Monetarism is a tendency in economic thought that emphasizes the role of governments in controlling the amount of money in circulation. It is the view within monetary economics that variation in the money supply has major influences on national output in the short run and the price level over longer periods and that objectives of monetary policy are best met by targeting the growth rate of the money supply.
Monetarism today is mainly associated with the work of Milton Friedman, who was among the generation of economists to accept Keynesian economics and then criticize it on its own terms. Friedman and Anna Schwartz wrote an influential book, A Monetary History of the United States, 1867-1960, and argued that "inflation is always and everywhere a monetary phenomenon." Though opposed to the existence of the Federal Reserve, but given that it does exist, Friedman advocated a central bank policy aimed at keeping the supply and demand for money at equilibrium, as measured by growth in productivity and demand.
Monetarism is an economic theory which focuses on the macroeconomic effects of the supply of money and central banking. Formulated by Milton Friedman, it argues that excessive expansion of the money supply is inherently inflationary, and that monetary authorities should focus solely on maintaining price stability.
This theory draws its roots from two almost diametrically opposed ideas: the hard money policies that dominated monetary thinking in the late 19th century, and the monetary theories of John Maynard Keynes, who, working in the inter-war period during the failure of the restored gold standard, proposed a demand-driven model for money which was the foundation of macroeconomics. While Keynes had focused on the value stability of currency, with the resulting panics based on an insufficient money supply leading to alternate currency and collapse, then Friedman focused on price stability, which is the equilibrium between supply and demand for money.
The result was summarized in a historical analysis of monetary policy, Monetary History of the United States 1867-1960, which Friedman coauthored with Anna Schwartz. The book attributed inflation to excess money supply generated by a central bank. It attributed deflationary spirals to the reverse effect of a failure of a central bank to support the money supply during a liquidity crunch.
Friedman originally proposed a fixed monetary rule, called Friedman's k-percent rule, where the money supply would be calculated by known macroeconomic and financial factors, targeting a specific level or range of inflation. Under this rule, there would be no leeway for the central reserve bank as money supply increases could be determined "by a computer", and business could anticipate all monetary policy decisions.
Clark Warburton is credited with making the first solid empirical case for the monetarist interpretation of business fluctuations in a series of papers from 1945.p. 493 Within mainstream economics, the rise of monetarism accelerated from Milton Friedman's 1956 restatement of the quantity theory of money. Friedman argued that the demand for money could be described as depending on a small number of economic variables. Thus, where the money supply 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 were reduced people would want to replenish their holdings of money by reducing their spending. In this, Friedman challenged a simplification attributed to Keynes suggesting that "money does not matter." Thus the word 'monetarist' was coined.
The rise of the popularity of monetarism also picked up in political circles when 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 system 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 disinflation. In 1979, President Jimmy Carter appointed a Federal Reserve chief Paul Volcker who made inflation fighting his primary objective, and restricted the money supply (in accordance with the Friedman rule) to tame inflation in the economy. The result was the creation of the desired price stability.
Monetarists not only sought to explain present 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 made famous the assertion of monetarism that 'inflation is always and everywhere a monetary phenomenon'. Many Keynesian economists initially believed that the Keynesian vs. monetarist debate was solely 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 other issues as monetarists began presenting a fundamental challenge to Keynesianism.
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).
When Margaret Thatcher, leader of the Conservative Party in the United Kingdom, won the 1979 general election defeating the incumbent Labour Party led by James Callaghan, Britain had endured several years of severe inflation, which was rarely below 10% and by the time of the election in May 1979 stood at 10.3%. Thatcher implemented monetarism as the weapon in her battle against inflation, and succeeded at reducing it to 4.6% by 1983 - although this was achieved largely by the mass closure of inefficient factories, which resulted in a recession and in unemployment doubling from around 1,500,000 people to more than 3,000,000. This policy was controversial with the public and even some of her own Members of Parliament (MPs) (as well as former Conservative prime ministers Harold Macmillanand Edward Heath), but her success in the Falklands war led to a recovery in her popularity which contributed to the Conservative victory in the 1983 general election. This came at a time of a global recession, and Thatcher's monetarist policies earned her the respect of political leaders worldwide as Britain was a world leader in the fight against the recession and one of the first nations to re-establish economic growth.
