Monetarist
An economics school of thought that engages economic growth with the money supply.
What Is a Monetarist?
Monetarism is an economics school of thought that engages economic growth with the money supply. The basic principle of monetarism is that the money supply is the driver of growth in any economy.
The economist who supports the hypothesis is known as a monetarist, who believes that the key driver of economic growth is the money supply, including physical stock of currency, credit, and deposits.
Some famous are Milton Friedman, Alan Greenspan, and Margaret Thatcher.
The theory of monetarism advocates that monetary policy works better than fiscal policy to revive any sinking economy. Hence, they disregard the role of government in the market.
The underlying cycle of events starts from the perception that when the money supply is increased in the economy, people have money in their hands and therefore demand more goods and services, leading to a jump in aggregate demand in the economy.
Since demands will lead to more production to curb the excess aggregate demand, this will, in turn, positively affect job creation and reduce unemployment.
The ultimate growth of the economy follows this whole cyclic thought process.
Monetarism uses monetary policy to be specific interest rates as tools to adjust economic growth within the targets.
The basic proposition is that as interest rates go down, the incentive to put money in banks goes down; therefore, consumption in the economy increases.
The other way to interpret this can be that when interest rates go down, the cost of borrowing goes down. Therefore loan intake increases, leading to higher consumption and a trigger to high money supply and, ultimately, growth.
The converse of this is when interest rates go up, it will achieve an incentive to save, and the cost of borrowing is increased; therefore, the consumption criteria also change. Moreover, this high interest rate is believed to lower the supply of money in the market.
The brief conclusion of the theory that economists agree with is the impact of inflation on the health of the economy and the idea that one can control inflation by controlling the money supply.
Since inflation and money supply are interrelated, economic growth via changing money stock is not a simple task.
Key Takeaways
- The economist who supports the hypothesis is known as a monetarist.
- They believe that the key driver of economic growth is the money supply which includes physical currency stock, credit, and deposits.
- Monetarism uses monetary policy, specifically interest rates, to adjust economic growth within the targets.
- Economist Milton Friedman was the "Founding Father" of Monetarism.
- It assumes that inflation in an economy can be eliminated by just using the money supply as a tool and no other thing is a direct implication of inflation in an economy.
- The model takes three ways the money supply in the economy can be controlled: reserve ratio, discount rate, and open market operations.
History of monetarism
Milton Friedman, an economist, is considered the "Founding Father" of Monetarism. He wrote a serious analysis in 1963 in his book, A Monetary History of The United States, 1867–1960, using the theory of "monetarism."
In the book, Friedman and Anna Jacobson Schwartz argued in favor of monetarism to combat inflation's economic impacts.
Monetarism took a prominent place in economics around the 1970s. The time around this decade was categorized as high and uncontrollable inflation in the United States of America. Not only that, but inflation accompanied a low growth of the economy.
After the peak recorded inflation of 20% in 1979, they worked on economic theories; ever since economists turned to a more robust approach and chose the monetarist growth path.
Even a similar situation prevailed in the United Kingdom, and they also took the path of monetary policy tools to fix the economy.
They argue that if the money supply grows more than the rate of growth of national income, inflation will be a repercussion.
If the growth in the supply of money results in an equivalent increase in income, it can eliminate the inflation phenomenon significantly.
Monetarists: Assumptions and characteristics
The first and foremost assumption is that inflation in an economy can be eliminated by just using the money supply as a tool, and no other thing is a direct implication of inflation in an economy.
Secondly, we take stock of money physically present in the economy or the banking system combined as debt or credit. It is important to note that the money supply does not include any financial assets like equity or stocks.
This can also be one of the issues; since equities give better returns than banking systems, people tend to save or invest their set aside amount in them, which means if they get better returns, their hands-on consumption will be more since more earning streams are flowing.
Since monetarism ignores such income streams, we can say that the part of increased aggregate demand in the economy is undefined.
Another assumed and observed phenomenon is that money supply tools have a short-term impact on fixing the national output and a long-term impact on the inflationary positions of any economy.
One fundamental assumption directly seen in the model is that v, the velocity of money, is assumed to be constant. The theory emphasizes targeting the interest rates and, thus, the money supply rather than using inflation as a deciding factor.
To well identify the model, we first need to understand some essential characteristics of monetarism.
Some characteristics of the model are as follows.
- The model is based primarily on the quantity theory of money.
- They pose a scenario where the economy is inherently stable, and markets work better when left at their own pace. Government control can be a disaster rather than help to free fair markets.
- It is crucial for the central bank or the monetary authority of countries to be responsible for fixing rules and properly conducting and implementing economic policies. They should not have discretion in conducting them since it is also possible they could make the economy worse off.
