Monetarism Understanding the Impact of Money Supply on Economic Stability

Core Description

• Monetarism is a macroeconomic school emphasizing that money supply is the chief factor influencing nominal income, output, and inflation.
• It advocates for steady, rules-based control of money growth rather than discretionary interventions by central banks.
• Practical application of monetarism relies on monitoring money aggregates and implementing systematic policy rules to stabilize economies and anchor expectations.

Definition and Background

Monetarism is a prominent macroeconomic theory that asserts changes in the money supply are the primary driver of nominal GDP and inflation over time. This school of thought contends that when central banks control the growth of money supply in a stable and predictable manner, economies experience low inflation and smoother business cycles. Among monetarists’ core beliefs is that persistent inflation cannot occur without sustained, excessive money growth.

Historical Origins

Monetarism has its roots in the quantity theory of money, originally discussed by thinkers like Jean Bodin and David Hume, and formulated mathematically by Irving Fisher in the well-known equation MV = PY (where M is money supply, V is velocity of money, P is price level, and Y is real output). This equation underpins the logic that controlling money supply influences nominal values in the economy.

During the interwar period and the Great Depression, debates arose about the causes of deep recessions. Monetarists later argued that it was the sharp contraction in money supply, not fundamental market failures, that transformed short downturns into historical crises such as the Great Depression.

Modern Monetarism

Milton Friedman and Anna Schwartz revived monetarism in the mid-twentieth century. Their empirical work documented how fluctuations in the money supply often preceded economic cycles and periods of inflation. Monetarists influenced significant policy shifts during the stagflation of the 1970s, arguing that only by severely restricting money supply growth could inflation be controlled.

Over time, monetarism has evolved. While modern central banks may not simply target money aggregates, the principles disseminated by monetarists—rule-based monetary policy, credible targets, and the importance of expectations—are integral to current frameworks, such as inflation targeting employed by the Federal Reserve, Bank of England, and Bank of Canada.

Calculation Methods and Applications

The application of monetarist thought relies heavily on analyzing and controlling money aggregates and understanding their interactions with output, prices, and expectations.

The Fundamental Equation

Monetarism is anchored in the equation:MV = PY

• M: Money supply (M1, M2, or M3, depending on policy)
• V: Velocity of money
• P: Price level
• Y: Real output

By rearranging and examining changes in these variables, monetarists predict how shifts in money supply will affect inflation and economic growth.

In growth terms:
Δln P + Δln Y = Δln M + Δln V

• Δln represents the logarithmic change over a period (often quarters or years).
• If velocity is steady, money growth above real output growth translates into inflation.

Example (Hypothetical Case):
If money supply (M2) increases by 8% year-on-year, real GDP grows by 2%, and velocity remains constant, predicted inflation is approximately 6%.

Computation of Money Velocity

Velocity (V) is estimated as:V = NGDP / M
Where NGDP is nominal gross domestic product. To address data volatility, trend velocity (V*) is often estimated using moving averages. This helps smooth short-term fluctuations and highlights longer-term monetary trends.

The Money Multiplier

In fractional-reserve banking, the money multiplier (m) shows how the monetary base (MB) translates into broader money (M):
M = m × MB
Where m depends on factors such as the currency-deposit ratio, required reserves, and excess reserves.

Monetary Policy Rules

Milton Friedman proposed the “k-percent rule”: the central bank should grow money supply at a constant annual rate (k), equating roughly to long-run real GDP growth plus the desired inflation rate. This approach aims to reduce discretionary error and policy-induced cycles.

Application Example (U.S. Volcker Era):
During Paul Volcker’s tenure at the Federal Reserve, the emphasis shifted to controlling nonborrowed reserves and allowing interest rates to fluctuate to achieve targeted money growth. This stance was credited with reducing double-digit inflation, even though it resulted in a notable but temporary recession.

Nominal GDP Targeting

An updated monetarist application is to target the path of nominal GDP (NGDP), adjusting money growth so that the sum of inflation and real output growth matches a pre-set target. Changes in money velocity are forecast, and policy is adjusted accordingly.

Comparison, Advantages, and Common Misconceptions

Monetarism exists among a broad landscape of macroeconomic theories and faces both advocates and critics.