Callaghan himself had adopted policies echoing monetarism while serving as prime minister from 1976 to 1979, adopting deflationary policies and reducing public spending in response to high inflation and national debt. He initially had some success, as inflation was below 10% by the summer of 1978, although unemployment now stood at 1,500,000. However, by the time of his election defeat barely a year later, inflation had soared to 27%.
A realistic theory should be able to explain the deflationary waves of the late 19th century, the Great Depression, and the stagflation period beginning with the uncoupling of exchange rates in 1972. Monetarists argue that there was no inflationary investment boom in the 1920s. Instead, monetarist thinking centers on the contraction of the M1 during the 1931-1933 period, and argues from there that the Federal Reserve could have avoided the Great Depression by moves to provide sufficient liquidity. In essence, they argue that there was an insufficient supply of money.
From their conclusion that incorrect central bank policy is at the root of large swings in inflation and price instability, monetarists argued that the primary motivation for excessive easing of central bank policy is to finance fiscal deficits by the central government. Hence, restraint of government spending is the most important single target to restrain excessive monetary growth.
With the failure of demand-driven fiscal policies to restrain inflation and produce growth in the 1970s, the way was paved for a new policy of fighting inflation through the central bank, which would be the bank's cardinal responsibility. In typical economic theory, this would be accompanied by austerity shock treatment, as is generally recommended by the International Monetary Fund: such a course was taken in the United Kingdom, where government spending was slashed in the late '70s and early '80s under the political ascendance of Margaret Thatcher. In the United States, the opposite approach was taken and real government spending increased much faster during Reagan's first four years (4.22%/year) than it did under Carter (2.55%/year).
In the ensuing short term, unemployment in both countries remained stubbornly high while central banks raised interest rates to restrain credit. These policies dramatically reduced inflation rates in both countries (the United States' inflation rate fell from almost 14% in 1980 to around 3% in 1983 ), allowing liberalization of credit and the reduction of interest rates, which led ultimately to the inflationary economic booms of the 1980s. Arguments have been raised, however, that the fall of the inflation rate may be less from control of the money supply and more to do with the unemployment level's effect on demand; some also claim the use of credit to fuel economic expansion is itself an anti-monetarist tool, as it can be argued that an increase in money supply alone constitutes inflation.
Monetarism re-asserted itself in central bank policy in western governments at the end of the 1980s and beginning of the 1990s, with a contraction both in spending and in the money supply, ending the booms experienced in the US and UK.
With the crash of 1987, questioning of the prevailing monetarist policy began. Monetarists argued that the 1987 stock market decline was simply a correction between conflicting monetary policies in the United States and Europe. Critics of this viewpoint became louder as Japan slid into a sustained deflationary spiral and the collapse of the savings-and-loan banking system in the United States pointed to larger structural changes in the economy.
In the late 1980s, Paul Volcker was succeeded by Alan Greenspan, a leading monetarist. His handling of monetary policy in the run-up to the 1991 recession was criticized from the right as being excessively tight, and costing George H. W. Bush re-election. The incoming Democratic president Bill Clinton reappointed Alan Greenspan, and kept him as a core member of his economic team. Greenspan, while still fundamentally monetarist in orientation, argued that doctrinaire application of theory was insufficiently flexible for central banks to meet emerging situations.
The crucial test of this flexible response by the Federal Reserve was the Asian financial crisis of 1997-1998, which the Federal Reserve met by flooding the world with dollars, and organizing a bailout of Long-Term Capital Management. Some have argued that 1997-1998 represented a monetary policy bind, just as the early 1970s had represented a fiscal policy bind, and that while asset inflation had crept into the United States (which demanded that the Fed tighten the money supply), the Federal Reserve needed to ease liquidity in response to the capital flight from Asia. Greenspan himself noted this when he stated that the American stock market showed signs of irrationally high valuations.
In 2000, Alan Greenspan raised interest rates several times. These actions were believed by many to have caused the bursting of the dot-com bubble. In late 2001, as a decisive reaction to the September 11 attacks and the various corporate scandals which undermined the economy, the Greenspan-led Federal Reserve initiated a series of interest rate cuts that brought the Federal Funds rate down to 1% in 2004. His critics, notably Steve Forbes, attributed the rapid rise in commodity prices and gold to Greenspan's loose monetary policy, and by late 2004 the price of gold was higher than its 12 year moving average; these same forces were also blamed for excessive asset inflation and the weakening of the dollar . These policies of Alan Greenspan are blamed by the followers of the Austrian School for creating excessive liquidity, causing lending standards to deteriorate, and resulting in the housing bubble of 2004-2006.
