Monetarism is aschool of thought inmonetary economics that emphasizes the role of policy-makers in controlling the amount ofmoney in circulation. It gained prominence in the 1970s, but was mostly abandoned as a direct guidance tomonetary policy during the following decade because of the rise of inflation targeting through movements of the official interest rate.[citation needed]
The monetarist theory states that variations in themoney supply have major influences onnational output in the short run and onprice levels over longer periods. Monetarists assert that the objectives ofmonetary policy are best met by targeting the growth rate of themoney supply rather than by engaging indiscretionary monetary policy.[1] Monetarism is commonly associated withneoliberalism.[2]
Monetarism is mainly associated with the work ofMilton Friedman, who was an influential opponent ofKeynesian economics, criticising Keynes's theory of fighting economic downturns usingfiscal policy (e.g.government spending). Friedman andAnna Schwartz wrote an influential book,A Monetary History of the United States, 1867–1960, and argued thatinflation is "always and everywhere a monetary phenomenon".[3]
Although opposed to the existence of theFederal Reserve,[4] Friedman advocated, given its existence, acentral bank policy aimed at keeping the growth of the money supply at a rate commensurate with the growth in productivity anddemand for goods. Money growth targeting was mostly abandoned by the central banks who tried it, however. Contrary to monetarist thinking, the relation between money growth and inflation proved to be far from tight. Instead, starting in the early 1990s, most major central banks turned to directinflation targeting, relying on steering short-runinterest rates as their main policy instrument.[5]: 483–485 Afterwards, monetarism was subsumed into thenew neoclassical synthesis which appeared in macroeconomics around 2000.
Monetarism is an economic theory that focuses on themacroeconomic effects of thesupply of money andcentral banking. Formulated byMilton Friedman, it argues that excessive expansion of the money supply is inherentlyinflationary, and that monetary authorities should focus solely on maintainingprice stability.
Monetarist theory draws its roots from thequantity theory of money, a centuries-old economic theory which had been put forward by various economists, among themIrving Fisher andAlfred Marshall, before Friedman restated it in 1956.[6][7]
Monetarists argued that central banks sometimes caused major unexpected fluctuations in the money supply. Friedman asserted that actively trying to stabilize demand through monetary policy changes can have negative unintended consequences.[5]: 511–512 In part he based this view on the historical analysis of monetary policy,A Monetary History of the United States, 1867–1960, which he coauthored withAnna Schwartz in 1963. The book attributed inflation to excess money supply generated by a central bank. It attributed deflationary spirals to the reverse effect of a failure of a central bank to support themoney supply during aliquidity crunch.[8] In particular, the authors argued that theGreat Depression of the 1930s was caused by a massive contraction of the money supply (they deemed it "theGreat Contraction"[9]), and not by the lack of investment that Keynes had argued. They also maintained that post-war inflation was caused by an over-expansion of the money supply. They made famous the assertion of monetarism that "inflation is always and everywhere a monetary phenomenon."
Friedman proposed a fixedmonetary rule, calledFriedman's k-percent rule, where the money supply would be automatically increased by a fixed percentage per year. The rate should equal the growth rate of realGDP, leaving the price level unchanged. For instance, if the economy is expected to grow at 2 percent in a given year, the Fed should allow the money supply to increase by 2 percent. Becausediscretionary monetary policy would be as likely to destabilise as to stabilise the economy, Friedman advocated that the Fed be bound to fixed rules in conducting its policy.[10]
However, the effectiveness of such monetary rules may depend critically on how money is measured and incorporated into macroeconomic models. Traditional simple-sum monetary aggregates, which treat all monetary assets as perfect substitutes, may provide misleading signals for monetary policy, particularly during periods of financial innovation.[11][12] Studies using theoretically-grounded Divisia monetary aggregates have found more stable relationships between money growth, inflation expectations, and economic activity, suggesting that properly measured money can provide clearer guidance for monetary policy implementation.[13][14][15] Moreover, incorporating money into forward-looking macroeconomic models with proper measurement can enhance the transmission mechanism of monetary policy and improve the effectiveness of rules-based approaches.[16][17][18]
Most monetarists oppose thegold standard. Friedman viewed a pure gold standard as impractical. For example, whereas one of the benefits of the gold standard is that the intrinsic limitations to the growth of the money supply by the use of gold would prevent inflation, if the growth of population or increase in trade outpaces the money supply, there would be no way to counteract deflation and reduced liquidity (and any attendant recession) except for the mining of more gold. But he also admitted that if a government was willing to surrender control over its monetary policy and not to interfere with economic activities, a gold-based economy would be possible.[19]
Clark Warburton is credited with making the first solid empirical case for the monetarist interpretation ofbusiness fluctuations in a series of papers from 1945.[1]p. 493 Withinmainstream economics, the rise of monetarism started withMilton Friedman's 1956 restatement of thequantity theory of money. Friedman argued that thedemand for money could be described as depending on a small number of economic variables.[20]
Thus, according to Friedman, when themoney supply 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 henceaggregate demand would rise. Similarly, if the money supply were reduced people would want to replenish their holdings of money by reducing their spending. In this, Friedman challenged a simplification attributed to Keynes suggesting that "money does not matter."[20] Thus the word 'monetarist' was coined.
