What Is Monetarist Theory?

What Is Monetarist Theory?

I'm here to explain monetarist theory directly to you: it's an economic idea that says changes in the money supply are the biggest factors influencing a nation's economic growth rate and how the business cycle behaves. When this theory plays out in real life, central banks—which handle monetary policy—hold significant sway over growth rates. The main rival to this theory is Keynesian economics.

Key Takeaways

Let me break it down for you assertively: under monetarist theory, the money supply stands as the top determinant of economic growth speed. It's all guided by the MV = PQ formula, where M means money supply, V is the velocity of money, P is the price of goods, and Q is the quantity of goods and services. In the U.S., the Federal Reserve manages money using three primary tools—the reserve ratio, discount rate, and open market operations—to either expand or shrink the money supply in the economy.

Understanding Monetarist Theory

You need to grasp this: according to monetarist theory, boosting a nation's money supply ramps up economic activity, and cutting it does the opposite. The theory relies on the straightforward formula MV = PQ, with M as money supply, V as the average times a dollar gets spent yearly, P as goods and services prices, and Q as their quantity. If V stays constant and you increase M, then either P, Q, or both will go up.

Here's the impartial fact: general prices usually climb faster than goods and services production when the economy nears full employment. But if there's economic slack, Q rises quicker than P in monetarist views. In the U.S., the Federal Reserve sets monetary policy independently of government, focusing on stable prices for low inflation, full employment, and moderate interest rates.

Controlling Money Supply

Directly to you: the Federal Reserve handles money supply control in the U.S., using three main levers. The reserve ratio is the percentage of deposits banks must keep as reserves—a lower ratio lets banks lend more, increasing money supply. The discount rate is what the Fed charges banks borrowing extra reserves—dropping it encourages more borrowing and lending. Open market operations involve buying or selling government securities: buying from big banks adds to the money supply, while selling reduces it.

Example of Monetarist Theory

Consider this real-world case: Alan Greenspan, former Federal Reserve Chair, supported monetarist theory. In his early days starting 1988, he hiked interest rates, which slowed growth and pushed inflation near 5%. The economy slipped into recession in the early 1990s, so Greenspan responded with rate cuts that sparked the longest U.S. economic expansion ever. However, that loose policy with low rates left the economy vulnerable to bubbles, leading to the 2008 financial crisis and Great Recession.