Monetarism is a powerful economic theory that argues controlling the money supply is the primary tool to influence economic activity and combat inflation. Economists and investors use this theory to understand how changes in the amount of money circulating in an economy can impact everything from interest rates to investment decisions and, ultimately, economic growth.
What is Monetarism?
The Monetarist school of thought is a mainstream macroeconomic thought. It believes that the money supply is the primary determinant of economic growth. Those who hold this view are monetarists or monetary economists.
Monetarists believe monetary policy is more effective in influencing economic activity. Money has a significant role to play in the modern economy. Money is not only a means of payment, but it also becomes a commodity to be transacted. The money’s demand and supply determine the interest rate in the economy.
Ultimately, interest rates influence decisions, such as consumption and investment. Some household purchases rely on bank loans, as do business investments.
Monetary policy affects the amount of money circulating in the economy. During periods of weak growth, policymakers should increase the money supply. And, during an economic boom, policymakers reduce the money supply, thereby slowing the inflation rate.
The modern economy cannot run without money. Money represents the monetary (financial) side of the economy, complementing the non-financial side (goods and services). Without it, you cannot buy goods and services or save for retirement.
Historical context: the rise of monetarism
Monetarism has its roots in Milton Friedman’s thinking. He and Anna Schwartz co-authored the influential book A Monetary History of the United States, 1867 – 1960. This work challenged prevailing economic thought by arguing that inflation is not simply a byproduct of a growing economy but rather a monetary phenomenon.
In other words, inflation is caused by an excessive increase in the money supply relative to the growth of goods and services. This core principle laid the foundation for monetarism’s focus on monetary policy, the set of tools central banks use to influence the amount of money circulating in an economy.
Friedman believed that central banks should carefully manage the money supply, keeping its growth rate in line with economic productivity and demand for goods. Deviations from this approach, he argued, could lead to severe consequences like hyperinflation (rapid, uncontrolled price increases) or deflation (a sustained decrease in the price level).
Core Principles of Monetarism
Monetarism hinges on several key ideas that explain how the money supply influences economic activity and inflation. Here’s a breakdown of these core principles:
Money supply as the engine of economic activity
Monetarists believe the total amount of money circulating in an economy (money supply) is the primary driver of economic growth. They argue that more money in circulation allows people and businesses to spend more, stimulating production, investment, and overall economic activity.
Imagine a new dollar entering the economy. People and businesses don’t just hold onto that dollar; they spend it. When someone spends a dollar, it becomes income for the recipient, who then spends a portion of it themselves. This cycle of spending and re-spending continues, with each dollar generating a ripple effect throughout the economy. This is known as the multiplier effect.
Monetarists argue that by increasing the money supply, the government or central bank injects more “seed money” into the system. This jumpstarts the multiplier effect, leading to a larger total spending throughout the economy. Here’s how it plays out:
- More loans and investment: With more money available, banks can loosen lending standards, making it easier for businesses to borrow and invest. This can lead to increased production capacity and job creation.
- Greater consumer spending: Consumers also have more money available, allowing them to spend more on goods and services. This increased demand encourages businesses to produce more.
- Boost in confidence: A growing money supply can also create a sense of economic optimism, further encouraging spending and investment.
The quantity theory of money
Monetarists view the money supply and its circulation as a function of the economy’s price level and real output. They then formulated the formula for the quantity theory of money as follows:
- M × V = P × Y
Where:
- M = money supply
- V = Velocity of money
- P = Price level
- Y = Real output
The velocity of money shows you the number of times the same money changed hands during the year. Meanwhile, the product of the price level and real output represents nominal GDP.
To explain this formula, I will try to take a simple example. Assume that the economy’s output comes from one producer. Let’s say a manufacturer produces 100 units and sells them at $200. So, in other words, the nominal GDP is $10,000 (100 units x $200).
Say the central bank supplies $500 to the economy. Thus, the money supply will change hands 20 times ($10,000 / $500) to purchase the same item.
Furthermore, the central bank increased the money supply to $1,000. Assume that the velocity of money is fixed (20 times) and that real output is stagnant (100 units). Thus, it will push up the price from $200 to $2,000 (20x $1,000 / 100).
The short-run quantity theory of money
Monetarists assume that the velocity of money in the short run is constant. Therefore, from the above equation, we know that an increase in the money supply is the primary determinant of nominal GDP. For this reason, monetarists view controlling the money supply as the key to stabilizing the economy.
Increasing the money supply will have two possible consequences: an increase in the price level (inflation), an increase in real output, or both. If the economy can increase real output, the effect of increasing the money supply on inflation is relatively minimal.
Conversely, if the real output is stagnant, then an increase in the money supply will only result in high inflation. However, suppose the central bank reduces the money supply. In that case, it will only result in a decrease in the price level (deflation). This is why, during stagflation, economic stimulus through expansionary monetary policy was not the right choice.
The long-run quantity theory of money
The vertical line of the long-run aggregate supply curve reflects that long-run real output and velocity are constant.
Hence, an increase in the money supply (M) will only increase the price level. Friedman views inflation as having always existed because it is a monetary phenomenon. Changes in the money supply will only cause inflation in the long run.
