The State of Monetarism

In the 1980s and 1990s, it seemed that the key macroeconomic controversy in the discipline was between Keynesians and Monetarists. In a rather simple breakdown, Keynesians believed in using fiscal policy to control the level of aggregate demand in the economy, bringing about desired economic objectives, whilst monetarists believed in controlling the money supply. Some sources felt that the two schools of thought never agreed on anything and that the row would continue.

In the new century, however, the debate seems to have shifted. Monetarists and monetarism do not seem to be quite as popular as they were. What was the debate about and what has happened to monetarism? This article looks at what monetarism is about and what it currently contributes to the debate on economic policy. The aim is to help you incorporate an understanding of some of the issues surrounding the monetarist debate in exam answers that cover the topic.

What is Monetarism?

"Inflation is always and everywhere a monetary phenomenon" is an often quoted line from Milton Friedman, a Nobel Prize winning economist and foremost thinker on monetarism. It does provide us with some clues as to the underlying debate on the subject.

Monetarism is the belief that changes in the quantity of money in circulation in an economy is a determinant of the level of national income. We can think of national income as gross domestic product, the value of output in an economy over a given period of time.

The argument is not so much about whether money supply does in fact act as a determinant of national income - most economists would agree that it has a role to play but on the extent to which changes in the money supply impact on national income. Keynesians would believe that changes in the money supply will take some time to work through to national income whilst monetarists believe it is likely to happen far more quickly. The importance of this distinction is in the implications it has for policy makers.

Money - notes and coins, obviously, but what else might be classed as money? One of the difficulties faced by monetarism - defining what money actually is! Copyright: Wilke Reints, from stock.xchng.

Task 1

Assume that there was a high level of unemployment in the economy. You are charged with devising a policy to reduce the level of unemployment.

Why is an awareness of the speed with which a policy instrument like monetary policy works through to the economy important in your decision making?

This difference manifests itself in the appropriate policy that is to be focused on in dealing with economic problems. Keynesians believe that fiscal policy, changing government income and expenditure, is a more effective means of dealing with problems such as inflation and unemployment. Monetarists believe that monetary policy should be the primary weapon in dealing with these problems.

The Equation of Exchange

Why do monetarists believe in the power of monetary policy? In simple terms, their views stem from a statement called the equation of exchange. The equation of exchange is often cited as being a truism - it is obviously true. The extent to which it can be claimed to be a theory is thus debatable. To be an effective theory, it has to have some predictive value.

The equation of exchange, or the Fisher equation, named after its founder Irving Fisher in 1911, states the following:

P x T is referred to as nominal income. Let us assume that nominal income is £1 billion. That could mean 1 billion 'goods' produced and sold at £1 each, or a million 'goods' sold at £1,000 each, or 100 million 'goods' sold at a price of £10 each, or indeed any other combination of price and quantity.

Money is needed to buy the output of the economy. The value of output is given by total output multiplied by price - nominal income. Copyright: Robert Van, from stock.xchng.

How is that nominal income purchased? It is purchased by using the notes and coins (let us assume that 'money' is notes and coins for the moment) in circulation and the number of times it changes hands depends on the price that each good is sold for. The two sides of the equation, therefore, are just a different way of saying the same thing. The amount of goods produced and the value of those goods must be the same as the amount of money available and the number of times it was used to purchase that output!

From Equation to Theory

Fisher then made some important assumptions that gave the equation some predictive qualities. The velocity of circulation was assumed to be relatively stable over a period - let us say it has a value of 50. In other words, the stock of money in circulation (500) changes hands 50 times to buy the output of the economy.

Now let us assume that we want to find the price level. Assume that we know that the number of transactions in the economy is 200. What is the price level? A bit of simple arithmetic gives us the answer:

This tells us that the average price of each good that changed hands was 125. Now assume that there is some boost to the money supply - perhaps due to the government printing more notes or the discovery of new reserves of gold. M now rises to 600 as a result. Remember that the velocity of circulation is assumed to be stable. We might also further assume that the number of transactions or the output of the economy is also relatively stable, or at least only rises by a small amount over time. Assume that T rises to 205. What now happens to the price level?

In this example, the price level has risen by 17.04%. What has been the cause of this rise in the price level? The rise in the money supply! The money supply increased by 20% but the output of the economy (the number of transactions) increased by only 2.5%.

When we have built in these assumptions, it seems fairly obvious that the money supply has an impact on the price level or inflation. Concern over the rate at which the money supply grows, therefore, might be of concern to policy makers charged with controlling inflation.

When we look at the statement issued by the Bank of England after the Monetary Policy Committee (MPC) raised interest rates by a quarter point to 5% in November 2006, we can see that the rate of economic growth was around 2.6%. However, the MPC reported that 'credit and broad money growth remain rapid' - in other words, the money supply was increasing rapidly.

If the money supply grows at a faster rate than the level of output in the economy then the price level will rise (assuming a stable velocity of circulation).

Further Pages in the Series

Behind this simple analysis lies a whole host of assumptions and problems, which lead to an equally large number of disputes about monetarism.

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