What Is Monetarism?

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What Is Monetarism?

Let me explain monetarism directly: it's a key macroeconomic theory that argues the money supply is the main factor in maintaining economic stability. Economist Milton Friedman pushed this idea, saying governments can keep economies steady by managing how the money supply grows. This differs from Keynesian economics, which focuses on fiscal policy to handle economic demand. If you grasp these differences, you'll get better insights into how economic policies work and what drives stability.

Key Takeaways

Monetarism is a macroeconomic theory that stresses the money supply as the primary driver of economic growth and stability.
At its core, monetarism relies on the quantity theory of money, where changes in the money supply impact prices, production, and employment.
Milton Friedman, a major advocate, called for a steady increase in the money supply to match natural economic growth.
Monetarism differs from Keynesian economics, which uses government spending and fiscal policy to manage the economy.
Though monetarism lost popularity later on, ideas like controlling inflation still influence modern economic thinking.

How Monetarism Impacts Economic Growth

Monetarism holds that the money supply in an economy is what primarily drives growth. When there's more money circulating, it increases demand for goods and services. This rise in demand leads to more jobs, lower unemployment, and overall economic expansion. You need to understand that monetary policy is the tool here—it's used to tweak interest rates and thus control the money supply. Higher rates push people to save rather than spend, shrinking the money supply. Lower rates make borrowing cheaper, encouraging spending and giving the economy a boost.

Monetarism's Evolution Under Milton Friedman

Monetarism is tightly linked to Milton Friedman, who built on the quantity theory of money to argue that governments should maintain a steady money supply, growing it just a bit each year to support natural economic expansion. He warned that expanding money too fast causes inflation, so monetary policy must regulate growth for stability. In his book 'A Monetary History of the United States 1867–1960,' Friedman proposed the K-percent rule, tying money supply growth to nominal GDP. This approach means the money supply grows moderately, businesses can predict changes annually and plan ahead, the economy expands steadily, and inflation stays low.

Exploring the Quantity Theory of Money

The quantity theory of money is central to monetarism; monetarists took it from earlier theories and fit it into the broader Keynesian macroeconomic framework. It's summed up in the equation of exchange by John Stuart Mill: MV = PQ, where M is money supply, V is velocity (how fast money changes hands), P is the average price of goods and services, and Q is the quantity sold. Monetarists emphasize that changes in M drive the equation, directly affecting employment, inflation (P), and production (Q). Originally, V was seen as constant, but Keynes dropped that, and monetarists agree V is predictable instead. Economic growth comes from activity (Q) and inflation (P). If V is steady or predictable, shifts in M affect P or Q. An increase in P with constant Q means inflation without growth, while rising Q with stable P indicates real expansion. Monetarism says money supply variations influence prices long-term and output short-term, directly determining prices, production, and jobs.

Comparing Monetarism to Keynesian Economics

Keynesians challenge the idea that velocity is constant, arguing it's not because economies are volatile and unstable. They focus on liquidity preference, where changes in money demand (and velocity) affect prices and demand. Monetarism builds on Keynesian foundations by using the same framework and the equation of exchange, but with V cycling as Keynes said, and it stresses money supply's role. Since monetarists see V as predictable, they revive the equation for stabilization policy, favoring monetary tools. They argue fiscal policy distorts markets and reduces efficiency, preferring monetary policy for neutral demand management without the losses fiscal approaches create.

Tracing the History of Monetarism

Monetarism gained traction in the 1970s amid high inflation and sluggish growth, and its policies helped lower inflation in the US and UK. In 1979, with US inflation at 20%, the Federal Reserve adopted monetarist strategies. Economists and governments watched money supply data closely then. Monetary policy is either contractionary—raising rates or cutting supply to fight inflation—or expansionary—growing supply or lowering rates. Later, monetarism lost favor as links between money supply and inflation blurred, and it couldn't fully explain the economy. Now, central banks target inflation directly. Still, monetarism's core—that inflation needs money supply growth to persist—holds, and central banks must control it. Former Fed chair Ben Bernanke drew on Friedman's ideas to cut rates and expand money during the 2007 recession.

Case Studies: Monetarism in Action

In 'A Monetary History of the United States, 1867–1960,' Friedman and Anna Schwartz blamed the Fed's poor monetary policy for the Great Depression, saying it failed to support the money supply and even reduced it when it shouldn't have. They believed markets stabilize unless money is mishandled. In 1979, Fed chair Paul Volcker targeted inflation by restricting money supply, raising rates to 20% in 1980. This ended stagflation but caused recessions from 1980-1982. In the UK, Prime Minister Margaret Thatcher used monetarist policies from 1979, halving inflation from 10% to 5% by 1983. But by the 1980s and 1990s, the money supply-GDP link weakened, questioning the quantity theory, and many economists dropped monetarism.

What Is the Main Idea of Monetarism?

The core of monetarism is that money supply drives economic demand, so regulating it—through expansionary or contractionary policy—controls performance.

What Is an Example of Monetarism?

Expansionary policy lowers rates or reserve requirements to boost money supply and borrowing; contractionary does the opposite to curb it.

What Is the Difference Between Monetarism and Keynesianism?

Monetarism manages the economy via money supply, while Keynesianism uses government spending; in reality, both tools are applied.

The Bottom Line

Monetarism, led by Milton Friedman, stresses monetary policy's role in stability by targeting money supply. It rose in the 20th century to fight inflation in the 1970s. Unlike Keynesianism's focus on spending, monetarism sees monetary tools as more effective. Though strict monetarism faded, its principle that managing money supply controls inflation remains key in policy.

What Is Monetarism?

Highlights