Monetarists - Theories

Much of the Monetarists' theory is a development of earlier Classical theoretical work. Their main contribution is in updating many of these ideas to fit them into a more modern context. The two key areas of Monetarist work that we will look at are:

• Quantity Theory of Money
• Expectations-augmented Phillips Curve

Quantity Theory of Money

The Quantity Theory of Money was a bit of Classical theory based around the Fisher Equation of Exchange. This equation stated that:

MV = PT

where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place

Classical economists suggested that V would be relatively stable and T would (as we have seen above) would always tend to full employment. Friedman developed this and tested it further, coming to the conclusion that V and T were both independently determined in the long-run. The conclusion from this was that:

M P

If the money supply grew faster than the underlying growth rate of output there would be inflation. Inflation would be bad for the economy because of the uncertainty it created. This uncertainty could limit spending and also limit the level of investment. Higher inflation may also damage our international competitiveness. Who will want to buy UK goods when our prices are going up faster than theirs?

Expectations-augmented Phillips Curve

The Phillips Curve showed a trade-off between unemployment and inflation. However, the problem that emerged with it in the 1970s was its total inability to explain unemployment and inflation going up together - stagflation. According to the Phillips curve they weren't supposed to do that, but throughout the 1970s they did. Friedman then put his mind to whether the Phillips Curve could be adapted to show why stagflation was occurring, and the explanation he came up with was to include the role of expectations in the Phillips Curve - hence the name 'expectations-augmented' Phillips Curve. Once again the supreme logic of economics comes to the fore!

Friedman argued that there were a series of different Phillips Curves for each level of expected inflation. If people expected inflation to occur then they would anticipate and expect a correspondingly higher wage rise. Friedman was therefore assuming no 'money illusion' - people would anticipate inflation and account for it. We therefore got the situation shown below:

Say the economy starts at point U, and the government decides that it want to lower the level of unemployment because it is too high. It therefore decides to boost demand by 5%. The increase in demand for goods and services will fairly soon begin to lead to inflation, and so any increase in employment will quickly be wiped out as people realise that there hasn't been a real increase in demand. So having moved along the Phillips Curve from U to V, the firms now begin to lay people off once again and unemployment moves back to W. Next time around the firms and consumers are ready for this, and anticipate the inflation. If the government insist on trying again the economy will do the same thing (W to X to Y), but this time at a higher level of inflation.

Any attempt to reduce unemployment below the level at U will simply be inflationary. For this reason the rate U is often known as the natural rate of unemployment.

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