Currently, the American Federal Reserve follows a modified form of monetarism, where broader ranges of intervention are possible in light of temporary instabilities in market dynamics. This form does not yet have a generally accepted name.
In Europe, the European Central Bank follows a more orthodox form of monetarism, with tighter controls over inflation and spending targets as mandated by the Economic and Monetary Union of the European Union under the Maastricht Treaty to support the euro. This more orthodox monetary policy followed credit easing in the late 1980s through 1990s to fund German reunification, which was blamed for the weakening of European currencies in the late 1990s.
Critics point to policies that add "restraint on compensation increases" as a consequence of Monetarism.
However, total compensation, (including e.g. health insurance), has in fact increased.
Since 1990, the classical form of monetarism has been questioned because of events which many economists have interpreted as being inexplicable in monetarist terms, namely the unhinging of the money supply growth from inflation in the 1990s and the failure of pure monetary policy to stimulate the economy in the 2001-2003 period. Alan Greenspan, former chairman of the Federal Reserve, argued that the 1990s decoupling was explained by a virtuous cycle of productivity and investment on one hand, and a certain degree of "irrational exuberance" in the investment sector. Economist Robert Solow of MIT suggested that the 2001-2003 failure of the expected economic recovery should be attributed not to monetary policy failure but to the breakdown in productivity growth in crucial sectors of the economy, most particularly retail trade. He noted that five sectors produced all of the productivity gains of the 1990s, and that while the growth of retail and wholesale trade produced the smallest growth, they were by far the largest sectors of the economy experiencing net increase of productivity. "2% may be peanuts, but being the single largest sector of the economy, that's an awful lot of peanuts."
There are also arguments which link monetarism and macroeconomics, and treat monetarism as a special case of Keynesian theory. The central test case over the validity of these theories would be the possibility of a liquidity trap, like that experienced by Japan. Ben Bernanke, Princeton professor and current chairman of the US Federal Reserve, has argued that monetary policy could respond to zero interest rate conditions by direct expansion of the money supply. In his words, "We have the keys to the printing press, and we are not afraid to use them." Another popular economist, Paul Krugman, has advanced the counterargument that this would have a corresponding devaluationary effect, like the sustained low interest rates of 2001-2004 produced against world currencies.
Historian David Hackett Fischer, in his study The Great Wave, questioned the implicit basis of monetarism by examining long periods of secular inflation that stretched over decades. In doing so, he produced data which suggest that prior to a wave of monetary inflation, there is a wave of commodity inflation, which governments respond to, rather than lead. Whether this formulation undermines the monetary data which underpin the fundamental work of monetarism is still a matter of contention.
Monetarists of the Milton Friedman school of thought believed in the 1970s and 1980s that the growth of the money supply should be based on certain formulations related to economic growth. As such, they can be regarded as advocates of a monetary policy based on a "quantity of money" target. This can be contrasted with the monetary policy advocated by supply-side economics and the Austrian School which are based on a "value of money" target (albeit from different ends of the formula). Austrian economists criticise monetarism for not recognizing the citizens' subjective value of money and trying to create an objective value through supply and demand.
These disagreements, along with the role of monetary policies in trade liberalization, international investment, and central bank policy, remain lively topics of investigation and arguments.
Most monetarists oppose the gold standard. Friedman, for example, viewed a pure gold standard as impractical. For example, whereas one of the benefits of the gold standard is that the intrinsic limitations to the growth of the money supply by the use of gold or silver would prevent inflation, if the growth of population or increase in trade outpaces the money supply, there would be no way to counteract deflation and reduced liquidity (and any attendant recession) except for the mining of more gold or silver under a gold or silver standard.
Redistributional Effects of Monetary Policy
Inflation targeting is not a neutral pareto improvement. Any choice of target redistributes from some groups to others - making some worse off. For example, high inflation harms holders of fixed rate debt - including pensioneers, holders of fixed income securities, employees with protected jobs and annuity-like compensation (including most government employees, and policy makers, and most tenured academics), and creditors. It benefits net debtors - particularly if they have fixed rate debt or debt with interest rate caps. It also benefits owners of commodities, real estate, foreign currencies, equity in export oriented firms, local employees in trade sensitive and offshoring-capable sectors, and the unemployed. Low inflation benefits holders of fixed rate debt, business that export to the target country, importers, employees who gain from offshoring, retired people on fixed pensions and people with protected annuity like wages (academics, government employees, and policy makers). Low inflation therefore tends to favor rentiers - increasing their wealth by boosting the purchasing power of their assets, and transfers wealth away from debtors, owners of real estate, owners of commodities, local import sensitive businesses, and the insecurely employed.