Monetary Policy as the central bank’s tool for stabilization
Monetarists view changes in the money supply as the key to influencing economic activity. To influence economic growth, the central bank must adjust the money supply at an appropriate growth rate.
The central bank must consider real output in the economy to determine the money supply’s growth rate. For example, if the real output is stagnant, the increase will only increase inflation. Conversely, if the central bank reduces the money supply, it will lead to deflation. Thus, the central bank must change the money supply at a rate consistent with real output growth.
The two types of monetary policy are:
- Expansionary monetary policy is to encourage economic growth and stimulate the inflation rate. In this case, the central bank increases the money supply. Another term for expansionary monetary policy is a loose monetary policy or an easy monetary policy.
- Contractionary monetary policy is to avoid an unsustainable inflation rate. In this case, the central bank reduces the money supply. You may be familiar with the terms tight monetary policy or restrictive monetary policy.
Expansionary vs. contractionary policy tools
Central banks have a toolbox filled with instruments to manipulate the money supply:
- Interest rates: Raising interest rates discourages borrowing and investment, slowing economic activity and potentially reducing inflation. Conversely, lowering interest rates makes borrowing cheaper, stimulating spending and potentially increasing inflation.
- Reserve requirements: This is the portion of deposits banks must hold in reserve, limiting their lending capacity. Increasing reserve requirements reduces the money supply while lowering them allows banks to lend more, expanding the money supply.
- Open Market Operations: Here, the central bank buys or sells government bonds. Buying bonds injects money into the economy by increasing bank reserves while selling bonds reduces the money supply by drawing reserves out of the banking system.
Monetary policy tools influence interest rates, which in turn affect borrowing costs for businesses and consumers. Lower interest rates generally encourage investment and spending, leading to higher aggregate demand (total demand for goods and services) and potential economic growth. Conversely, higher interest rates can dampen investment and spending, reducing aggregate demand.
Business cycles and money supply fluctuations
Monetarists believe fluctuations in the money supply are a major culprit behind business cycles, the periods of economic expansion (booms) and contraction (recessions). They argue that central bank decisions regarding the money supply directly influence aggregate demand (total demand for goods and services) and play a critical role in these cycles.
Excessive growth in the money supply can lead to economic overheating. When there’s more money chasing a similar amount of goods and services, prices begin to rise – this is inflation. As inflation accelerates, consumers become hesitant to spend, fearing further price increases. Businesses may also experience a decline in profit margins due to rising production costs. This ultimately leads to a slowdown in economic activity, potentially triggering a recession.
On the other hand, an inadequate money supply can stifle economic growth. If the money supply doesn’t grow at a rate consistent with real output growth (increased production of goods and services), there’s not enough money circulating in the economy to sustain spending. This can lead to stagnant demand, reduced investment, and, ultimately, a recession. In extreme cases, a persistently shrinking money supply can even trigger deflation, a sustained decrease in the price level, which can be equally damaging to the economy.
Monetarists and the multiplier effect
The core of this theory lies in the concept of the multiplier effect. Imagine a new dollar entering the economy. People and businesses spend it, generating income for the recipient. This recipient then spends a portion of that income, further stimulating the economy.
This cycle of spending and re-spending creates a ripple effect, amplifying the initial increase in the money supply. Monetarists believe that by controlling the money supply, central banks can influence the multiplier effect and, therefore, the overall level of economic activity.
Monetarism vs. Keynesian Economics
Monetarism and Keynesian economics are two prominent schools of economic thought that offer contrasting approaches to managing the economy. While both aim for economic stability and growth, they differ significantly in the tools they advocate for.
Central banks vs. government spending
Monetarists: Focus on monetary policy, using central bank tools like interest rates and money supply adjustments to influence economic activity. They believe controlling the money supply directly affects aggregate demand (total spending in the economy) and inflation.
Keynesians: Emphasize fiscal policy, relying on government spending and taxation to stimulate economic growth during downturns. They argue that injecting money directly into the economy through government spending can create jobs and boost demand.
Monetarist criticisms of Keynesianism:
Neglecting the role of money: Monetarists argue that Keynesians underestimate the importance of money in economic decision-making. They believe households and businesses consider the amount of money available (and its price – interest rates) when making spending and investment decisions. Simply increasing government spending without managing the money supply can lead to unintended consequences.
Government debt and interest rates: Monetarists criticize Keynesians for not adequately addressing the impact of government debt on interest rates. Keynesian policies often involve increasing government spending or lowering taxes, leading to budget deficits. To finance these deficits, governments often borrow money, which can drive up interest rates. Higher interest rates can then “crowd out” private sector investment, as businesses find borrowing more expensive.
The Lag of fiscal policy: Monetarists argue that fiscal policy (government spending and taxation) has a longer lag time compared to monetary policy. Implementing changes in government spending and taxes often takes time due to the political process. By the time these changes are enacted, the economic situation may have already shifted, potentially rendering them ineffective.
Key takeaways:
- Monetarists advocate for using monetary policy tools to control the money supply and influence economic activity.
- Keynesians emphasize the use of fiscal policy through government spending and taxation to manage the economy.
- Monetarists criticize Keynesians for neglecting the role of money and the potential drawbacks of government debt.
