The Monetarist Theory: Milton Friedman

Economic theories explore the relationships linking changes in the money supply to changes in economic activity and prices. With a mixture of theoretical ideas, philosophical beliefs, and policy prescriptions, these theories can help elaborate on both historic and current financial situations. For instance, the general understanding of the monetarist theory, founded by economist Milton Friedman, focuses on macroeconomic activities that examine the impact of changes in the money supply and central banking.

This economic school of thought theoretically challenges Keynesian economics (OnlineTexts) to contend that variations in the money supply are the most significant determinants of the rate of economic growth, the behavior of the business cycle, the national output in the short run, and the price level over longer periods of time (Investopedia). Through the developments from other theories, more laissez-faire government approaches, and the use of the quantity theory of money, monetarism has dramatically impacted and helped explain changes in monetary policy and the banking system for nearly one hundred years.

To fully grasp this economic theory, the history behind it and what influenced its existence must be understood. Following the Great Depression, Keynesian economics mainly dominated the United States as well as countries globally. This economic theory focused on total spending in the economy and its effects on output and inflation (Blinder). Keynesians traditionally saw fiscal policy as the key tool for economic management, believed monetary policy should simply be used as a backup, and believed that the government’s role was to maintain the economy at full employment (Biz/Ed).

This theory also emphasized interest rates as a target of monetary policy, raising rates to slow down the economy and reducing rates to speed things up (Allen 283). Although these views were the main focus for some time, many economists saw that the theory was leaving most of our economic problems unexplained. As Keynesian economics seemed unable to explain or cure the seemingly contradictory problems of rising unemployment and inflation (Allen 284) economits like Milton Friedman began making different, more accurate observations.

Monetarism’s rise to intellectual prominence began with writings on basic monetary theory by Friedman and other economists during the 1950s (McCallum). These proposals were influential because of their devotion to fundamental neoclassical principles, particularly Friedman’s presidential address to the American Economic Association in 1967, published in 1968 as “The Role of Monetary Policy. ” In this paper Friedman developed the natural-rate hypothesis and used it as a pillar in the argument for less government intervention and a constant-growth-rate rule for monetary policy (McCallum).

From this point the monetarist theory drew its roots from two almost entirely opposing ideas, the hard money policies that dominated monetary thinking in the late 19th century, and the theories of Keynesian economics (Wikipedia). While Keynes had focused on total spending and the value stability of currency which resulted with problems based on an insufficient money supply, Friedman centered on price stability acting as the equilibrium between supply and demand for money (Wikipedia).

Friedman and other monetarists began challenging Keynesian ideas and strongly started to suggest that “money does not matter” (Wikipedia). Monetarist’s goals involved seeking to explain present problems while also striving to interpret historical ones. Since monetarists strongly believe that the money supply is the primary determinant of nominal GDP in the short run and of the price level in the long run, they stress that the control of the money supply should not be left to the discretion of central bankers and that the focus should shift to a more laissez-faire approach for the banking system (OnlineTexts).

Monetarists do not believe that the government should intervene in economic and monetary decisions by trying to manage the level of aggregate demand or total spending (Biz/Ed). Friedman explains that if we are experiencing government deficits and must make a monetary decision, then the deficits should be financed by increasing the money supply instead of affecting aggregate demand, and vice versa for budget surpluses.

Monetarists argue that interventionist policy regarding managing total spending will be destabilizing in the long run and should therefore be avoided. By trusting free markets rather than large governments, monetarists quickly and simultaneously agreed that government intervention will destabilize the economy more than it will help, since intervention typically interferes in the workings of free markets and can lead to bloated bureaucracies, unnecessary social programs, and large deficits (OnlineTexts).

Markets will benefit by working on their own since market forces will cause inflation, unemployment and production to adjust themselves automatically and efficiently around a fixed amount of money (Milton Friedman and Monetarism). A key problem with discretionary demand management policies is the time lags, which monetarists believe make fiscal policy too difficult to use to manage the economy effectively (Biz/Ed). The best thing therefore, is to take a long-run view of price stability and use monetary policy to achieve this.

Monetarists always say that where fiscal policy could be beneficial, monetary policy would do the job better. Government attempts to influence GDP and other economic measures through fiscal policy are at best ineffectual, mainly because expansionary fiscal policy only causes inflation (Monetarist Theory of Inflation). The monetarist theory believes that the Fed should not have discretion but rather be bound to fixed rules in conducting monetary policy.

For example, monetarists prefer the money growth rule which states that the Fed should be required to target the growth rate of money so that it equals the growth rate of real GDP, leaving the price level unchanged (OnlineTexts). The relationship between inflation and money growth is virtually a one-to-one relationship, so if the economy is expected to grow at a certain percent in a given year, the Fed should allow the money supply to increase by the same percent. By following this rule there will be a tight control of money and credit allowing the economy to maintain price stability (Riley).

Monetarist’s stress incorrect central bank policy is often the root of large fluctuations in inflation and price stability, showing that the key to success is to ensure that monetary policy is credible so that people’s expectations of inflation are controlled (Riley). Friedman states within his academic paper, “The Role of Monetary Policy” that “monetary authorities should guide themselves by magnitudes that they can control, not by ones that they cannot” (Friedman 14), which is why the quantity theory of money and other monetarist concepts are of huge importance and assistance.