Comparison with Other Theories

Keynesianism

• Keynesian approaches favor active fiscal policy and counter-cyclical demand management.
• Monetarists emphasize stable monetary policy rules, doubting the reliability or effectiveness of fine-tuning aggregate demand through government spending.

New Classical and New Keynesian Economics

• New Classical models build on rational expectations and agree with monetarists that anticipated monetary policy has limited real effects.
• New Keynesians use interest rate rules to stabilize economies, valuing credible, rule-based policy, but focusing on rate targeting rather than money supply.

Austrian School, Real Business Cycle, and Modern Monetary Theory (MMT)

• Austrians focus on credit expansion and malinvestment; monetarism centers on the stability of money supply.
• Real Business Cycle theories ascribe fluctuations primarily to technology and real shocks, considering money as largely neutral.
• MMT emphasizes fiscal authority, which monetarists counter by highlighting central bank independence and warning of inflation risk from unchecked money creation.

Advantages of Monetarism

• Reduces policy discretion and political interference by relying on observable targets.
• Provides a clear nominal anchor that assists in anchoring inflation expectations.
• Improvements in central bank credibility can lower risk premia, as seen in the Volcker disinflation era.
• Simple rules may act as reliable cross-checks during periods of uncertainty.

Disadvantages and Criticisms

• Financial innovation has weakened the stable relationship between money aggregates and GDP, making strict targeting difficult.
• Stable velocity cannot always be assumed (for example, post-2008 with rapid shifts in payment technology and precautionary saving).
• Sudden monetary restraint may cause recessions (the early 1980s U.S. experience).
• At the effective lower bound for interest rates, money growth may not translate to spending if banks or households hoard cash (as observed in Japan in the late 1990s).
• Inflexible rules may not address every unexpected economic shock or regime change.

Common Misconceptions

Monetarism claims central banks can precisely control money supply.
Operational complexity, shadow banking, and regulatory nuances often make control of broad money difficult.

Stable money velocity is always assumed.
Actual velocity frequently shifts due to innovation and changing economic behaviors.

Any burst in inflation is solely due to money.
Supply shocks, regulatory changes, or expectations can also trigger short-term price surges.

Interest rates alone gauge monetary policy.
Low or high rates can coincide with both easy and tight policy, depending on context; it is important to also assess monetary aggregates, inflation, and expectations.

Practical Guide

Monetarism provides several practical insights for investors, analysts, and policymakers seeking to anticipate macroeconomic shifts and inflation risks.

Monitoring Money Aggregates and Policy Stance

• Track growth rates of broad money aggregates (such as M2 or M3), alongside real GDP growth and inflation expectations.
• Persistent money supply growth exceeding real output growth tends to signal rising inflation risk in the medium term.
• Monitor central bank communication on monetary targets, rule-based frameworks, and operating procedures.

Using Monetary Tools in Practice

• Central banks adjust money supply through open-market operations, reserve requirements, and discount lending.
• By analyzing trends in monetary aggregates, investors can better anticipate changes in liquidity, inflation trends, and cyclical turning points.

Interpreting Real-World Data

Case Study: The U.S. Volcker Disinflation (1979–1987)
In the late 1970s, the United States experienced high inflation, peaking at nearly 14%. Under Chairman Paul Volcker, the Federal Reserve shifted focus from controlling interest rates to controlling money supply growth. By restricting money supply, inflation was reduced to approximately 3-4% by the mid-1980s (Federal Reserve Economic Data, source: FRED). This move stabilized long-run expectations but was accompanied by a temporary recession.

Hypothetical Example
Suppose in “Country A,” M2 grows at 10% per year while real output grows at 2%. If velocity remains steady, predicted inflation would be around 8%. This allows analysts and corporations in Country A to adjust contracts, pricing, and wage arrangements accordingly. This is a hypothetical scenario and not investment advice.

Practical Tips for Investors and Treasurers

• Consider money growth and inflation trends when assessing the risk environment for asset classes (bonds, equities, commodities).
• Monitor monetary policy frameworks (inflation targeting, money supply growth ranges) in major economies as part of scenario analysis.
• For multinational operators, compare local monetary aggregates and trends across countries to gauge currency and inflation risks in global operations.

