Monetarism

Monetarism, theory of macroeconomics particularly concerned with money supply. Although “monetarism” is widely identified with a particular view of the way that the supply of money in the economy affects other variables—such as prices, output, and employment—there are, in fact, many different schools of thought that might be included under the umbrella term of “monetarism”. Monetarism is commonly contrasted with Keynesianism, which roughly corresponds to the view that changes in the money supply have little, if any, short-term impact on the economy, that the economy will not automatically move towards full employment, and that fiscal policy can be effective in helping attain full employment. What monetarists have in common is mainly a dissent from these propositions, particularly the first and the third. They also share a belief in the overriding importance of the money supply in determining the level of prices. What monetarists do not have in common is an agreed view on whether monetary policy has any effect on output in the short term, as well as many other relatively minor matters, such as the proper definition of the money supply. Also, insofar as some monetarists would only expect a strict relationship to hold between the money supply and the price level in the long term, their central proposition would be accepted by almost all other economists if the long term is sufficiently long and certain other variables—such as the nature of financial institutions and so on—remain constant.

Monetarism in one form or another has a long tradition in the history of economic thought, and detailed and sophisticated explanations of the way that an increase in the quantity of money would eventually affect prices, and possibly output over the short term, were advanced in the mid-18th century in the works of the French economist Richard Cantillon and the Scottish economist and philosopher David Hume. Eventually the “quantity theory of money”, as it became known, came to dominate monetarism, partly under the influence of Irving Fisher in the 20th century. It was formalized in an equation showing the price level as identically equal to the quantity of money multiplied by its “velocity of circulation” and divided by the volume of transactions. An alternative version of the quantity equation theory was the “Cambridge” version, which presented the demand for money as a function of the price level, the income level, and the volume of transactions.

In the 1950s, particularly under the leadership of Milton Friedman, the demand for money by individuals was analysed in the same terms as the demand for any other commodity—as dependent on the individual's wealth and the relative price of the commodity in question. More exactly, the demand for money was seen as dependent on certain variables, including notably wealth (of which expected income was regarded as a good approximation), the division of a person's wealth between human and non-human capital (the former exhibiting less liquidity than the latter), the price level, the expected rate of return on other assets (in turn influenced by the rate of interest and expected changes in prices), and other variables determining the utility that people expected to obtain from holding money.

The emphasis on money as a component of people's wealth implied that they would try to eliminate any discrepancy between the amount of “real” money balances (that is, money divided by the price level) that they held and the amount they wanted to hold by either changing their assets and liabilities—for example, by selling or buying bonds—or changing the flow of their income or expenditures. Keynesians would tend to emphasize the former method of adjustment and earlier monetarists would emphasize the latter, whilst more modern monetarists would tend to accept both.

The basic idea of monetarist economics, then, would appear to be the confrontation between the total demand for and supply of money balances. The authorities have a considerable power to determine the supply of “nominal” money balances (that is, uncorrected for the price level) since they usually control the amount of money printed or created by the banking system. But people decide how much in “real” money balances they wish to hold. One possible sequence, therefore, if, for example, too much money is printed, is that people will try to get rid of the excess by buying goods or assets (real or financial). If the economy is at full employment, the increase in expenditure will either raise the prices of home-produced goods or lead to a balance of payments deficit that would cause the exchange rate to depreciate and hence push up import prices. In either case, the rise in prices tends to reduce the “real” money balances that people hold. And insofar as they buy, say, financial assets such as bonds, the rise in the price of bonds reduces the rate of interest, which, in turn will stimulate investment and hence economic activity. The increase in economic activity, and hence in incomes, increases the demand for money balances. Thus, the total demand for real money balances will be brought into equality with the excess supply partly by a rise in the price level (which reduces the “real” money balances that people hold) and partly by a rise in incomes (which raises the level that they want to hold).

A further tenet of monetarism is that changes in the desired level of “real” money balances tend to proceed slowly, whereas large changes in nominal balances can, and frequently do, occur independently and are caused by action of the monetary authorities. This factual assertion implies that large changes in prices or nominal incomes must almost inevitably be the result of changes in the supply of money. This, in turn, leads to the famous Friedmanite assertion that inflation is always and everywhere a monetary phenomenon. In other words, it is believed that the demand for “real” money balances is essentially stable and is basically a function of real wealth (though the other variables play some part, at least in the short run). Large changes in the supply of “real” balances must be caused by changes in the money supply or changes in prices. If such changes take place, people will seek to restore their original stock of money balances by an adjustment mechanism such as that outlined above, which will have some short-term effects on the economy. (This is disputed by some modern schools of monetarism which, in accordance with the tenets of “rational expectations”, assume that price changes will be instantaneous and expected, so that no economic agents will have any incentive to react by changes in demand for or supply of goods or labour.)