Monetarism

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Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on national output in the short run and on price levels 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. [1]

Contents

Monetarism today is mainly associated with the work of Milton Friedman, who was among the generation of economists to accept Keynesian economics and then criticise Keynes's theory of fighting economic downturns using fiscal policy (government spending). Friedman and Anna Schwartz wrote an influential book, A Monetary History of the United States, 1867–1960 , and argued "inflation is always and everywhere a monetary phenomenon". [2]

Though he opposed the existence of the Federal Reserve, [3] 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 demand for goods.

Description

Monetarism is an economic theory that 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 historically antagonistic schools of thought: 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. [4] While Keynes had focused on the stability of a currency's value, with panics based on an insufficient money supply leading to the use of an alternate currency and collapse of the monetary system, Friedman focused on price stability.

The result was summarised 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. [5]

Friedman originally proposed a fixed monetary rule, called Friedman's k-percent rule, where the money supply would be automatically increased by a fixed percentage per year. 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 money supply changes. [6] [7] With other monetarists he believed that the active manipulation of the money supply or its growth rate is more likely to destabilise than stabilise the economy.

Opposition to the gold standard

Most monetarists oppose the gold standard. Friedman, for example, viewed a pure gold standard as impractical. [8] 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 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.

Rise

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. [1] 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. [9]

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." [9] 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, United States President Jimmy Carter appointed as Federal Reserve chief Paul Volcker, who made fighting inflation his primary objective, and who restricted the money supply (in accordance with the Friedman rule) to tame inflation in the economy. The result was a major rise in interest rates, not only in the United States; but worldwide. The "Volcker shock" continued from 1979 to the summer of 1982, decreasing inflation and increasing unemployment. [10]

By the time Margaret Thatcher, Leader of the Conservative Party in the United Kingdom, won the 1979 general election defeating the sitting Labour Government led by James Callaghan, the UK had endured several years of severe inflation, which was rarely below the 10% mark and by the time of the May 1979 general election, stood at 15.4%.[ citation needed ] 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. [11]

Money supply decreased significantly between Black Tuesday and the Bank Holiday in March 1933 in the wake of massive bank runs across the United States. Money supply during the great depression era.png
Money supply decreased significantly between Black Tuesday and the Bank Holiday in March 1933 in the wake of massive bank runs across the United States.

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 the 1930s was caused by a massive contraction of the money supply (they deemed it "the Great Contraction" [12] ), 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.

Monetarists argued that central banks sometimes caused major unexpected fluctuations in the money supply. They asserted that actively increasing demand through the central bank can have negative unintended consequences.

Current state

Former Federal Reserve chairman Alan Greenspan 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 on the other.

There are also arguments that monetarism is 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 another former chairman of the U.S. Federal Reserve, 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."

These disagreements—along with the role of monetary policies in trade liberalisation, international investment, and central bank policy—remain lively topics of investigation and argument.

Notable proponents

See also

General:

Related Research Articles

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Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. Instead, it is influenced by a host of factors – sometimes behaving erratically – affecting production, employment, and inflation.

Macroeconomics Branch of economics that studies aggregated indicators

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Milton Friedman American economist and statistician

Milton Friedman was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the complexity of stabilization policy. With George Stigler and others, Friedman was among the intellectual leaders of the Chicago school of economics, a neoclassical school of economic thought associated with the work of the faculty at the University of Chicago that rejected Keynesianism in favor of monetarism until the mid-1970s, when it turned to new classical macroeconomics heavily based on the concept of rational expectations. Several students, young professors and academics who were recruited or mentored by Friedman at Chicago went on to become leading economists, including Gary Becker, Robert Fogel, Thomas Sowell and Robert Lucas Jr.

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<i>A Monetary History of the United States</i>

A Monetary History of the United States, 1867–1960 is a book written in 1963 by Nobel Prize–winning economist Milton Friedman and Anna J. Schwartz. It uses historical time series and economic analysis to argue the then-novel proposition that changes in the money supply profoundly influenced the U.S. economy, especially the behavior of economic fluctuations. The implication they draw is that changes in the money supply had unintended adverse effects, and that sound monetary policy is necessary for economic stability. Economic historians see it as one of the most influential economics books of the century. The chapter dealing with the causes of the Great Depression was published as a stand-alone book titled The Great Contraction, 1929–1933.

History of macroeconomic thought Aspect of history

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Market monetarism is a school of macroeconomic thought that advocates that central banks target the level of nominal income instead of inflation, unemployment, or other measures of economic activity, including in times of shocks such as the bursting of the real estate bubble in 2006, and in the financial crisis that followed. In contrast to traditional monetarists, market monetarists do not believe monetary aggregates or commodity prices such as gold are the optimal guide to intervention. Market monetarists also reject the New Keynesian focus on interest rates as the primary instrument of monetary policy. Market monetarists prefer a nominal income target due to their twin beliefs that rational expectations are crucial to policy, and that markets react instantly to changes in their expectations about future policy, without the "long and variable lags" postulated by Milton Friedman.

References

  1. 1 2 Phillip Cagan, 1987. "Monetarism", The New Palgrave: A Dictionary of Economics , v. 3, Reprinted in John Eatwell et al. (1989), Money: The New Palgrave, pp. 195–205, 492–97.
  2. Friedman, Milton (2008). Monetary History of the United States, 1867-1960. Princeton University Press. ISBN   978-0691003542. OCLC   994352014.
  3. Doherty, Brian (June 1995). "Best of Both Worlds". Reason. Retrieved July 28, 2010.
  4. Mankiw, N. Gregory. "Real Business Cycles: A New Keynesian Perspective". Journal of Economic Perspectives 3.3 (1989): 79–90. Web.|date=October 2013
  5. Bordo, Michael D. (1989). "The Contribution of A Monetury History". Money, History, & International Finance: Essays in Honor of Anna J. Schwartz. The Increase in Reserve Requirements, 1936-37. University of Chicago Press. p.  46. CiteSeerX   10.1.1.736.9649 . ISBN   0-226-06593-6 . Retrieved 2019-07-25.
  6. Thomas Palley (November 27, 2006). "Milton Friedman: The Great Conservative Partisan" . Retrieved June 20, 2013.[ unreliable source? ]
  7. Ip, Greg; Whitehouse, Mark (2006-11-17). "How Milton Friedman Changed Economics, Policy and Markets". The Wall Street Journal.
  8. "Monetary Central Planning and the State, Part 27: Milton Friedman's Second Thoughts on the Costs of Paper Money". Archived from the original on November 14, 2012.
  9. 1 2 Friedman, Milton (1970). "A Theoretical Framework for Monetary Analysis". Journal of Political Economy . 78 (2): 193–238 [p. 210]. doi:10.1086/259623. JSTOR   1830684.
  10. Reichart Alexandre & Abdelkader Slifi (2016). 'The Influence of Monetarism on Federal Reserve Policy during the 1980s.' Cahiers d'économie Politique/Papers in Political Economy, (1), pp. 107–50. https://www.cairn.info/revue-cahiers-d-economie-politique-2016-1-page-107.htm
  11. "Real Gross Domestic Product for United Kingdom, Federal Reserve Bank of St. Louis" . Retrieved December 16, 2018.
  12. Milton Friedman; Anna Schwartz (2008). The Great Contraction, 1929–1933 (New Edition). Princeton University Press. ISBN   978-0-691-13794-0.

Further references