Monetarism

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Updated: Aug 20, 2021

A particular approach to macroeconomic theory and policy which has the following central elements:

(a) in the long-run the leve! of real national income or output is determined by the interaction of the forces of supply and demand in all markets, including those for labour. This full-employment leve! of output is determined therefore solely by the real underlying elements of the economy: the amounts of resources it possesses and the technology of production. Prices and wage rates will adjust to whatever relative levels are necessary to establish this full employment equilibrium in which by definition there is no involuntary unemployment.

(b) It follows that neither fiscal nor monetary policy can effect output and employment in the long-run. The money supply is, however, a key policy instrument, first because it determines the general leve! of prices in the long-run, and second because it may have short-run effects on output and employment. To see this, suppose there is an increase in the money supply. This will stimulate demand for goods and services, first because the rate of interest will fall, thus increasing investment and possibly some forms of consumer expenditure, and second because the value of money balances will have increased, thus making people feel wealthier and inducing them to spend more. The immediate effect of this increased expenditure is to increase output and employment. However, prices and wages will start to rise in response to increased demand. This then causes a rise in everyone’s expectations of inflation, causing a further wage-price spiral. Finally, therefore, though with a time-lag which may be ‘long and variable’, the increased money supply will lead to more inflation.

(c) Fiscal policyis at best irrelevant and at worst positively harmful. It can by definition have no effect on the leve! of full-employment output, simply changing its composition by ‘crowding out’ private­sector output. Insofar as it is financed by increasing the money supply it will cause inflation.

(d) The demand for money depends on real output and the real interest rate in a stable, predictable way. This is the modem extension of the assumption underlying the ‘simple’ quantity theory of money that the velocity of circulation is a constant. In effect it is saying that the latter may vary, but in away which can be explained and predicted in terms of interest rate and income changes.

(e) The money supply is controllable: it is possible for a monetary authority such as the Bank of England to determine its leve! and rate of growth.

(f) Because in the long-run output is independent of the money supply (as well as fiscal policy), the policy which should be adopted is to allow the money supply to grow at the same rate as the growth of output. This will ensure growth without inflation, since the quantity theory implies that in the long-run the rate of inflation will equal the rate of growth of the money supply minus the rate of growth of real output. Coupled with this is a general opposition to discretionary policy, i.e. policy which can be varied at will by the government. This is regarded as more likely to be destabilizing and so should be replaced by non-discretionary fixed rules such as that of allowing the money supply growth rate to grow at the same rate as output. This therefore suggests a less active economic role for government. Within the set of economists who would accept being termed ‘monetarists’, there are differences in emphasis and some diversity of views; for example, not all believe in rational expectations. The above propositions however are the common core. The antecedents of monetarism can be traced back at !east three hundred years. For example, there is a clear statement of point (b) in the writings of David Hume. However, following the work of J. M. Keynes in the 1930s almost diametrically opposed views, particularly in relation to economic policy, became dominant among economists. The revival of monetarism in its present form owes a great deal to the theoretical and empirical work of Milton Friedman and his co-workers at the University of Chicago.

Reference: The Penguin Business Dictionary, 3rd edt.



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James Knight
Editor of Education
James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.