Monetarism

Monetarism is a set of views concerning the determination of national income and monetary economics. It focuses on the supply and demand for money as the primary means by which economic activity is regulated. Monetary theory focuses on money supply and on inflation as an effect of the supply of money being larger than the demand for money.

The rise of monetarism

The rise of monetarism within mainstream economics dates mostly from Milton Friedman's 1956 restatement of the quantity theory of money. Friedman argued that the demand for money depended predictably on several major economic variables. Thus, if the money supply was expanded, people would not simply wish to hold the extra money in idle money balances; i.e., if they were in equilibrium before the increase, they were already holding money balances to suit their requirements, and thus after the increase they would have money balances surplus to their requirements. These excess money balances would therefore be spent and hence aggregate demand would rise. Similarly, if the money supply was reduced people would want to replenish their holdings of money by reducing their spending. Thus Friedman challenged the Keynesian assertion that "money does not matter"; he argued that the supply of money does affect the amount of spending in an economy. Thus the word 'monetarist' was coined.

Related Topics:
Milton Friedman - Money supply

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The rise of the popularity of monetarism in political circles accelerated as Keynesian economics seemed unable to explain or cure the seemingly contradictory problems of rising unemployment and inflation in response to the collapse of the Bretton Woods Conference in 1972 and the oil shocks of 1973. On the one hand, higher unemployment seemed to call for Keynesian reflation, but on the other hand rising inflation seemed to call for Keynesian deflation. The result was a significant disillusionment with Keynesian demand management: a Democratic President Jimmy Carter appointed a monetarist Federal Reserve chief Paul Volcker who made inflation fighting his primary objective, and restricted M1 to tame inflation in the economy. The result was the most severe recession of the post-war period, but also the creation of the desired price stability.

Related Topics:
Unemployment - Inflation - Bretton Woods Conference - Oil shocks of 1973 - Reflation - Deflation - Jimmy Carter - Paul Volcker

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Monetarists not only sought to explain contemporary problems; they also interpreted historical ones. Milton Friedman and Anna Schwartz in their book A Monetary History of the United States, 1867-1960 argued that the Great Depression of 1930 was caused by a massive contraction of the money supply and not by the lack of investment Keynes had argued. They also maintained that post-war inflation was caused by an over-expansion of the money supply. They coined the famous assertion of monetarism that 'inflation is always and everywhere a monetary phenomenon'. At first, to many economists whose perceptions had been set by Keynesian ideas, it seem that the Keynesian vs. monetarist debate was merely about whether fiscal or monetary policy was the more effective tool of demand management. By the mid-1970s, however, the debate had moved on to more profound matters as monetarists presented a more fundamental challenge to Keynesian orthodoxy.

Related Topics:
Anna Schwartz - Great Depression - Monetary policy

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Many monetarists sought to resurrect the pre-Keynesian view that market economies are inherently stable in the absence of major unexpected fluctuations in the money supply. Because of this belief in the stability of free-market economies they asserted that active demand management (e.g. by the means of increasing government spending) is unnecessary and indeed likely to be harmful. The basis of this argument is an equilibrium between "stimulus" fiscal spending and future interest rates. In effect, Friedman's model argues that current fiscal spending creates as much of a drag on the economy by increased interest rates as it creates present consumption: that it has no real effect on total demand, merely that of shifting demand from the investment sector (I) to the consumer sector (C).

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