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Monetarists refer to economists who hold a strong belief that changes in the money supply are the main determinants of economic performance and business cycle behavior. In their argument, the economic health of a country depends on monetary supply or money. From there, comes monetary policy.
When the money supply expands, the economy grows, and if it contracts, economic growth weakens. Therefore, monetarists view monetary policy as a more effective tool to influence economic activity. They advocate using monetary policy instead of fiscal policy to control the cycle in real GDP, inflation, and employment.
Monetarist vs. Keynesians: Key differences explained
Monetarism is a popular school of macroeconomics besides Keynesians. Simply put, monetarists recommend controlling money in the economy to influence the economy. Meanwhile, Keynesian economics proposes fiscal intervention, namely government spending and taxes.
The monetarist view inspires monetary policy. Meanwhile, the Keynesian view inspires fiscal policy.
Both are important in influencing aggregate demand. While the government is responsible for fiscal policy, the central bank is responsible for implementing monetary policy.
Today, Monetary Theory is mainly associated with Nobel Prize-winning economist Milton Friedman. He is considered the father of Monetary Theory. Friedman received the 1976 Nobel Memorial Prize for his research on consumption analysis, monetary history and theory, and the complexity of stabilization policies.
Meanwhile, John Maynard Keynes is the father of Keynesian economics. He posed his idea as a way out of the Great Depression, which took place in the 1930s.
Monetarist’s recipe for economic policy
The central bank implements monetary policy to influence the money supply and the availability of credit in the economy. The central bank uses several instruments, including policy rates, open market operations, and reserve requirement ratios.
Contractionary monetary policy
The central bank implements a contractionary monetary policy to moderate economic growth by reducing the growth rate of the money supply. Such a policy is needed when the economy is overheated and to avoid hyperinflation. That can be done through:
- Increase in policy rates
- Open market operations by selling government securities
- Increase the reserve requirement ratio
All three contribute to reducing the rate of money supply and weakening aggregate demand. Weakening aggregate demand leads to slower economic growth, more moderate inflation, and increased unemployment.
Increase in policy rates
Raising the benchmark interest rate, often referred to as the federal funds rate, directly affects borrowing costs. When interest rates go up, loans become more expensive for consumers and businesses. This discourages borrowing for things like car purchases, home mortgages, or business expansion, ultimately reducing spending and investment in the economy.
Open market operations by selling government securities
Open market operations involve the central bank buying and selling government bonds in the open market. In a contractionary policy, the central bank sells government securities to banks and other investors. This action pulls money out of circulation. Here’s how it works:
- The central bank sells government bonds to banks.
- Banks pay for these bonds with reserves they hold.
- This reduces the amount of reserves banks have available, limiting their lending capacity.
- With fewer reserves, banks become more cautious about lending, leading to tighter liquidity (less money readily available) and potentially pushing interest rates up even further.
Increase the reserve requirement ratio
The reserve requirement ratio is the portion of customer deposits that banks must hold in reserve as opposed to lending them out. By raising the reserve requirement ratio, the central bank forces banks to hold onto a larger percentage of their deposits as reserves. This reduces the amount of money banks have available to lend, effectively tightening the money supply and slowing down economic activity.
Expansionary monetary policy
The central bank carries out expansionary policies to stimulate economic growth. The policy is suitable when the economy is weak or in recession due to a decrease in aggregate demand. To boost the economy, the central bank eases its monetary policy through:
- Interest rate cut
- Open market operations by buying government securities
- Lower the reserve requirement ratio
The easing above ultimately increases aggregate demand. Increasing demand stimulates businesses to increase output. Stronger aggregate demand spurs economic growth and reduces unemployment as businesses increase production and absorb more labor. It also raises inflationary pressure along with business steps to raise selling prices to compensate for rising production costs.
Interest rate cut
Lowering the benchmark interest rate makes borrowing costs cheaper for consumers and businesses, incentivizing borrowing for various purposes. Consumers are more likely to apply for loans for cars, homes, or even credit card purchases, increasing overall consumer spending. This can be particularly true for durable goods, like appliances or electronics, where affordability becomes more attractive with lower interest rates.
Businesses also benefit from cheaper borrowing costs. Lower interest rates make investments in capital goods, such as machinery and equipment, more profitable. This can lead to increased business investment, which can create jobs, boost production, and contribute to economic growth.
Open market operations by buying government securities
Open market operations involve the central bank buying and selling government bonds in the open market. In an expansionary policy, the central bank injects money into the economy by purchasing government securities from banks and other investors. Here’s the breakdown:
- The central bank buys government bonds from banks.
- Banks receive payment for these bonds in the form of central bank reserves.
- This injection of reserves increases the amount of money banks have available to lend.
- With more reserves, banks are more likely to approve loan applications, increasing the money supply circulating in the economy and stimulating economic activity.
Lower the reserve requirement ratio
The reserve requirement ratio is the portion of customer deposits that banks must hold in reserve rather than lending out. By lowering the reserve requirement ratio, the central bank allows banks to lend out a larger portion of their deposits. This increases the amount of money available for loans, making it easier for businesses and consumers to borrow and spend, ultimately stimulating economic growth.
Monetarist theory of inflation
Monetarists believe a high inflationary pressure occurs if the money supply grows faster than aggregate output. Imagine a scenario where the amount of money circulating in the economy (money supply) increases rapidly, while the production of goods and services (aggregate output) remains stagnant. In this situation, according to monetarists, there’s “more money chasing fewer goods.” This imbalance creates an environment where prices tend to rise – inflation.
Monetarists argue that inflation is not simply a byproduct of a growing economy, but rather a monetary phenomenon. They believe the level of inflation can be directly influenced by controlling the money supply. In other words, by managing the amount of money in circulation, central banks can influence how much “chasing” occurs and, therefore, impact inflation.
The quantity theory of money is the cornerstone of monetarist thought. It defines the relationship between the money supply (M) and its circulation (V), inflation (aggregate prices or P), and real output (Y).
- M x V = P x Y
The equation attempts to capture the relationship between the money supply (M), its velocity (V), the price level (P), and real output (Y). Velocity refers to how often money changes hands within a specific period. Simply put, the equation suggests that nominal GDP (P x Y) is equal to the money supply multiplied by its velocity.
However, monetarists acknowledge that velocity (V) is not a fixed value and can change over time due to factors like financial innovation and consumer behavior. This is a limitation of the quantity theory of money, as it assumes a constant velocity.