In theory, this could be corrected - restoring its neutrality (and Pareto improvement), however transaction costs, moral hazard, information asymmetry and political resistance would make such wealth transfers grossly impractical.
To the extent that Monetary policy creates a known and predictable transfer of wealth between a priori known counterparties, it is not a neutral economic tool and cannot be divorced from political considerations and preferred constituencies.
Furthermore, such constituencies will try to influence choice of monetary policy targets - rentiers/creditors and pensioners will prefer tight monetary policy, debtors will prefer looser monetary policy, as will exporters and other participants in (internationally) tradeable sectors of the economy, owners of commodities and real estate, and the precariously employed
If redistribution of wealth via such mechanisms has differential efficiency impact and impacts the network of business formation and production within and between trading nations, some monetary policy targets may also move an economy away from an efficient frontier.
Moral Hazard of Monetary Policy Making Agents
From a principal agent perspective, monetary policy makers face a personal moral hazard - since their compensation typically takes the form of a secure fixed annuity. This would incentivize them to favor tight monetary policy - even at the expense of lower real GDP growth. Compensation schemes that made their personal wealth inversely related to the unemployment rate would create a moral hazard in favor of overly loose monetary policy. Compensation schemes that made their personal wealth contingent on real GDP growth may be more efficient by reducing their overall moral hazard.
- Andersen, Leonall C., and Jerry L. Jordan, 1968. Monetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization, Federal Reserve Bank of St. Louis Review (November), pp. 11 24. PDF (30 sec. load: press +) and HTML.
- _____, 1969. Monetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization Reply, Federal Reserve Bank of St. Louis Review (April), pp. 12 16. PDF (15 sec. load; press +) and HTML.
- Brunner, Karl, and Allan H. Meltzer, 1993. Money and the Economy: Issues in Monetary Analysis, Cambridge. Description and chapter previews, pp. ix-x.
- Cagan, Phillip, 1965. Determinants and Effects of Changes in the Stock of Money, 1875-1960. NBER. Foreword by Milton Friedman, pp. xiii-xxviii. Table of Contents.
- Friedman, Milton, ed. 1956. Studies in the Quantity Theory of Money, Chicago. Chapter 1 is previewed at Friedman, 2005, ch. 2 link.
- _____, 1960. A Program for Monetary Stability. Fordham University Press.
- _____, 1968. "The Role of Monetary Policy," American Economic Review, 58(1), pp. 1-17 (press +).
- _____,  2005. The Optimum Quantity of Money. Description and table of contents, with previews of 3 chapters.
- Friedman, Milton, and David Meiselman, 1963. The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1897-1958, in Stabilization Policies, pp. 165 268. Prentice-Hall/Commission on Money and Credit, 1963.
- Friedman, Milton, and Anna Jacobson Schwartz, 1963a. "Money and Business Cycles," Review of Economics and Statistics, 45(1), Part 2, Supplement, p p. 32-64. Reprinted in Schwartz, 1987, Money in Historical Perspective, ch. 2.
- _____. 1963b. A Monetary History of the United States, 1867-1960. Princeton. Page-searchable links to chapters on 1929-41 and 1948-60
Johnson, Harry G., 1971. "The Keynesian Revolutions and the Monetarist Counter-Revolution," American Economic Review, 61(2), p p. 1-14. Reprinted in John Cunningham Wood and Ronald N. Woods, ed., 1990, Milton Friedman:: Critical Assessments, v. 2, p p. 72- 88. Routledge,
- Laidler, David E.W., 1993. The Demand for Money: Theories, Evidence, and Problems, 4th ed. Description.
Schwartz, Anna J., 1987. Money in Historical Perspective, University of Chicago Press. Description and Chapter-preview links, pp. vii-viii.
- Warburton, Clark, 1966. Depression, Inflation, and Monetary Policy; Selected Papers, 1945-1953 Johns Hopkins Press. Evaluation in Anna J. Schwartz, Money in Historical Perspective, 1987.
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