the late nineteenth century, and the theories of economist John Maynard Keynes, who proposed a demand-driven model for determining the national money supply which would later prove the basis of macroeconomics. Keynes, who theorized economic panic to stem from an insufficient national money supply leading the nation toward an alternate currency followed by eventual economic collapse, focused his theories on the value of currency stability to maintain national economic health. Milton Friedman, in contrast, focused on price stability to ensure economic health and sought a stable equilibrium between the supply of and the demand for money to bring about such well-being.
The result of Friedman’s monetary analysis was summarized in his Monetary History of the United States 1867 - 1960 (Friedman and Schwartz 1971), which attributed inflation to a supply of money that exceeded its demand, a situation generated by the central bank. Friedman also attributed deflationary spirals to the reverse effect: the limiting of the money supply by the central bank to a level that falls short of national money demand during a critical liquidity crunch.
Friedman argued that "inflation is always and everywhere a monetary phenomenon” and advocated a central bank policy aimed at keeping the supply and demand for money at an economic equilibrium, as measured by a balanced growth in productivity and demand. Friedman originally proposed a fixed "monetary rule," where the money supply would be calculated by known macroeconomic and financial factors and would target a specific level or range of inflation. There would be no leeway for the central reserve bank, and businesses could anticipate all monetary policy decisions.
Within his Monetary History, Friedman restated the quantity theory of money, and argued that the demand for money depended predictably on several major economic variables. He claimed that if the money supply were to be expanded, consumers would not seek to hold the extra money in idle money balances. This argument follows that consumers, assumed to be in equilibrium before the money supply increase, already held money balances that suited their requirements. With the increase, consumers would have a surplus of money balances that exceeded their requirements. These excess money balances would therefore be spent and cause an increase in aggregate demand levels. Similarly, if the money supply experienced a reduction, consumers would aim to replenish their holdings of money by reducing their spending levels. In this argument, Friedman challenged the Keynesian assertion that the money supply was ineffectual in analyzing aggregate consumption levels. In contrast, Friedman argued that the supply of money does indeed affect the amount of spending in an economy; in doing so the term "monetarist" was coined.
Monetarist theory regards a nation’s economic growth as fostered by changes in its money supply. Therefore, any and all changes within a set economic system, such as a change in interest rates, are believed to be a direct result of changes in the money supply. Monetarist policy, which is enacted to regulate and promote growth within a nation’s economy, ultimately seeks to increase a nation’s domestic money supply moderately and steadily over time.
The popularity of monetarism in political circles increased as Keynesian economics seemed unable to explain or cure the seemingly contradictory problems of rising unemployment and price inflation which erupted after the collapse of the Bretton Woods system gold standard in 1972 and the oil crisis shocks of 1973. Though higher unemployment levels seemed to call for Keynesian inflationary policy, rising inflation levels seemed to call for Keynesian deflation. The result was a significant disillusionment with Keynesian demand management. In response, Democratic President Jimmy Carter appointed as Federal Reserve chief Paul Volcker, a follower of the monetarist school. Volcker sought as a primary objective to reduce inflation, and consequently restricted the money supply to tame high levels of economic inflation. The result was the most severe recession of the post-war period, but also the accomplishment of the desired price stability.
Followers of the Monetarism school not only sought to explain contemporary problems but also interpret historical ones. Within A Monetary History Milton Friedman and Anna Schwartz argued that the Great Depression of 1930 was caused by a massive contraction of the money supply and not by a dearth of investment as argued by Keynes. They also maintained that post-war inflation was caused by an over-expansion of the money supply. For many economists whose perceptions had been formed by Keynesian ideas, it seemed that the Keynesian-Monetarism debate was merely about whether fiscal or monetary policy was the more effective tool of demand management. By the mid-1970s, however, the debate had moved on to more profound matters, as monetarists presented a more fundamental challenge to Keynesian orthodoxy in seeking to revive the pre-Keynesian idea that the economy was of an inherently self-regulating nature.
Many monetarists resurrected the former view that market economies prove inherently stable in the absence of major unexpected fluctuations in the money supply. This belief in the stability of free-market economies also asserted that active demand management, in particular fiscal policy, is unnecessary and in fact likely to be economically harmful. The basis of this argument centered around an equilibrium formed between "stimulus" fiscal spending and future interest rates. In effect, Friedman's model argued that current fiscal spending creates as much of a drag on the economy by increasing interest rates as it does to create consumption. According to monetarists, fiscal policy was shown to have no real effect on total demand, but merely shifted demand from the investment sector to the consumer sector.
