An economic policy based on the control of a country's money supply. It assumes that the quantity of money in an economy determines its economic activity, and particularly its rate of inflation. If the money supply is allowed to rise too quickly, prices will rise, resulting in inflation. To curb inflationary pressures, governments therefore need to reduce the supply of money and raise interest rates. This view was a major influence on British and US economic policy in the 1980s.
Monetarism is a set of views concerning the determination of national income and monetary economics. It focuses on the supply and demand for money as the primary means by which economic activity is regulated. Monetary theory focuses on money supply and on inflation as an effect of the supply of money being larger than the demand for money.
Monetarism today is mainly associated with the work of Milton Friedman, who was among the generation of liberal economists to accept Keynesian economics and then critique it on its own terms. Friedman advocated a central bank policy aimed at keeping the supply and demand for money at equilibrium, as measured by growth in productivity and demand. The monetarist argument that the demand for money is a stable function gained considerable support during the late 1960s and 1970s from the work of David Laidler.
Critics of monetarism include both neo-Keynesians who argue that demand for money is intrinsic to supply, and some conservative economists who argue that demand for money cannot be predicted. Supply-sider Jude Wanniski declared monetarism a failure because it assumed that the velocity of money is roughly constant . Joseph Stiglitz has argued that the relationship between inflation and money supply growth is weak for ordinary inflation, as opposed to hyperinflation (meaning perhaps more than 10% year-over-year) which is almost universally regarded as an effect of government spending at a time when output growth can not absorb it (See inflation by government spending). In an interview with the Financial Times from June 6, 2003, Milton Friedman even seemed to repudiate the monetary policy of monetarism and was quoted as saying "The use of quantity of money as a target has not been a success," ...
Though monetarism is commonly associated with conservative economics and economists, not all conservatives are monetarists, and not all monetarists are conservatives.
Monetarism is an economic theory which 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.
This theory draws its roots from two almost diametrically opposed ideas: the hard money policies which dominated monetary thinking in the late 19th century, and the monetary theories of John Maynard Keynes, who, working in the interwar period during the failure of the restored gold standard, proposed a demand-driven model for money which was the foundation of macroeconomics. Whereas Keynes had focused on the value stability of currency—with the resulting panics based on an insufficient money supply leading to alternate currency and collapse—Friedman focused on price stability: the equilibrium between supply and demand for money.
The result was summarized in Friedman's historical analysis of monetary policy: Monetary History of the United States 1867-1960, which attributed inflation to excess money supply generated by a central bank. It attributes deflationary spirals to the reverse effect: failure of a central bank to support the money supply during a liquidity crunch.
Friedman originally proposed a fixed monetary rule, where the money supply would be calculated by known macroeconomic and financial factors, targeting a specific level or range of inflation.
The rise of monetarism
The rise of monetarism within mainstream economics dates mostly from Milton Friedman's 1956 restatement of the quantity theory of money. Friedman argued that the demand for money depended predictably on several major economic variables. Thus, if the money supply were expanded, people would not simply wish to hold the extra money in idle money balances; i.e., if they were in equilibrium before the increase, they were already holding money balances to suit their requirements, and thus after the increase they would have money balances surplus to their requirements. These excess money balances would therefore be spent and hence aggregate demand would rise. Similarly, if the money supply was reduced people would want to replenish their holdings of money by reducing their spending. Thus Friedman challenged the Keynesian assertion that "money does not matter"; he argued that the supply of money does affect the amount of spending in an economy.
The rise of the popularity of monetarism in political circles accelerated as Keynesian economics seemed unable to explain or cure the seemingly contradictory problems of rising unemployment and inflation in response to the collapse of the Bretton Woods system in 1972 and the oil shocks of 1973. The result was a significant disillusionment with Keynesian demand management: a Democratic President Jimmy Carter appointed a monetarist Federal Reserve chief Paul Volcker who made inflation fighting his primary objective, and restricted the money supply to tame inflation in the economy. Milton Friedman and Anna Schwartz in their book A Monetary History of the United States, 1867-1960 argued that the Great Depression of 1930 was caused by a massive contraction of the money supply and not by the lack of investment Keynes had argued. They also maintained that post-war inflation was caused by an over-expansion of the money supply.
Many monetarists sought to resurrect the pre-Keynesian view that market economies are inherently stable in the absence of major unexpected fluctuations in the money supply. In effect, Friedman's model argues that current fiscal spending creates as much of a drag on the economy by increased interest rates as it creates present consumption: that it has no real effect on total demand, merely that of shifting demand from the investment sector (I) to the consumer sector (C).
Monetarism in practice
The crucibles of economic theories are the cataclysmic events which reshape economic activity.
Monetarists argue that there was no inflationary investment boom in the 1920s, in contrast to both Keynesians and to economists of the Austrian School, who argue that there was significant asset inflation and unsustainable GNP growth during the 1920s. In essence, they argue that there was 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.
From their conclusion that incorrect central bank policy is at the root of large swings in inflation and price instability, monetarists argued that the primary motivation for excessive easing of central bank policy is to finance fiscal deficits by the central government.
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. Some claim that the use of credit to fuel economic expansion is itself an anti-monetarist tool, as it can be argued that an increase in money supply alone constitutes inflation.
Monetarism re-asserted itself in central bank policy in western governments at the end of the 1980s and beginning of the 1990s, with a contraction in spending and in the money supply ending the booms experienced in the US and UK.
The crucial test of this flexible response by the Federal Reserve was the Asian financial crisis of 1997-1998, which the 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—and that while asset inflation had crept into the United States, demanding that the Fed tighten, the Federal Reserve needed to ease liquidity in response to the capital flight from Asia.
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, followed by a similarly drastic series of loosenings in the wake of the 2000-2001 recession.
Currently the American Federal Reserve follows a modified form of monetarism, where broader ranges of intervention are possible in light of temporary instabilities in market dynamics.
In Europe, the European Central Bank follows a more orthodox form of monetarism, with tighter controls over inflation and spending targets as mandated by the Economic and Monetary Union of the European Union under the Maastricht Treaty to support the euro.
The current state of monetary theory
Since 1990, the classical form of monetarism has been questioned because of events which many economists have interpreted as being inexplicable in monetarist terms - the unhinging of the money supply growth from inflation in the 1990s and the failure of pure monetary policy to stimulate the economy in the 2001-2003 period.
There are also arguments which link monetarism and macroeconomics, and treat monetarism as a special case of Keynesian theory. Ben Bernanke, Princeton Professor and current Chairman of the US Federal Reserve, has argued that monetarism could respond to zero interest rate conditions by direct expansion of the money supply.
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.
Monetarists of the Milton Friedman school of thought believed in the 1970s and 1980s that the growth of the money supply should be based on certain formulations related to economic growth. As such, they can be regarded as advocates of a monetary policy based on a "quantity of money" target. This can be contrasted with the monetary policy advocated by supply side economics or Austrian economics which are based on a "value of money" target.
In 2003, Milton Friedman renounced many of the policies from the 1980s that were based on quantity targets.
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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