Monetarism - New World Encyclopedia
Monetarist say the government has contributed to the economy's business cycles through .. Monetarists argue that money supply growth is an important part of basically an inverse relationship between inflation and unemployment. LR, The. The first relates to the economic thought that sees in the quantity of money. is the basis for the relationship between inflation and unemployment. monetarists believe that the trade off can be systematically exploited in the. While most economists believe that long-run neutrality is a feature of actual market All monetarists emphasized the undesirability of combating inflation by to the American Economic Association in , published in as “The Role of.
Explanation of why money supply leads to inflation Monetarists believe that in the short-term velocity V is fixed This is because the rate at which money circulates is determined by institutional factors, e. Milton Friedman admitted it might vary a little but not very much so it can be treated as fixed Monetarists also believe output Y is fixed.
They state it may vary in the short run but not in the long run because LRAS is inelastic and determined by supply-side factors. The level of output Y is units. In year 2, if the output stays at 1, units, but money supply increases to 15, Consumers have more money to buy the same amount of goods. Therefore, firms put up prices to reflect this increase in money supply. Other points Milton Friedman predicted an increase in the money supply would take about months to lead to higher output.
Friedman placed great emphasis on the role of price expectations. If there are expectations of higher inflation, it becomes self-fulfilling — workers demand higher wages to meet rising living costs. Firms put up prices to meet rising costs.
Strict monetarist policies would help reduce expectations. In the early s, the UK and US adopted monetarist policies with mixed results. This rate of increase should depend on institutional factors and be determined independently of policymakers.
Friedman believed this rule would avoid the extremes of deflation Falling money supply, e. Great Depression and inflation due to rising money supply. It would give business strong expectations of what would happen to money supply and inflation.
Thus, if aggregate private demand i. The central issue underlying Keynesian thought was that those individuals who have incomes demand goods and services and, in turn, help to create jobs. The government should thus find a way to increase aggregate demand. One direct way of doing so was to increase government spending. Increased government spending would generate jobs and incomes for the persons employed on government projects. This, in turn, would create demand for goods and services of private producers and generate additional employment in the private sector.
Keynesian economists thus recommended that the government should use fiscal policy which includes decisions regarding both government spending and taxes to make up for the shortfall in the private aggregate demand to reignite the job creating private sector. Keynesian economists even went so far as to recommend that it was worthwhile for the government to employ people to in meaningless jobs, as long as they were employed.
The Roosevelt administration did follow Keynesian recommendations, although reluctantly, and embarked on a variety of government programs aimed at boosting incomes and the aggregate demand.
As a result, the Depression economy started moving forward. The really powerful push to the depressed U. S economy, however, came when World War II broke out. It generated such an enormous demand for U. Serious unemployment disappeared for a long period of time. Modern Keynesians also, known as neoKeynesians recommend utilizing monetary policy, in addition to fiscal policy, to manage the level of aggregate demand.
Monetarist view of the Phillips Curve
Monetary policy affects aggregate demand in the Keynesian system by affecting private investment and consumption demand. An increase in the money supply, for example, leads to a decrease in the interest rate. This lowers the cost of borrowing and thus increases private investment and consumption, boosting the aggregate demand in the economy.
An increase in aggregate demand under the Keynesian system, however, not only generates higher employment but also leads to higher inflation. This causes a policy dilemma—how to strike a balance between employment and inflation.
According to laws that were enacted following the Great Depression, policy makers are expected to use monetary and fiscal policies to achieve high employment consistent with price stability. Keynesian macroeconomic thought became the new standard in place of the old classical standard. The birth of monetarism took place in the s.
The original proponent of monetarism was Milton Friedman, now a Nobel Laureate. The monetarists argue that while it is not possible to have full employment of the labor force all the time as classical economists arguedit is better to leave the macroeconomy to market forces. Friedman modified some aspects of the classical theory to provide the rationale for his noninterventionist policy recommendation. In essence, monetarism contends that use of fiscal policy is largely ineffective in altering output and employment levels.
Moreover, it only leads to crowding out. Monetary policy, on the other hand, is effective. However, monetary authorities do not have adequate knowledge to conduct a successful monetary policy—manipulating the money supply to stabilize the economy only leads to a greater instability. Hence, monetarism advocates that neither monetary nor fiscal policy should be used in an attempt to stabilize the economy, and the money supply should be allowed to grow at a constant rate. Friedman contends that the government's use of active monetary and fiscal policies to stabilize the economy around full employment leads to greater instability in the economy.
He argues that while the economy will not achieve a state of bliss in the absence of the government intervention, it will be far more tranquil. The monetarist policy recommendations are similar to those of the classical economists, even though the reasoning is somewhat different.
A detailed discussion of the key elements of monetarism follows.
Monetarist Theory of Inflation
In particular, an effort is made to explain the theoretical framework that monetarists employ and how they arrive at policy recommendations regarding the use of monetary and fiscal policies. Theories and Policies, the key propositions advanced by monetarist economists in particular, Milton Fried-man can be summarized as follows.
The supply of money has the dominant influence on nominal income. Two economic concepts enter this proposition—money supply and nominal income. Money supply can be narrowly defined as the sum of all money currency, checkable deposits, and travelers checks with the nonbank public in the economy.
The money supply so defined is technically called MI by monetary authorities and economists. Nominal income can simply be understood as the gross domestic product GDP at current prices. GDP is thus made up of a price component and a real output component.
The current value of the GDP can go up due to an increase in the prices of goods and services included in the GDP or due to an increase in the actual production of goods and services included in the GDP or both.
