4/19/2020 Monetarism Definition

ECONOMICS MACROECONOMICS

Monetarism
By AKHILESH GANTI | Updated Nov 12, 2019

What Is Monetarism?
Monetarism is a macroeconomic concept, which states that governments can foster economic
stability by targeting the growth rate of 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.

KEY TAKEAWAYS
Monetarism is a macroeconomic concept that states that governments can foster
economic stability by targeting the growth rate of money supply.
Central to monetarism is the "Quantity Theory of Money," which states that the money
supply (M) multiplied by the rate at which money is spent per year (V) equals the
nominal expenditures (P * Q) in the economy.
Monetarists believe that velocity (V) is constant and changes to money supply (M) is the
sole determinant of economic growth, a view that serves as a bone of contention to
Keynesians.

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. However, in the long-term, the increasing demand will eventually be greater than
supply, causing a disequilibrium in the markets. The shortage caused by a greater demand than
supply will force prices to go up, leading to inflation.

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Monetary policy, an economic tool used in monetarism, is used to adjust interest rates to
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. On the other hand,
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.

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 mainly to allow for the natural growth of the economy. Due to
the inflationary effects that can be brought about by excessive expansion of the money supply,
Friedman, whose work 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 Friedman’s k-percent rule, which suggested that money supply should grow
at a constant annual rate tied to the nominal GDP growth and expressed as a fixed percentage
per year. This way, money supply will be expected to grow moderately, businesses will be able
to anticipate the changes to the money supply every year and plan accordingly, the economy
will grow at a steady rate, and inflation will be kept at low levels.

Friedman's Quantity Theory of Money

Central to monetarism is the "Quantity Theory of Money," 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:

MV = PQ
where:
M = money supply
V = velocity (rate at which money changes hands)
P = average price of a good or service
Q = quantity of goods and services sold

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A key point to note is that monetarists believe that changes to M (money supply) is the driver of
the equation. In short, a change in M directly affects and determines employment, inflation (P),
and production (Q). They view velocity as constant, implying that the money supply is the major
factor of GDP, or economic, growth.

Economic growth is a function of economic activity (Q) and inflation (P). If V is constant and
predictable, then an increase (or decrease) in M will lead to an increase (or decrease) in either P
or Q. An increase in P denotes that the Q will remain constant, while an increase in Q means that
P will be relatively constant. According to monetarism, variations in the money supply will affect
price levels over the long-term and economic output in the short-term. A change in the money
supply, therefore, will directly determine prices, production, and employment.

Monetarism vs. Keynesian Economics

The view that velocity is constant serves as a bone of contention to Keynesians, who believe
that velocity should not be constant since the economy is volatile and subject to periodic
instability. Keynesian economics argues that aggregate demand is the key to economic growth
and supports any action of central banks to inject more money into the economy in order to
increase demand. As stated earlier, this runs contrary to monetarist theory, which asserts that
such actions will result in inflation.

Proponents of monetarism believe that controlling an economy through fiscal policy is a poor
decision. Excessive government intervention interferes with the workings of a free market
economy and could lead to large deficits, increased sovereign debt, and higher interest rates,
which would eventually force the economy into a state of destabilization.

Monetarism had its heyday in the early 1980s when economists, governments, and investors
eagerly jumped at every new money supply statistic. In the years that followed, however,
monetarism fell out of favor with economists, and the link between different measures of
money supply and inflation proved to be less clear than most monetarist theories had
suggested. Many central banks today have stopped setting monetary targets and instead have
adopted strict inflation targets.

Related Terms
Equation of Exchange Definition

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4/19/2020 Monetarism Definition

The equation of exchange is a model that shows the relationship between money supply, price level, and
other elements of the economy. more

Monetarist Theory Definition

The monetarist theory is a concept, which contends that changes in money supply are the most
significant determinants of the rate of economic growth. more

Quantity Theory of Money Definition

The quantity theory of money is a theory about the demand for money in an economy. more

What is a Monetarist?
A monetarist is someone who believes an economy should be controlled predominantly by the supply of
money. more

Monetary Theory Definition

Monetary theory is a set of ideas about how changes in the money supply impact levels of economic
activity. more

Velocity of Money Definition

The velocity of money is a measurement of the rate at which consumers and businesses exchange money
in an economy. more

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