Resources for Learning and Improvement

To develop a deeper understanding and practical skills in monetarist economics, the following resources are recommended:

Foundational Books

• A Monetary History of the United States by Milton Friedman and Anna Schwartz
• The Optimum Quantity of Money and The Counter-Revolution in Monetary Theory by Milton Friedman
• A History of the Federal Reserve by Allan Meltzer
• Money in a Free Society by Tim Congdon

Seminal Articles and Papers

• “The Role of Monetary Policy” (Friedman, 1968)
• “Some Unpleasant Monetarist Arithmetic” (Sargent and Wallace, 1981)
• Essays by Brunner and Meltzer

Data and Statistical Portals

• FRED (Federal Reserve Economic Data): https://fred.stlouisfed.org/
• IMF IFS database, BIS statistics, OECD datasets
• Central bank websites (Federal Reserve, Bank of England, ECB)

Academic Journals and Working Papers

• Journal of Monetary Economics
• Journal of Money, Credit and Banking
• AEJ: Macroeconomics
• Economic Journal

Case Studies

• FOMC archives and staff reports for the Volcker era
• Bank of England and Bundesbank documents from the 1980s
• Case studies on Israel’s 1985 stabilization and Chile’s reforms in the 1970s–80s

Online Courses and Lectures

• University of Chicago, MIT OpenCourseWare, and London School of Economics monetary theory courses
• Hoover Institution archives and central bank lecture series

Think Tanks and Media

• Hoover Institution, Cato Institute, Institute of Economic Affairs (UK)
• Podcasts: EconTalk, Macro Musings, interviews with monetarist scholars

FAQs

What is monetarism?

Monetarism is a theory that the money supply set by the central bank is the primary determinant of nominal GDP and inflation in the long run. It supports rules-based, predictable monetary policy to achieve stability.

How does money supply affect inflation?

If the money supply grows faster than real economic output and velocity is stable, prices will rise. This result is formalized by the quantity theory of money equation.

What is money velocity and why does it matter?

Money velocity measures how frequently money circulates in the economy. When velocity is stable, changes in the money supply have predictable effects on inflation and output. When velocity fluctuates, targeting money supply becomes less precise.

What policy rules are favored by monetarists?

Monetarists propose rules-based frameworks such as the constant k-percent money growth rule, inflation targeting, or nominal GDP targeting to limit discretionary intervention and anchor expectations.

How does monetarism differ from Keynesianism?

Keynesianism values activist fiscal and monetary intervention, especially during downturns, while monetarism highlights the importance of stable money growth and gives less emphasis to fiscal effectiveness when money supply is controlled.

Which monetary aggregate should be tracked?

There is no universal answer. Early monetarists focused on M1 or M2, but with financial innovation, broader aggregates (like M3) or direct nominal GDP/inflation targets are now often chosen.

What evidence exists for or against monetarism?

Episodes such as high inflation during the 1970s–80s followed by disinflation under strong monetary restraint support the theory. However, unstable money velocity and instances of low inflation during central bank balance-sheet expansions (such as quantitative easing after 2008) present ongoing challenges.

Is monetarism still relevant with large-scale quantitative easing (QE)?

Yes, the importance of expectations, credible rules, and the money-inflation relationship remains. Monetarists maintain that managing monetary growth and anchoring expectations is crucial, even with large central bank balance sheets.

Conclusion

Monetarism has significantly shaped economic thought and policymaking. By emphasizing that persistent inflation is mainly a monetary phenomenon and advocating rule-based discipline, it contributed to the foundations of modern approaches to price stability. While monetary aggregates have become harder to control—due to innovation, changes in velocity, and evolving markets—the main insight remains relevant: credible, predictable policy frameworks are essential for achieving stable inflation and anchoring expectations.

Currently, while few central banks follow rigid money-growth targets, the principles of monetarism continue to influence frameworks such as inflation targeting, nominal GDP targets, and systematic policy approaches. Understanding these principles can help investors, analysts, and policymakers navigate the complexities of macroeconomic cycles, inflation risks, and changing financial environments.