Friedman’s monetarism is based on various analyzes of fundamental economic elements that include varying levels of aggregate demand, controversial theories of price inflation, and contrasting variants of money demand. However, no element proved as controversial as his analysis of the quantity theory of money, or the "equation of exchange."
This equation, originating in the seventeenth century, puts forth a relationship between the quantity of money within an economy and the price level, and was often adhered to by classical economists. Milton Friedman, in expanding several theoretical elements of this equation in the mid-twentieth century, shaped the central elements of the monetarist school of economic thought.
The equation of exchange is delineated as
In analyzing the quantity theory of money, Friedman defined the "velocity of money" as a constant variable, thus eliminating its role in cataclysmic economic events, like the Great Depression of the early 1930s. In this way the monetarist model, as defined by Friedman, eliminated the velocity circulation of money as a variable contributing to economic health or periods of instability. Friedman defined the variable as “the average number of times that the money stock is used for making income transactions.” According to Friedman, if is to be held constant then the quantity of money, or , is shown to directly control levels of price and quantity which constitute the level of national income. Therefore, if the quantity of money is managed appropriately by the central bank, inflationary pressures can be eliminated. Recognizing the growth of the national economy to range between 2.5 percent and 3.0 percent per year, Friedman put forth that similar annual increases in the supply of money, or , would produce an economy of general stability.
Dominant economic theories often seek to explain and/or rectify major cataclysmic events that have proved to reshape economic activity. Hence, economic theories which aspire to a policy role often seek to explain the great deflationary waves of the late nineteenth century and their repeated panics, the Great Depression of the 1930s, and the stagflation period beginning with the uncoupling of exchange rates in 1972.
Monetarist theory has focused on the events of 1920s America and the economic crises of the Great Depression. Monetarists argued that there was no inflationary investment boom in the 1920s that later caused the Great Depression. This argument was in contrast to both Keynesians and economists of the Austrian School who argued the presence of significant asset inflation and unsustainable Gross National Product (GNP) growth during the 1920s. Instead, monetarist thinking centered on the contraction of the national money supply during the early 1930s, and argued that the Federal Reserve could have avoided the Great Depression by efforts to provide sufficient liquidity. In essence, Monetarists believe the economic crises of the early twentieth century erupted as a result of an insufficient supply of money. This argument is supported by macroeconomic data, such as price stability in the 1920s and the slow rise of the money supply that followed.
The counterargument to this position is that certain microeconomic data support the conclusion of a maldistributed pooling of liquidity in the 1920s, caused by an excessive easement of credit. This viewpoint is argued by followers of Ludwig von Mises, who stated that the expansion was unsustainable, and by Keynes, whose ideas were included in Franklin D. Roosevelt's first inaugural address.
Based on the monetarist position that incorrect central bank policies are at the root of large swings in inflation and price instability, monetarists have argued that the primary motivation for excessive easing of central bank policies is to finance fiscal deficits by the central government. In this argument, monetarists conclude that a restraint of government spending is the most important single target to restrain excessive monetary growth.
With the failure of demand-driven fiscal policies to restrain inflation and produce growth in the 1970s, the way was paved for a new change in policy that focused on fighting inflation as the cardinal responsibility for the central bank. In typical economic theory, this would be accompanied by "austerity shock treatment," as is generally recommended by the International Monetary Fund. Indeed, in the United Kingdom and the United States, government spending was slashed in the late 1970s and early 1980s with the political ascendance of the United States’ Ronald Reagan and Great Britain’s Margaret Thatcher. In the ensuing short term, unemployment in both countries remained stubbornly high while central banks worked to raise interest rates in attempts to restrain credit. However, the policies of both countries' central banks dramatically brought down the inflation rates, allowing for the liberalization of credit and the reduction in interest rates which paved the way for the inflationary economic booms of the 1980s.
During the late 1980s and the early 1990s, monetarism again re-asserted itself in central bank policies of western governments by proving to contract spending and the money supply which would end the booms experienced in the U.S. and U.K.
With the 1987 "Black Monday" crash of the U.S. stock market, the questioning of the prevailing monetarist policy began. Monetarists argued that the 1987 stock market crash was simply a correction between conflicting monetary policies in the United States and Europe. Critics of this viewpoint grew more numerous as Japan slid into a sustained deflationary spiral and the collapse of the savings and loan banking system in the United States pointed toward the need for larger structural changes within the economy.
