Table of Contents
- The root of the monetarist school of thought
- Monetary and Keynesian differences
- Monetary school ideas
- How monetary policy affects the economy
- Monetarist view over the business cycle
What’s it: Monetarist school of thought is one of the mainstream macroeconomic thought. It believes that money supply is the primary determinant of economic growth. Those who hold this view we call 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 as 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 well as investments by businesses.
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.
The root of the monetarist school of thought
Monetarism has its roots in the thinking of Milton Friedman. He and Anna Schwartz wrote the famous book “A Monetary History of The United States, 1867 – 1960“. They argued that inflation is a monetary phenomenon.
Due to monetary phenomena, the key to influencing inflation is the amount of money in the economy. The policy to influence the money supply is what we call monetary policy.
Friedman advises central banks to maintain growth in the money supply at a rate consistent with growth in productivity and demand for goods. Otherwise, it can produce negative consequences such as hyperinflation and deflation.
Monetary and Keynesian differences
The main difference between Monetary and Keynesian lies in what drives the economy. Both of them then formulate several solutions on how policymakers should influence economic activity.
Monetarism gave birth to monetary policy. Meanwhile, Keynesian gave birth to fiscal policy. Both are mainstream policies in today’s modern economy.
Under the monetary policy, the central bank or monetary authority takes a role. They influence the economy through instruments such as policy interest rates, open market operations, and reserve requirements.
Under the fiscal policy, the government influences the economy through its budget. They can change expenditures or taxes to influence economic activity.
Monetary criticism of Keynesians
Friedman criticized Keynes’s solution on how to influence the economy. The three main criticisms are:
First, Keynesians put money aside.
They do not explain how money affects decisions by economic actors. Of course, these decisions ultimately affect economic activity.
Friedman views money as another essential facet of the modern economy. Households take into account the money they have before making decisions to buy goods and services. Likewise, businesses look at money and its price (interest rate) when deciding on investments.
Second, Keynesians fail to explain the impact of government debt on interest rates and economic activity.
In the Keynesian argument, to stimulate economic growth, the government increases spending or decreases taxes. That often leads to a higher budget deficit.
The government covers the budget deficit through debt. Rising taxes in the future to cover the deficit is less popular politically. Therefore, a more comfortable option is debt.
Well, here is the point. Keynesians do not explain how debt affects the economy.
The increase in debt by the government pushed up interest rates in the domestic economy. Rising interest rates affect the cost of capital and private sector investment decisions (via the crowding-out effect).
Third, fiscal policy involves a longer lag. It is ineffective to have an immediate impact on the economy.
Budgeting (taxes and expenses) takes longer and is more complicated because it involves a political process. So, when implemented, the economy has likely changed course.
Monetary school ideas
The theoretical foundation of monetarism is the Quantity Theory of Money. This theory tries to link the amount of money circulating in the economy with nominal GDP.
They also view that government intervention should be minimal. Interventions often have no better consequences. Therefore, the market should be allowed to work on its own.
Regarding the long-run and short-term Keynesian concepts, monetarists believe that the economy is inherently stable. They view the aggregate supply curve as more vertical, indicating the economy is always close to or rapidly approaching full employment. Therefore, fiscal stabilization policies are not so important in directing the economy towards long-run macroeconomic equilibrium.
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
- 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 in 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 that the key to stabilizing the economy is controlling the money supply.
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
Long-run real output is constant, as reflected by the vertical line of the long-run aggregate supply curve. Velocity is also constant.
Hence, an increase in the money supply (M) will only increase the price level. That explains why Friedman views that inflation has always existed because it is a monetary phenomenon. Changes in the money supply will only cause inflation in the long run.
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.
How monetary policy affects the economy
As I have already mentioned, under the monetary policy, the central bank influences the money supply. This can be done through three monetary policy tools. The three affect economic activity through monetary policy transmission channels such as financial market interest rates, the balance of payments, exchange rates, wealth, equity, and bank loans.
The first is the policy rate. This is the official interest rate to influence short and long term interest rates on financial markets.
The specific definition varies between countries. One of them is the central bank’s interest rate on overnight loans to banks if their reserves fall below the required level.
An increase in the policy rate reduces the money supply. Conversely, if it falls, it increases the money supply.
The second is the reserve requirement ratio. This is the deposit portion that the bank has to keep and should not be borrowed or invested. For example, a 10% ratio means that the bank has to set aside Rp10 of the Rp100 deposit as reserves. The rest, they can lend it.
So when the ratio falls, the bank has more money to lend, increasing the economy’s money supply. The opposite effect applies when the central bank increases the ratio.
The third is the open market operation. In this case, the central bank sells and buys government securities. When done massively, we call it quantitative easing.
When buying securities from a bank, money goes from the central bank to banks. They can use it to make loans. That, in turn, increases the money supply.
Conversely, if the central bank sells securities, money goes from the banks to the central bank’s pockets. The money supply decreases, and banks have less cash to lend.
Expansionary monetary policy
When the economy contracts, the central bank stimulates economic growth by increasing the money supply. Say, the central bank chooses to cut policy rates.
The decline in policy interest rates pushed down bank lending rates. It stimulates households to apply for new loans to buy durable goods like houses and cars.
Lower interest rates decrease the cost of capital. It stimulates businesses to invest in capital assets. Initially, they will buy more light equipment, which contributes to operational efficiency.
An increase in consumption and investment drives up aggregate demand in the economy. It stimulates producers to increase production. Initially, they will increase overtime hours instead of adding a new workforce.
So, at the beginning of the economic recovery, the unemployment rate is still relatively high. However, the income outlook improves as overtime hours increase.
If demand gets stronger, businesses will increase their production again. They also start to recruit more workers and order heavy capital goods (such as machinery) to increase production. The unemployment rate falls. The economy then entered an expansion phase. In this phase, the inflation rate begins to creep up.
The fall in the unemployment rate leads to a tighter supply in the labor market. That pushes the nominal wage up, resulting in an increase in the cost of production. Businesses pass higher production costs on to consumers by raising selling prices.
Higher prices create upward pressure on the price level. The inflation rate starts to surge. This situation usually occurs during an economic boom, the final part of the expansion phase before the peak.
To avoid an overheated economy, the central bank put a brake on the money supply’s growth rate. If uncontrolled, the inflation rate can lead to hyperinflation. To prevent this, the central bank adopts a contractionary monetary policy.
Contractionary monetary policy
During the economic boom, the inflation rate goes so high that it overheats the economy. That forces the central bank to implement a contractionary monetary policy.
An overheated economy could cause a burst if not appropriately handled. The effects can be severe and often lead to hyperinflation.
Under contractionary policies, the central bank can take the following policy alternatives:
- Raising the policy rate
- Increasing the reserve requirement ratio
- Selling government securities
Say, the central bank chooses to raise policy rates. That pushed up interest rates on financial markets. Higher interest rates make new loans more expensive.
Consumers reduce lending to banks. They delay the purchase of durable goods. Likewise, businesses delay investing because the cost of capital becomes higher. As a result, aggregate demand weakens. Weak demand prompts producers to reduce production rates.
Monetarist view over the business cycle
Monetarists believe that variations in the growth rate of the money supply cause business cycles. The decision to change the money supply causes aggregate demand to fluctuate.
An economic boom occurs because the growth in the money supply exceeds the growth in real output. It generates upward pressure on the price level.
Conversely, during a recession, growth in the money supply cannot keep pace with real output growth. The quantity of goods and services is increasing rapidly, but the economy does not have the money to buy them. That results in a decrease in aggregate demand and forces producers to cut production.