- Fiscal policy should play a minimal role in economic growth progress.
- Milton Friedman predicted that an increase in the money supply would take about 9-12 months, leading to greater output.
Model of monetarist approach
The first factor we need to specify before deriving a complex model is how the central monetary authority controls the money supply. The model takes three ways to control the money supply in the economy. They are discussed as follows.
The Reserve Ratio
The reserve ratio indicates the percentage of deposits that commercial banks must keep to themselves and not lend to the public.
If the central authority wants to increase the supply, it will decrease the reserve ratios so that more lending is available in the market.
Discount Rates
Discount rates are the rate of interest on which commercial banks borrow from the monetary authority.
By increasing the discount rates, the central monetary authority discourages reserves from going into the hands of commercial banks, and, therefore, lending to the public also decreases.
Since the cost of borrowing for banks has increased, they transfer this cost by increasing the rate of interest for borrowing for the general public.
This further creates a decline in loan demand, and therefore, the overall money supply in the economy decreases.
Open Market Operations
This is a tool that the government uses to control the money supply by issuing securities or bonds. If they want to decrease the money supply, they can give guarantees to the general public or commercial banks.
In this way, selling securities will lead to excess money in the economy getaway to the government, and therefore, the ultimate objective is achieved.
As the model is based on the short and long-term impacts of money supply, we will bifurcate the rules and implications.
Short run: quantity theory of money
The theory starts with a general exchange equation, which tells the macroeconomic equilibrium in any economy.
That is
M * V = P * Y
Here, M is the total money supply in the economy pertaining to M1. M1 is the money supply composed of currency, demand deposits, and other liquid deposits, including savings deposits.
- V = the velocity of money; it is the number of times an average dollar changes hands per year.
- P = the price of goods and services in the economy.
- B = the actual output or can be termed as the economy's income; therefore, we can take either Y or Q as the variable in the equation.
Note that V is taken to be constant in the short run.
Now taking V as constant, we change it to.
M X 
The transformed equation is called the quantity theory of money.
Where P X Y is considered to be the nominal GDP.
This explains that when any change is made to M, there will be a subsequent equal effect to the RHS, P X Y.
However, this can be misleading and ambiguous on how P X Y changes. In a sense, is P rising due to M rising, or is Y rising due to M?
This explains why they see the money supply as a solid variable to control and accelerate economic growth.
In other terms, strong evidence is given by the quantity theory of money that money supply can be a factor of change in national income growth.
It is also pre-assumed that in the short run, prices are less flexible and, therefore, will showcase most of the P X Y change due to M via increased Y or actual output and not much by P.
Long Run: The quantity theory of money
The monetarists believed that markets work independently and are assumed to be stable.
When we theoretically examine this assumption, it implies that full employment is always in the economy.
When we say full employment in the long run also means that actual output or income will be stable in the long run.
Therefore, in a futuristic model, we take Y as a constant variable or as ȳ.
Our transformed equation is:
M X
The equation now shows that when velocity and actual output, in the long run, are taken to be non-affecting or constant variables, we see that a change in M will only lead to a change in P in the long run.
Now, this is a clear implication of monetarist theory, that in the long run, any changes in money supply will impact or target the price change or inflation in the economy.
Another implicit effect would be that the rate of growth of the money supply will always equate to the rate of growth of price levels.
One very important implication of this long-run quantity theory of money that monetarists believe is that there is no trade-off between inflation and unemployment in the long run.
This is evident as we assume output to be at full employment in the long run. An increase in the money supply would lead to increases in only prices and therefore increase in nominal GDP but not the real GDP.
Criticisms: Keynesian Theory vs. Monetarist
Both the Keynesian schools of thought and monetarists follow the equation of the quantity theory of money. The point of tug-war relies on the effectiveness of the monetary and fiscal policy.
The Keynesian theory advocates that government should be given discretion and that fiscal policy can be used to support stability.
Whereas monetarists strictly follow that government should be given very little inclusiveness in stabilization and only monetary policies should be used to aim at growth.
Even after being a very sophisticated and specified model, the theory is still vague in some factors. These factors do allow critics to eliminate the success of the monetarist approach.
- Money's velocity ( V ), specifically M1, is not static and, in the practical world. Therefore, taking it constantly will result in a vague analysis of the quantity theory of money.
- The monetarist approach based on money supply targeting is an old concept, whereas, in modern days, economists feel that this approach can cause a severe recession and unemployment.
- This might be where increasing the monetary base may not lead to inflation. Therefore the set pattern can deviate. Therefore, economists argue to target inflation straightaway.
- According to monetarists, income can vary in the short run. But at the same time, the short run could be long and, therefore, can make a certain monetary policy fruitless.
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