Monetarist Theory

Monetarist theory, also known as monetarism, is an economic concept that claims that changes in the money supply are the most important determinants of economic growth and business cycle activity. Monetarist thinking is based on the premise that the size of the money supply is more significant than any other economic factor. It is an essential macroeconomic theory that centers around the significance of the cash supply as a key financial power. At the point when monetarist hypothesis works practically speaking, national banks, which control the switches of financial strategy, can apply a lot of control over monetary development rates.

Today, monetary policy is most closely associated with the work of Milton Friedman, who was among the generation of economists who accepted Keynesian economics before criticizing Keynes’ theory of using fiscal policy to combat economic downturns (government spending). Expanding cash supply, as per the theory, unavoidably prompts greater costs and swelling, while at the same time diminishing the cash supply prompts emptying and dangers, causing a downturn. It is governed by the MV = PQ formula, in which M = money supply, V = velocity of money, P = price of goods, and Q = quantity of goods and services.

Changes in the money supply have an impact on jobs and productivity, but according to monetarist theory, such effects are only temporary, while the impact on inflation is more long-lasting and important. During the 1970s governments guided by the then-prevailing school of economic idea, Keynesian economics (in view of the works of British market analyst John Maynard Keynes), were doing combating high expansion (the ascending of costs across the economy that makes cash lose worth) and states of economic stagnation. The Federal Reserve manages liquidity in the United States and uses three key levers to raise or decrease money supply: the reserve ratio, discount rate, and free market operations.

Example of monetarist theory

Monetarists, driven by American economist Milton Friedman, kept up that the Keynesian methodology was defective and that swelling could be managed by controlling the development of the cash supply. According to the theory, monetary policy is a much more powerful method for stimulating the economy and slowing inflation than fiscal policy. Monetarist theory is governed by a simple formula: MV = PQ, where M is the money supply, V is the velocity (number of times per year the average dollar is spent), P is the price of goods and services and Q is the quantity of goods and services. Assuming constant V, when M is increased, either P, Q, or both P and Q rise.

The hard money policies that dominated monetary thought in the late nineteenth century, and the monetary theories of John Maynard Keynes, who advocated a demand-driven model for money during the interwar era, when the restored gold standard failed. While Keynes had zeroed in on the steadiness of a cash’s worth, with alarms dependent on a deficient cash supply prompting the utilization of a substitute money and breakdown of the financial framework, Friedman zeroed in on value security. While monetarism remained prevalent well into the twenty-first century, it was in a changed form that took into account variables other than the money supply.

As the economy approaches full employment, general price levels appear to grow faster than the output of goods and services. While the monetarist ideology serves as a guide for central bank policies, Friedman was opposed to central banks in general, including the Federal Reserve Bank of the United States. Indeed, Friedman accused a significant part of the Great Depression of the 1930s on the Federal Reserve, contending that the Fed fixed the cash supply at the exact second that it ought to have been extending it to invigorate financial development.

In the U.S., it is the job of the Fed to control the money supply. The Fed has three main levers:

  • The reserve ratio: The minimum amount of assets a bank must keep against deposits. A lower ratio allows banks to lend more, increasing the amount of capital available.
  • The discount rate: The interest rate that the Federal Reserve charges commercial banks when they need to borrow more reserves. A lower discount rate encourages banks to borrow more from the Fed and, as a result, lend more to their customers.
  • Open market operations: The buying and sale of government securities is known as open market operations. Purchasing securities from large banks increase the supply of capital in the economy while selling securities contracts reduces it.

As per the monetarist theory, expansion is constantly brought about by there being an excess of cash available for use. Cash, as different items available to be purchased in the economy, is dependent upon the powers of the organic market. The central bank of a country may manipulate interest rates to expand or contract the money supply. The monetarist theory draws several key points from the equation of trade:

  • An increase in the money supply will lead to overall price increases in the economy.
  • Increased money supply would only have a short-term impact on economic growth (i.e., Gross Domestic Product (GDP)) and job levels.
  • The best monetary policy for a central bank to adopt is to adjust the rate of growth of the money supply to the rate of growth of real GDP. This is the best policy for supporting continued economic growth while keeping inflation low.

Monetarists accept that if an administration’s national bank can save the market interest for cash adjusted, at that point swelling can be controlled. Most monetarists go against the highest quality level. Friedman, for instance, seen an unadulterated best quality level as illogical. For example, although one of the advantages of the gold standard is that the inherent limits to the growth of the money supply imposed by the use of gold prevent inflation, if population or trade growth outpaces the money supply, there would be no way to avoid deflation and decreased liquidity (and any resulting recession) other than to mine more gold.

All in all, as the sum and worth of the items created by the economy expand, the cash supply should increment proportionately. If this happens, then inflation will remain low. Overall, Keynesians believe in the direct central bank and government interference in the economy, while monetarists like Friedman believe that free markets self-adjust in terms of prices and jobs to have the greatest economic gain.

Monetarists contended that national banks now and then caused major startling vacillations in the cash supply. They stated that effectively expanding requests through the national bank can have negative unseen side effects. Fiscal policy is inefficient and causes more issues than it solves, while monetary policy can be relied on to have specific economic consequences. Monetarists argued that policymakers should abandon their attempts to control the economy by fiscal policy and instead focus solely on monetary policy.

Information Sources:

  1. encyclopedia.com
  2. corporatefinanceinstitute.com
  3. investopedia.com
  4. wikipedia