Monetarism (economic theory)
Monetarism is an economic theory that emphasizes the role of government in controlling inflation by managing the money supply within the economy. Developed in the 1940s by economist Milton Friedman, monetarism arose as a counterpoint to Keynesian economics, which advocates for government intervention to stabilize economic fluctuations. Monetarists argue that excessive government spending can lead to inflation, proposing instead that a stable money supply should be maintained to ensure economic stability.
Central to monetarism is the quantity theory of money, which posits that the amount of money in circulation, multiplied by its velocity (the rate at which money changes hands), equals nominal expenditures. Monetarists advocate for a constant money-growth rule, suggesting that the money supply should grow at a rate consistent with economic growth to keep prices stable. While monetarism was particularly influential in the latter half of the twentieth century, its principles continue to inform discussions about monetary policy today. In contemporary economics, elements of both monetarist and Keynesian thought are often integrated, reflecting an evolving understanding of how best to manage economic stability and growth.
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Monetarism (economic theory)
Monetarism is an economic school of thought that focuses on using the federal government to control inflation by tightly controlling the amount of new currency entering the economy. Monetarism was created in the 1940s and remained popular throughout the 1980s. It was often cited in opposition to the popular Keynesian school of economics. Keynesian economics was created in the 1930s as a way to explain the Great Depression. This school promoted lower taxes and higher government spending as a way to stimulate the economy. In the twenty-first century, the two schools are often blended and cited together.
Background
Monetarism was pioneered by economist Milton Friedman, one of the most famous economists of the twentieth century. Friedman was a strong advocate of the free market and clashed with economists who promoted Keynesian economics about market regulation and government intervention.
In his first book, Income from Independent Professional Practice, published in 1945, he argued against government licensing practices. He believed the free market could better regulate industries that require licensing. In an ideal free market, any business that failed to produce the promised results would not be selected by the consumer and would then fail.
Widely considered his most important publication, A Theory of Consumption Function (1957) challenged Keynesian economics. According to Keynesian economists, households usually adjust their expenditures to account for their available income. In A Theory of Consumption Function, Friedman helped prove that individuals usually spend their money in relation to how much money they expect to have in the future.
Unlike most popular economists of the time, Friedman disagreed with many of the central tenets of Keynesian economics. As he published more material, his theories gradually became more influential and were later referred to as monetarism. Friedman's theories remained popular throughout the 1980s.
Overview
Monetarism was a reactionary economic school of thought formed in opposition to Keynesian economics, developed by John Maynard Keynes. According to Keynes, government intervention is sometimes necessary to stabilize the economy. Some economic schools believed that in a free, unrestricted market, the amount a consumer is willing to pay and the amount for which a producer is willing to sell will eventually find a balance. Over time, the price will drift to the highest average amount that a consumer is willing to pay, a price suitable to both parties. This balance is called the invisible hand. Competition among producers may drive that cost down, making the balance of power between producers and consumers skewed in favor of the consumer.
According to Keynesian economics, an economy that encourages investment over savings causes inflation. When inflation occurs, money is devalued. Commodities that used to cost one dollar might now cost two dollars. However, Keynesian economics also states that an economy that encourages savings over investment falls into recession. Thus, Keynesian economics argues for government spending during periods of recession.
Monetarism disagrees with this premise. According to Friedman and his monetarist followers, continuous government spending to push the economy away from recession leads to unbridled inflation. They believe that the government should strictly control the amount of money circulating in the economy to curtail inflation and that such practices will lead to a more stable economy.
Monetarism is based on the quantity theory of money. According to this theory, money supply multiplied by velocity equals nominal expenditures in any given economy. Velocity is defined as the rate at which money is exchanged, and nominal expenditures are the number of commodities multiplied by the average price paid for them. While most economists agree that this equation is theoretically sound, velocity is notoriously difficult to accurately measure. Most monetarists argue that velocity is relatively stable, while other economists disagree.
When economists dissect the quantity theory of money, they are able to divide it into several general rules: the constant money-growth rule, interest rate flexibility, long-run monetary neutrality, and short-run monetary non-neutrality. The constant-money growth rule was a recommendation by Friedman that the Federal Reserve should be required to attempt to inject money into the economy at the same rate as the growth of the gross domestic product (GDP). According to monetarists, if the amount of money and the GDP remain locked, prices would remain constant, and inflation would cease.
If the constant money-growth rule went into effect, it would allow for interest rate flexibility. If inflation is kept constant, and the economy is kept stable, predictions about future economic trends become much more reliable. This would allow for more flexibility with interest rates, making it easier for small businesses and individuals to get loans.
Monetarism remained relevant into the twenty-first century. During the booms and recessions of the late twentieth and early twenty-first centuries, Keynesian economics became extremely popular. Economists urged the government to borrow and spend in large quantities to stimulate the economy. They argued that if the government was spending money, individuals would feel more comfortable spending money, setting the economy on a path away from recession. In response to renewed interest in Keynesian economics, many economists turned to Friedman's monetarism. In some situations, the two schools are cited together.
While most modern economists do not believe that inflation and the amount of currency circulating in the economy need to be tracked as carefully as Friedman and the original monetarists advised, they acknowledge that monetarist principals are economically sound. They also acknowledge that the central bank and Federal Reserve need to tightly control the money supply, as inflation cannot continue to rise without the injection of more currency into the economy. \
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