The popularity of monetarism picked up in political circles when the prevailing view ofneo-Keynesian economics seemed unable to explain the contradictory problems of risingunemployment andinflation in response to theNixon shock in 1971 and theoil shocks of 1973. On one hand, higher unemployment seemed to call forreflation, but on the other hand rising inflation seemed to call fordisinflation. The social-democraticpost-war consensus that had prevailed infirst world countries was thus called into question by the risingneoliberal political forces.[2]
In 1979, United States PresidentJimmy Carter appointed as Federal Reserve ChiefPaul Volcker, who made fighting inflation his primary objective, and who restricted the money supply (in accordance with theFriedman rule) to tame inflation in the economy. The result was a major rise in interest rates, not only in the United States; but worldwide. The "Volcker shock" continued from 1979 to the summer of 1982, decreasing inflation and increasing unemployment.[21]
In May 1979,Margaret Thatcher, Leader of theConservative Party in theUnited Kingdom, won thegeneral election, defeating the sittingLabour Government led byJames Callaghan. By that time, the UK had endured several years of severeinflation, which was rarely below the 10% mark and stood at 10.3% by the time of the election.[22] Thatcher implemented monetarism as the weapon in her battle against inflation, and succeeded at reducing it to 4.6% by 1983. However,unemployment in the United Kingdom increased from 5.7% in 1979 to 12.2% in 1983, reaching 13.0% in 1982; starting with the first quarter of 1980, the UK economy contracted in terms of real gross domestic product for six straight quarters.[23]
Monetarist ascendancy was brief, however.[10] The period when major central banks focused on targeting the growth of money supply, reflecting monetarist theory, lasted only for a few years, in the US from 1979 to 1982.[24]
The money supply is useful as a policy target only if the relationship between money and nominal GDP, and therefore inflation, is stable and predictable. This implies that thevelocity of money must be predictable. In the 1970s velocity had seemed to increase at a fairly constant rate, but in the 1980s and 1990s velocity became highly unstable, experiencing unpredictable periods of increases and declines. Consequently, the stable correlation between the money supply and nominal GDP broke down, and the usefulness of the monetarist approach came into question. Many economists who had been convinced by monetarism in the 1970s abandoned the approach after this experience.[10]
The changing velocity originated in shifts in thedemand for money and created serious problems for the central banks. This provoked a thorough rethinking of monetary policy. In the early 1990s central banks started focusing on targeting inflation directly using the short-runinterest rate as their central policy variable, abandoning earlier emphasis on money growth. The new strategy proved successful, and today most major central banks follow a flexibleinflation targeting.[5]: 483–485
Even though monetarism failed in practical policy, and the close attention to money growth which was at the heart of monetarist analysis is rejected by most economists today, some aspects of monetarism have found their way into modern mainstream economic thinking.[10][25] Among them are the belief that controlling inflation should be a primary responsibility of the central bank.[10] It is also widely recognized that monetary policy, as well as fiscal policy, can affect output in the short run.[5]: 511 In this way, important monetarist thoughts have been subsumed into thenew neoclassical synthesis or consensus view of macroeconomics that emerged in the 2000s.[26][5]: 518
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