Monetarist 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 will grow, and if the money supply contracts, so will economic growth weaken. Therefore, they view monetary policy as a more effective tool to influence economic activity. Monetarists advocate the use of monetary policy instead of fiscal policy to control the cycle in real GDP, inflation, and employment.
The difference between monetarist and Keynesians
Monetarism is a popular school in macroeconomics besides Keynesians. Simply put, to influence the economy, monetarists recommend controlling money in 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 to influence aggregate demand. While the government is responsible for fiscal policy, the central bank is responsible for implementing monetary policy.
Today, Monetarism is mainly associated with Nobel Prize-winning economist Milton Friedman. He is considered the father of Monetarism. He received the 1976 Nobel Memorial Prize for his research on consumption analysis, monetary history, and theory, as well as the complexity of stabilization policies.
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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.
Types of monetary policy
The central bank carries out a monetary policy to influence the money supply and the availability of credit in the economy. For implementation, the central bank uses several instruments, including policy rates, open market operations, and reserve requirement ratios.
Based on its objectives, two types of monetary policy: contractionary and expansionary.
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. That makes borrowing costs more expensive, reducing consumer and business interest in applying for new loans to buy goods and services.
- Open market operations by selling government securities. Money moves from commercial banks to central banks. Commercial banks have less money to lend. Tight liquidity and pushing interest rates up.
- Increase the reserve requirement ratio. Banks have to set aside a more significant portion of the deposit as a reserve hence reduce the amount they can lend.
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.
Expansionary monetary policy
The central bank carries out expansionary policies to stimulate economic growth. The policy is suitable when the economy is weak or recession due to a decrease in aggregate demand. To boost the economy, the central bank eases its monetary policy through:
- A cut in benchmark interest rates. Now, borrowing costs are cheaper. Consumers are eager to apply for new loans to finance the purchase of some goods and services, especially durable goods. For businesses, lower costs make the investment in capital goods such as machinery and equipment more profitable.
- Open market operations by buying government securities held by commercial banks. Money moves from the central bank to commercial banks. With more money, commercial banks can make more new loans.
- Lower the reserve requirement ratio. Now, banks deviate fewer deposits as reserves. Banks have more money to lend.
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.
Monetarist views on inflation
Monetarists believe a high inflationary pressure occurs if the money supply grows faster aggregate output. In this condition, more money chases fewer goods.
They argue that inflation is always everywhere, and it is a monetary phenomenon. In a sense, inflation can change through intervention on the money supply.
The quantity theory of money defines the relationship between the money supply (M) and its circulation (V) with inflation (aggregate prices or P) and real output (Y).
M x V = P x Y
Money circulation is assumed to be constant because the change takes a long time and depends on financial technology and innovation in a country. With this assumption, we know that when the money supply rises (M), it carries two consequences: an increase in price, real output, or a combination of both.