Monetarism is a school of economic thought that maintains that the money supply (the total amount of money in an economy, in the form of coin, currency, and bank deposits) is the chief determinant on the demand side of short-run economic activity.
American economist Milton Friedman is generally regarded as monetarism’s leading exponent. Friedman and other monetarists advocate a macroeconomic theory and policy that diverge significantly from those of the formerly dominant Keynesian school. The monetarist approach became influential during the 1970s and early ’80s.
Underlying the monetarist theory is the equation of exchange, which is expressed as MV = PQ. Here M is the supply of money, and V is the velocity of turnover of money (i.e., the number of times per year that the average dollar in the money supply is spent for goods and services), while P is the average price level at which each of the goods and services is sold, and Q represents the quantity of goods and services produced.
The monetarists believe that the direction of causation is from left to right in the equation; that is, as the money supply increases with a constant and predictable V, one can expect an increase in either P or Q. An increase in Q means that P will remain relatively constant, while an increase in P will occur if there is no corresponding increase in the quantity of goods and services produced. In short, a change in the money supply directly affects and determines production, employment, and price levels. The effects of changes in the money supply, however, become manifest only after a significant period of time.
One monetarist policy conclusion is the rejection of fiscal policy in favour of a “monetary rule.” In A Monetary History of the United States 1867–1960 (1963), Friedman, in collaboration with Anna J. Schwartz, presented a thorough analysis of the U.S. money supply from the end of the Civil War to 1960. This detailed work influenced other economists to take monetarism seriously.
Friedman contended that the government should seek to promote economic stability, but only by controlling the rate of growth of the money supply. It could achieve this by following a simple rule that stipulates that the money supply be increased at a constant annual rate tied to the potential growth of gross domestic product (GDP) and expressed as a percentage (e.g., an increase from 3 to 5 percent).
Monetarism thus posited that the steady, moderate growth of the money supply could in many cases ensure a steady rate of economic growth with low inflation.
Monetarism’s linking of economic growth with rates of increase of the money supply was proved incorrect, however, by changes in the U.S. economy during the 1980s. First, new and hybrid types of bank deposits obscured the kinds of savings that had traditionally been used by economists to calculate the money supply. Second, a decline in the rate of inflation caused people to spend less, which thereby decreased velocity (V). These changes diminished the ability to predict the effects of money growth on growth of nominal GDP.