The quantity theory of money is a basic theoretical explanation for the link between money and the general price level. This theory helps describe how by controlling the growth of the money supply and leaving interest rates unchanged; the Fed can better control inflation and foster stable economic growth (Riley). This identity relates total aggregate demand to the total value of output, and holds that changes in nominal prices reflect changes in the money supply and the velocity of money (Monetarism). Monetarists assume that the velocity of money within the economy, or rather the average number of times a dollar is used to purchase final good or service is assumed constant or changes at a predictable rate (Wikipedia). The value of real output (GDP), or the total volume of production of goods and services, is not influenced by monetary variables (Riley) allowing monetarists to also treat GDP as a constant. Looking at the quantity of money theory equation, M*V = P*Y, where M is the rate of growth in the money supply, V is the velocity of money, P is the overall price level, and Y is the total output or GDP, one can determine that with V and Y as constants, changes in the rate of money supply will equal changes in the price level (Riley).

By using this equation and theory, economists can determine and solve problems within the economy and we have seen this throughout history. The monetarist theory can effectively explain the deflationary waves of the late 19th Century, the Great Depression, and the stagflation period beginning in the early 1970’s (Wikipedia). Monetarists argue that there was no inflationary boom in the 1920’s, while Keynesians argue that there was significant asset inflation and unsustainable growth.

Monetarists’ claim that the contraction of the M1 money supply during 1931-1933 is to blame for the Great Depression and if the Fed had provided sufficient liquidity to make up for the insufficient money supply, then that financial crisis would have be avoided (Pettinger). In comparison, the increase in inflation rates throughout the 1970’s led many to consider monetarist policies to steady the money growth (Hafer 18). Even though the sudden rise in inflation in the 1970’s was related directly to oil price shocks, there was also a similar increase in the average rate of money growth.

To combat this, the Fed began adopting a monetarist platform and monetary targets were effectively used in official policy analysis (Hafer 18). Later in the 1980’s President Reagan imposed strict monetarist policies of restricted money stock growth in an effort to stop the dramatic rise of inflation. At this time, the prime interest rate was at twenty percent and unemployment reached double digits. The monetarist policies Reagan proposed brought down inflation and unemployment rates, suggesting that monetarist policies were succeeding (Allen 284).

Most recently in the early 1990’s, John Taylor, an economics professor at Stanford, showed that U. S. monetary policy could be accurately described by relating movements in the federal funds rate to deviations in inflation from a target rate and deviations in real output growth from potential growth (Hafer 19). This Taylor rule dominates much of the research on monetary policy during the past decade, both as a model of Fed behavior and as a model to guide policy decisions (Hafer 19).

While some disagreement remains, certain things are clear. Since 1990, the classical form of monetarism has been questioned because of events that have been interpreted as inexplicable in monetarist terms, primarily the unhinging of the money supply growth from inflation in the 1990’s and the failure of monetary policy to stimulate the economy in the early 2000’s (Wikipedia). Alan Greenp, former chairman of the Federal Reserve, explains why the monetarist theory unfortunately had no success in combating early financial problems.

He argued that the 1990’s economic decline had little to do with the monetarist view of the money supply and rather was “explained by a virtuous cycle of productivity and investment on one hand, and a certain degree of “irrational exuberance” in the investment sector” (Wikipedia). Along with Greenp, economist Robert Solow of MIT suggested that the 2001-2003 failure of the expected economic recovery also was not attributed by monetary policy, but by the decreasing productivity growth in crucial sectors of the economy (Investopedia).

Despite both the successes and failures of the monetarist theory, in 2005 most academic specialists in monetary economics described their orientation as new Keynesians (McCallum). However, even with that focus, most of the changes to Keynesian thinking that monetarists proposed are accepted today as part of standard macroeconomic and monetary analysis and most economists accept the proposition that monetary policy is more powerful and useful than fiscal policy for stabilizing the economy (McCallum).

In addition, current thinking clearly favors policy rules in contrast to discretion of central banks and stresses the importance of maintaining inflation at low rates. With new Keynesian views prominent in today’s society, it can be determine that it is only in the emphasis on monetary aggregates that monetarism is not being widely practiced today. Economic theories, including monetarism, are constantly changing to provide outlets for research in all areas of economics based on theoretical reasoning and analysis of economic problems.

Despite the drastic differences between the late 19th century and today’s economy, the same economic problems remain the same. We cannot put so much doubt and negativity onto monetarist views as we can be assured that new economic theories will continuously emerge as changes in the economy bring fresh insights and cause existing ideas to become obsolete.

Throughout these changes, the same motivating force is present regarding the need to understand the economy in order to achieve society’s goals. These economic theories are highly significant in finding the right monetary policy to bring about economic growth and financial stability in a country. The monetarist theory, as well as others more prominent today, will continue to be debated and tested in order to find answers to some of the most troubling economic questions throughout our history.

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