What Is Monetarism? Theory, Formula, and Comparison to Keynesian Economics

What Is Monetarism?

Monetarism is a macroeconomic theory which states that governments can foster economic stability by targeting the growth rate of the money supply. Essentially, it is a set of views based on the belief that the total amount of money in an economy is the primary determinant of economic growth.

Understanding Monetarism

Monetarism is an economic school of thought which states that the supply of money in an economy is the primary driver of economic growth. As the availability of money in the system increases, aggregate demand for goods and services goes up. An increase in aggregate demand encourages job creation, which reduces the rate of unemployment and stimulates economic growth.

Monetary policy, an economic tool used in monetarism, is implemented to adjust interest rates that, in turn, control the money supply. When interest rates are increased, people have more of an incentive to save than to spend, thereby reducing or contracting the money supply. Contrarily, when interest rates are lowered following an expansionary monetary scheme, the cost of borrowing decreases, which means people can borrow more and spend more, thereby stimulating the economy.

Milton Friedman and Monetarism

Monetarism is closely associated with economist Milton Friedman, who argued, based on the quantity theory of money, that the government should keep the money supply fairly steady, expanding it slightly each year to allow for the natural growth of the economy. Due to the inflationary effects that can be brought about by the excessive expansion of the money supply, Friedman, who formulated the theory of monetarism, asserted that monetary policy should be done by targeting the growth rate of the money supply to maintain economic and price stability.

In his book, "A Monetary History of the United States 1867–1960," Friedman proposed a fixed growth rate called the K-percent rule, suggesting that money supply should grow at a constant annual rate tied to the growth of nominal gross domestic product (GDP) and be expressed as a fixed percentage per year. This way, the money supply woud be expected to grow moderately, businesses would be able to anticipate the changes to the money supply every year and plan accordingly, the economy would grow at a steady rate, and inflation would be kept at low levels.

The Quantity Theory of Money

Central to monetarism is the quantity theory of money, which monetarists adopted from earlier economic theories and integrated into the general Keynesian framework of macroeconomics. The quantity theory of money can be summarized in the equation of exchange, formulated by John Stuart Mill, which states that the money supply, multiplied by the rate at which money is spent per year, equals the nominal expenditures in the economy. The formula is given as:

$\begin{aligned} &MV = PQ \\ &\textbf{where:} \\ &M = \text{money supply} \\ &V = \text{velocity (rate at which money changes hands)} \\ &P = \text{average price of a good or service} \\ &Q = \text{quantity of goods and services sold} \\ \end{aligned}$​MV=PQwhere:M=money supplyV=velocity (rate at which money changes hands)P=average price of a good or serviceQ=quantity of goods and services sold​

A key point to note is that monetarists believe that changes to M (money supply) are the driver of the equation. In short, a change in M directly affects and determines employment, inflation (P), and production (Q). In the original version of the quantity theory of money, V is held to be constant, but this assumption was dropped by John Maynard Keynes and is not assumed by the monetarists, who instead believe that V is easily predictable.

Economic growth is a function of economic activity (Q) and inflation (P). If V is constant (or at least predictable), then an increase (or decrease) in M leads to an increase (or decrease) in either P or Q.

An increase in P denotes that Q remains constant, while an increase in Q means that P remains relatively constant. According to monetarism, variations in the money supply affect price levels over the long term and economic output in the short term. A change in the money supply, therefore, directly determines prices, production, and employment.

Monetarism vs. Keynesian Economics

The view that velocity is constant is a source of contention among Keynesians, some of whom believe that velocity is not so since the economy is volatile and subject to periodic instability. Instead, Keynes' liquidity preference theory emphasizes how changes in money demand (and thus velocity) influence the price level and aggregate demand.

Monetarism builds on the Keynesian theory by assuming the same macroeconomic framework and integrating the equation of exchange (with V swinging cyclically, as Keynes argued), but instead focuses on the role played by money supply. Because they believe that V can be relatively easily predicted, monetarists argue that the equation of exchange could be resuscitated as an approach to stabilization policy, and they favor the use of monetary policy to do so.

Proponents of monetarism generally believe that controlling an economy through fiscal policy is a poor decision because it necessarily introduces microeconomic distortions that reduce economic efficiency. They prefer monetary policy as a tool to manage aggregate demand in a way that will be more neutral from a microeconomics standpoint and that avoids the deadweight losses and social costs that fiscal policy creates in markets.

History of Monetarism

Monetarism gained prominence in the 1970s, a decade characterized by high and rising inflation and slow economic growth. The policies of monetarism were responsible for bringing down inflation in the United States and the United Kingdom. After U.S. inflation peaked at 20% in 1979, the Federal Reserve (the Fed) switched its operating strategy to reflect monetarist theory. During this time period, economists, governments, and investors eagerly jumped at every new money supply statistic.

In the years that followed, however, monetarism fell out of favor with many economists, as the link between different measures of money supply and inflation proved to be less clear than most monetarist theories had suggested. In addition, monetarism's ability to explain the U.S. economy waned in the following decades. Many central banks today have stopped setting monetary targets and instead have adopted strict inflation targets.

Although most modern economists reject the emphasis on money growth that monetarists purported in the past, some core tenets of the theory have become a mainstay in non-monetarist analysis. One of the most important of these ideas is that inflation cannot continue indefinitely without increases in the money supply. In addition, it is the responsibility—although not the primary goal—of the central bank to control inflation.

That being said, monetarist interpretations of past economic events are still relevant today. Ben Bernanke, former Fed chairman, cited the work of Friedman in his decision to lower interest rates and increase the U.S. money supply in order to boost the economy during the global recession that began in 2007 in the United States.

Real-World Examples of Monetarism

In Friedman's seminal work, "A Monetary History of the United States, 1867–1960," which he wrote with fellow economist Anna Schwartz, the two economists argued that failed monetary policy executed by the Fed was responsible for the Great Depression in the U.S. in the 1930s. In the view of Friedman and Schwartz, the Fed failed to relieve downward pressure on the money supply, and their eventual actions to reduce the money supply were the opposite of what they should have done. According to Friedman and Schwartz, markets tend towards a stable center; markets behave erratically if the money supply is not properly set.

In 1979, when Paul Volcker became the chairman of the Fed, he made combatting inflation the primary goal of the central bank. In keeping with Friedman and Schwartz's recommendations, Volcker restricted the money supply in order to do this. He raised the federal funds rate to 20% in 1980. At this time, this strategy for fighting stagflation—a state of high inflation combined with high unemployment and stagnant demand—was successful. Volcker's policies drastically reduced the money supply, consumers stopped purchasing as much, and businesses stopped raising prices. However, while this caused inflation to greatly decline, it resulted in the recessionary periods between 1980 and 1982.

During the same time period, Britain was also struggling with severe inflation. When Margaret Thatcher was elected prime minister in 1979, she also implemented a set of monetarist policies to combat the rising prices in the country. By 1983, inflation in Britain had been halved, from 10% to 5%.

However, the popularity of monetarism was relatively brief. In the 1980s and 1990s, the link between the money supply and nominal GDP broke down, and the quantity theory of money—the backbone of monetarism—was called into question. Many economists who had recommended the policies of monetarism in the 1970s abandoned the approach.

The Bottom Line

Monetarism is an economic school of thought that emphasizes the role of monetary policy in the economy. It's associated with the economist Milton Friedman, and gained prominence in the second half of the 20th century. Monetarism is commonly distinguished from Keynesianism, which emphasizes the importance of aggregate demand in the economy.