In the late 1980s, Federal Reserve Chief Paul Volcker was succeeded by Alan Greenspan, former follower of economist Ayn Rand, and a leading monetarist. His handling of monetary policy in the events leading to the 1991 recession was criticized from the extreme right as being excessively tight, which was suggested as costing George H. W. Bush a presidential re-election. The incoming Democratic president Bill Clinton reappointed Alan Greenspan, and kept him as a core member of his economic team. Greenspan, while still fundamentally monetarist in orientation, argued that doctrinaire application of economic theory was insufficiently flexible for central banks to meet emerging situations.
The crucial test of this flexible response by the Federal Reserve was the Asian financial crisis of 1997-1998, which the U.S. Federal Reserve met by flooding the world with dollars, and organizing a bailout of Long-Term Capital Management. Some have argued that 1997-1998 represented a monetary policy bind, as the early 1970s had represented a fiscal policy bind. Many believed that while asset inflation which crept into the United States demanded the Federal Reserve to tighten, the institution also needed to ease liquidity in response to the capital flight from Asia. Greenspan himself noted this when he stated that the American stock market showed signs of irrational valuations.
In 2000, Greenspan pushed the economy into recession with a rapid and drastic series of tightening moves by the Federal Reserve to sanitize the intervention of 1997-1998. This was followed by a similarly drastic series of leniency in the wake of the 2000-2001 recession. The failure of these efforts to produce stimulus later led to a wide-spread questioning of monetary policy and its sufficiency to deal with economic downturns.
In Europe, the European Central Bank has followed a more orthodox form of monetarism that employs tighter controls over inflation and spending targets as mandated by the Economic and Monetary Union of the European Union under the Maastricht Treaty. This more orthodox monetary policy is in the wake of credit easing in the late 1980s and 1990s to fund German reunification, which was blamed for the weakening of European currencies in the late 1990s.
The early twenty-first century has shown the United States Federal Reserve to follow a modified form of monetarism, where broader ranges of intervention are possible in light of temporary instabilities in market dynamics. Since 1990, however, the classical form of monetarism has often been criticized due to events which many economists have interpreted as being inexplicable in monetarist terms. These include the unhinging of the money supply growth from inflation of the 1990s and the failure of pure monetary policy to stimulate the economy in the 2001-2003 period.
Some liberal economists have suggested that the 2001-2003 failure of the expected economic recovery should be attributed not to monetary policy failure but to the breakdown in productivity growth in crucial sectors of the economy, in particular retail trade. Economist Robert Solow noted that five sectors produced all of the productivity gains of the 1990s, and that while the growth of retail and wholesale trade produced the smallest growth, they were by far the largest sectors of the economy to experience a net increase in productivity .
There are also arguments which link monetarism and macroeconomics, and treat monetarism as a special case of Keynesian theory. The central test case over the validity of these theories would be the possibility of a "liquidity trap" which occurs when the economy is stagnant, the nominal interest rate is close or equal to zero, and the monetary authority is unable to stimulate the economy with traditional monetary policy tools . Chairman of the US Federal Reserve, Ben Bernanke has argued that monetarism could respond to zero interest rate conditions through a direct expansion of the money supply. In his words: "We have the keys to the printing press, and we are not afraid to use them."."
Economist David Hackett Fischer, in his study The Great Wave, questioned the implicit basis of monetarism by examining long periods of secular inflation that stretched over decades. In doing so, he produced data which suggest that prior to a wave of monetary inflation there occurs a wave of commodity inflation which governments respond to, rather than lead.
In the late 1970s and early 1980s, Monetarists of the Milton Friedman school of thought believed that the growth of the money supply should be based on certain formulations related to economic growth. As such, they were often regarded as advocates of a monetary policy based on a "quantity of money" target. However in 2003, Milton Friedman renounced many of the monetarist policies from the 1980s that were based on quantity targets. Despite standing by his central formulations, Friedman somewhat conceded that the demand for money is not so easily predicted. In a 2003 interview with Milton Friedman published in the Financial Times, Friedman himself seemed to repudiate the monetary policy of monetarist theory and is quoted as saying "The use of quantity of money as a target has not been a success… I'm not sure I would–as of today–push it as hard as I once did."
These disagreements, as well as the role of monetary policy in trade liberalization, international investment, and central bank policy, remain lively topics of investigation and argument, proving that monetarist theory remains a central area of study in market economics.
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