The above proposition then states that the stock of money in the economy is the primary determinant of the nominal GDP, or the level of economic activity in current dollars.
What Is Monetarism? - Back to Basics - Finance & Development, March
The proposition is vague regarding the breakdown of an increase in nominal gross domestic product into increases in the price level and real output. However, the proposition does assume that, for most part, a change in the money supply is the cause of a change in the GDP at current prices or nominal income. Also, the level and the rate of growth of the money supply are assumed to be primarily determined by the actions of the central monetary authority the Federal Reserve Bank in the United States.
In the short run, money supply does have the dominant influence on the real variables. Here, the real variables are the real output the real GDP and employment. The first proposition only alluded to real output—implied in the break up of the nominal GDP into the real and price components. Where does the employment variable come from? Employment is basically considered a companion of real output.
If real output increases, producers must generally employ additional workers to produce the additional output. Of course, sometimes producers may rely on overtime from existing workers. But, generally an increase in employment eventually follows an increase in real output. The second proposition, however, is not confined to real output and employment—prices are influenced as well.
Thus, the second proposition effectively states that changes in money supply strongly influence both real output and price level in the short run. Proposition two, therefore, provides a break down of a change in the nominal income, induced by a change in the money supply, into changes in real output and price level components mentioned in the first proposition. In the long run, the influence of a variation in the money supply is primarily on price level and on other nominal variables such as nominal wages.
Price level is a nominal variable in the sense that a change in price level is in sharp contrast to a change in real output and employment—it does not have the advantages that are associated with the latter two.
In the long run, the real macroeconomic variables, such as real output and employment, are determined by changes in real factors of production, not simply by altering a nominal variable, such as the money supply. Real output and employment are, in turn, determined by real factors such as labor inputs, capital resources, and the state of technology.
As was indicated in the second proposition, in the short run, a change in the stock of money affects both real output and price level. This, in conjunction with proposition three, leads to the implication that the long-run influence of money supply is only on the price level.
The private sector of the economy is inherently stable. Further, government policies are primarily responsible for instability in the economy.
This proposition summarizes the monetarist economists' belief in the working of the private sector and market forces. The private sector mainly consists of households and businesses that together account for the bulk of private sector demand, consumption, and investment.
This monetarist proposition, then, states that these components of the aggregate demand are stable, and are thus not a source of instability in the economy. In fact, monetarists argue that the private sector is a self-adjusting process that tends to stabilize the economy by absorbing shocks.
They contend that it is the government sector that is the source of instability. The government causes instability in the economy primarily through an unstable money supply.
Since the money supply has a dominant effect on real output and price level in the short run, and on price level in the long run, fluctuations in the money supply lead to fluctuations in these macroeconomic variables—i.
Moreover, the government, by introducing a powerful destabilizing influence changes in the money supplyinterferes with the normal workings of the self-adjusting mechanism of the private sector. In effect, the absence of money supply fluctuations would make it easier for the private sector mechanism to work properly. The above four propositions lead to some key policy conclusions.
Based on Froyen, the four monetarist propositions provide the bases for the following two policy recommendations: First, stability in the growth of money supply is absolutely crucial for stability in the economy. Monetarists further suggest that stability in the growth of money supply is best achieved by setting the growth rate at a constant rate—this recommendation has been termed as the constant money supply growth rule.
The chief proponent of monetarism, Milton Friedman, has long advocated a strict adherence to a money supply rule. Other monetarists favor following a less inflexible money supply growth rate rule. However, monetarists, in general, are in favor of following a rule regarding the money supply growth rate, rather than tolerating fluctuations in the monetary aggregate caused by discretionary monetary policy aimed at stabilizing the economy around full employment.
This policy difference from the activist economists primarily, the Keynesians is at the heart of the monetarist debate. This component of the debate is known among professional economists as "rule versus discretion" controversy.
One should note that while monetarists are adamant about following a money supply rule, they are not so rigid regarding the rate at which the money supply growth rate should be fixed.
A general rule of thumb suggests that the money supply should grow between 4 and 5 percent. How do economists arrive at these numbers? It is assumed that the long-term economic growth potential of the U. So, the money supply has to grow at about 3 percent just to keep the price level from falling—economists do not like falling prices because they cause other problems in the economy.
Monetarist Theory of Inflation | Economics Help
An inflation rate of percent per annum is considered acceptable. To generate percent inflation, the money supply must grow at percent above the growth rate of the real GDP. In effect, then, to have a modest percent inflation, the money supply should grow at about percent.
The issue of the money supply growth rule will be further clarified when theoretical principles underlying monetarism are discussed later. Second, fiscal policy is ineffective in influencing either real or nominal macroeconomic variables. Thus, the government can't use fiscal policy as a stabilization tool.
Monetarists contend that while fiscal policy is not an effective stabilization tool, it does lead to some harmful effects on the private sector economy—it crowds out private consumption and investment expenditures. In general, the theoretical framework employed by monetarist economists is a modified version of classical macroeconomic theory. The modifications were needed to address the Keynesian criticisms of the classical theory and to establish monetarist policy conclusions. Theoretical support for each of the four propositions will be briefly discussed in this section.
This proposition—that money supply has a dominant effect on nominal income—is the most basic part of the theoretical structure of the monetarist counterrevolution. Proposition one is based on a key classical theoretical framework known as the quantity theory of money.
Classical economists had argued that the quantity or the supply of money determines only price level a nominal variablenot real variables such as output and employment. The quantity theory of money is used to establish the link between the quantity of money and the price level, and thus its name simply emphasizes the importance of the quantity of money.