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Monetarism: Explained

Vrinda Mathur
Dec 06, 2023
Updated on: Sep 11, 2023

According to the macroeconomic theory of monetary theory, governments can promote economic stability by focusing on the pace of increase in the money supply. It is, in essence, a set of beliefs rooted in the conviction that the total amount of money in an economy is the key factor in determining economic growth.

The creation of jobs and economic growth is only temporarily boosted by expanding the money supply, according to monetarists (proponents of the monetarism theory). In the long run, inflation rises when the money supply is increased. Prices will increase to match as supply cannot keep up with demand.

What is Monetarism?

Monetarism is a school of economic thinking that holds that the primary driver of short-term economic activity on the demand side is the money supply, or the total amount of money in an economy in the form of coin, currency, and bank deposits. Most people consider Milton Friedman, an American economist, to be the main proponent of monetarism. Friedman and other monetarists promote a macroeconomic theory and approach that significantly departs from the Keynesian school's prior dominance. In the 1970s and early 1980s, the monetarist strategy gained popularity.

Fiscal policy (government spending and tax policy), in the opinion of monetarists, is less effective than monetary policy. Spending on stimuli expands the money supply, but it also results in a deficit, which raises a nation's sovereign debt. That might push up interest rates.

As they regulate the money supply, central banks, according to monetarists, are more powerful than the government. Additionally, they favor keeping an eye on actual interest rates above nominal rates. The majority of rates that are announced are nominal rates; real rates take inflation into account. Real rates depict the price of money more accurately.

Thus, monetary theory postulated that a constant rate of economic growth with minimal inflation could often be achieved by the gradual, moderate expansion of the money supply. However, changes in the American economy in the 1980s disproved monetary theory's assertion that rates of increase in the money supply correlate with rates of economic expansion. First, the sorts of savings that economists had traditionally used to estimate the money supply were hidden by new and hybrid types of bank deposits. Second, consumers started to spend less when the rate of inflation dropped, which reduced velocity (V). These modifications made it harder to anticipate how money expansion would affect nominal GDP growth.

How does it work?

The working of monetarism is as lower interest rates result from an expansion of the money supply. Banks are prepared to charge lower rates since they have more money to lend. This implies that customers borrow more money to purchase goods like homes, cars, and furniture. Money supply reduction hinders economic growth because higher interest rates make loans more expensive.

The Federal Reserve controls the amount of money in circulation in the US through the Federal funds rate. All other interest rates are influenced by this targeted rate, which the Fed establishes for banks to charge one another for overnight loans. To achieve the target federal funds rate, the Fed also employs other financial instruments, such as open market transactions and the buying and selling of government assets.

Through the manipulation of interest rates, a nation's central bank can increase or decrease the amount of money in circulation. For instance, the Fed Funds Rate, which determines the interest rate at which banks can lend money to one another overnight in the United States, is subject to fluctuation. All other interest rates in the economy are influenced by the Fed funds rate.

Interest rates generally rise when the Fed funds rate rises. It lessens the quantity of money lent to individuals and businesses, which lowers expenditure and slows economic growth. On the other hand, dropping interest rates encourages firms and consumers to borrow more, which boosts spending and promotes economic expansion.

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Advantages of Monetary Policy

Money boards, central banks, and even governments can regulate the supply of money by using monetary policy measures. The availability of consumer cash and the interest rates levied by lending institutions lay the economic groundwork for the development of enterprises. How stable the financial markets are depends on the methods used to control those fundamental demands. Monetary policy instruments can be applied in a variety of ways that are advantageous to society. They keep the value of currencies in balance, stabilize economies, and can even deal with problems like debt or unemployment. Some of the benefits being offered by the monetary policy are -

They encourage higher levels of economic activity

Based on the state of the economy at the time, monetary policy tools stimulate consumption. Banks might cut their interest rates on lending products to stimulate more expenditure when a stimulus is required to maintain growth. Lower interest rates lead to price reductions, which support stable expenditure. Even though their incomes are below the national median, people are more inclined to buy low, which implies that their spending helps the local economy.

They support a sound world economy

The majority of nations use exchange-traded currencies to do business. The most important financial nations in the world today do not adhere to any "gold standard." Because established scarcity factors exist, the financial markets are more stable as a result of monetary policy tools. Because of this, a government that decides to increase money printing will depreciate its currency. Additionally, it opens up options to buy bonds, boost reserves, or engage in foreign debt in order to produce several streams of income.

They could increase exports

The currency in question devalues when the national money supply rises or when interest rates fall sharply in comparison to the international market. From a global perspective, weaker currencies can occasionally gain because exports are boosted by purchases made by people in stronger economies. Foreigners purchase more because they discover the things to be more affordable.

Lower inflation rates are promoted by them

Price stability is one of the most important benefits that monetary policy tools provide. Consumers are more likely to make a purchase when they are aware of the price of the items or services they desire. Due to the constant usage of money and the stability of its value, this mechanism maintains stable pricing structures. By using these instruments, it is possible to maintain the value of money at or near its average level. The United States' inflation rate was under 10% from 2009 and 2018. Accordingly, $1 in 2009 was equivalent to $1.09 in 2018, preserving household wealth.

They establish financial freedom from governmental regulations

The use of monetary policy tools is maintained apart from centralized governments and is instead carried out by a central bank or other comparable organization. The government may attempt to sway these tools by enacting specific legislation against them, but it is unable to fully control them. The chance that the government will influence the typical person's vote, life, or choices by lowering the value of their overall income is decreased by keeping economic and political decisions apart.

Examples of Monetarism

Friedman's monetary theory has been applied and implemented in the US and the UK, with slightly conflicting results.

For instance, during the 1970s in the United States, monetarism was on the rise as a result of the Federal Reserve's efforts to manage the money supply in an effort to combat inflation and rising unemployment. Paul Volcker, who took over as FED chairman in 1979, vowed to combat inflation and address the issues preventing the economy from expanding. He took action to restrain the money supply and maintain economic stability. In order to do this, he in 1980 increased the federal funds rate to 20%.

Although the FED's policies reduced inflation, they also contributed to rising unemployment rates. In the end, it was to blame for a brief economic downturn that lasted until 1982. People started blaming the FED's monetarist policies, claiming they were to blame for the recession.

In the United States and other countries, the money supply was growing quickly, making it difficult to assess because it was no longer just savings accounts. This made the macroeconomic theory more difficult to comprehend, and many even asserted that the premise could be refuted.

During the worldwide recession that began in 2007 in the United States, Fed Chairman Bernanke cited the work of Friedman and Schwartz in his decision to reduce interest rates and boost the money supply to revive the economy. Leading monetarists, such as Schwartz, predicted that the Fed's stimulus would result in extraordinarily high inflation.

Conclusion

To summarize, Fiscal policy, which includes government spending and taxation, is viewed by monetarists as less effective than monetary policy. Spending on stimuli increases the money supply, but it also increases a nation's sovereign debt because it results in a deficit. Interest rates might rise as a result.

Due to their control over the money supply, monetarists assert that central banks are more powerful than the state.1In addition, they favor real interest rates over nominal ones in their monitoring. Most published rates are nominal rates, whereas real rates take inflation into account. The cost of money is more accurately represented by real rates.

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Monetarism: Explained

What is Monetarism?

How does it work?

Advantages of Monetary Policy

They encourage higher levels of economic activity

They support a sound world economy

They could increase exports

Lower inflation rates are promoted by them

They establish financial freedom from governmental regulations

Examples of Monetarism

Conclusion

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