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Monetarism is a school of thought in monetary economics that emphasizes the role of policy-makers in controlling the amount of money in circulation. It gained prominence in the 1970s, but was mostly abandoned as a direct guidance to monetary policy during the following decade because of the rise of inflation targeting through movements of the official interest rate.
The monetarist theory states that variations in the money supply have major influences on national output in the short run and on over longer periods. Monetarists assert that the objectives of monetary policy are best met by targeting the growth rate of the money supply rather than by engaging in discretionary monetary policy.Phillip Cagan, 1987. "Monetarism", , v. 3, Reprinted in John Eatwell et al. (1989), Money: The New Palgrave, pp. 195–205, 492–97. Monetarism is commonly associated with neoliberalism.
Monetarism is mainly associated with the work of Milton Friedman, who was an influential opponent of Keynesian economics, criticising Keynes's theory of fighting economic downturns using fiscal policy (e.g. government spending). 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".
Although opposed to the existence of the Federal Reserve, Friedman advocated, given its existence, a central bank policy aimed at keeping the growth of the money supply at a rate commensurate with the growth in productivity and aggregate demand. Money growth targeting was mostly abandoned by the central banks who tried it, however. Contrary to monetarist thinking, the relation between money growth and inflation proved to be far from tight. Instead, starting in the early 1990s, most major central banks turned to direct inflation targeting, relying on steering short-run as their main policy instrument. Afterwards, monetarism was subsumed into the new neoclassical synthesis which appeared in macroeconomics around 2000.
Monetarist theory draws its roots from the quantity theory of money, a centuries-old economic theory which had been put forward by various economists, among them Irving Fisher and Alfred Marshall, before Friedman restated it in 1956.
However, the effectiveness of such monetary rules may depend critically on how money is measured and incorporated into macroeconomic models. Traditional simple-sum monetary aggregates, which treat all monetary assets as perfect substitutes, may provide misleading signals for monetary policy, particularly during periods of financial innovation. Studies using theoretically-grounded Divisia monetary aggregates have found more stable relationships between money growth, inflation expectations, and economic activity, suggesting that properly measured money can provide clearer guidance for monetary policy implementation. Moreover, incorporating money into forward-looking macroeconomic models with proper measurement can enhance the transmission mechanism of monetary policy and improve the effectiveness of rules-based approaches.
Thus, according to Friedman, when 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 popularity of monetarism picked up in political circles when the prevailing view of neo-Keynesian economics seemed unable to explain the contradictory problems of rising unemployment and inflation in response to the Nixon shock in 1971 and the oil shocks of 1973. On one hand, higher unemployment seemed to call for reflation, but on the other hand rising inflation seemed to call for disinflation. The social-democratic post-war consensus that had prevailed in First World was thus called into question by the rising Neoliberalism political forces.
In May 1979, Margaret Thatcher, Leader of the Conservative Party in the United Kingdom, won the general election, defeating the sitting Labour Government led by James Callaghan. By that time, the UK had endured several years of severe inflation, which was rarely below the 10% mark and stood at 10.3% by the time of the election. Thatcher implemented monetarism as the weapon in her battle against inflation, and succeeded at reducing it to 4.6% by 1983. However, unemployment in the United Kingdom increased from 5.7% in 1979 to 12.2% in 1983, reaching 13.0% in 1982; starting with the first quarter of 1980, the UK economy contracted in terms of real gross domestic product for six straight quarters.
The money supply is useful as a policy target only if the relationship between money and nominal GDP, and therefore inflation, is stable and predictable. This implies that the velocity of money must be predictable. In the 1970s velocity had seemed to increase at a fairly constant rate, but in the 1980s and 1990s velocity became highly unstable, experiencing unpredictable periods of increases and declines. Consequently, the stable correlation between the money supply and nominal GDP broke down, and the usefulness of the monetarist approach came into question. Many economists who had been convinced by monetarism in the 1970s abandoned the approach after this experience.
The changing velocity originated in shifts in the demand for money and created serious problems for the central banks. This provoked a thorough rethinking of monetary policy. In the early 1990s central banks started focusing on targeting inflation directly using the short-run interest rate as their central policy variable, abandoning earlier emphasis on money growth. The new strategy proved successful, and today most major central banks follow a flexible inflation targeting.
Studies using theoretically-grounded Divisia monetary aggregates, which weight monetary components based on their "monetary services" or liquidity properties, have found considerably more stable money demand relationships. For instance, Belongia and Ireland demonstrated that money demand equations using Divisia measures remain stable even through periods of financial innovation and policy regime changes that destabilized traditional simple-sum specifications.
This finding has important implications for monetary policy frameworks. The breakdown in simple-sum money demand relationships was a key factor in central banks abandoning monetary targeting in favor of interest rate rules. However, research using Divisia aggregates suggests that money could still serve as a useful policy indicator or intermediate target if properly measured.
The stability of Divisia money demand functions has been demonstrated across different time periods and countries. For example, Hendrickson found that replacing simple-sum with Divisia measures resolves apparent instabilities in U.S. money demand, while similar results have been documented for other economies. Chen and Valcarcel argued that the properly measured monetary quantities and their holding costs maintain a stable, long-term cointegration.
These findings suggest that the historical shift away from monetary aggregates in policy frameworks may have been premature and based on flawed measurement rather than a true breakdown in the relationship between money and economic activity. While most central banks continue to focus primarily on interest rates, the stability of properly-measured money demand functions indicates that monetary aggregates could potentially play a more prominent role in policy frameworks.
Description
Monetary history of the United States
Fixed monetary rule
Opposition to the gold standard
Rise
Monetarism in the US and the UK
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Decline
Measurement Issues on the Stability of Money Demand
Legacy
Notable proponents
See also
Further reading
External links
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