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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.
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' theory of gluts 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." Though he opposed the existence of the Federal Reserve, Friedman advocated, given its existence, a central bank policy aimed at keeping the supply and demand for money at equilibrium, as measured by growth in productivity and demand.
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. While Keynes had focused on the value stability of currency, with the resulting panics based on an insufficient money supply leading to alternate currency and collapse, then Friedman focused on price stability, which is the equilibrium between supply and demand for money.
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.
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. 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. 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 or silver 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 or silver under a gold or silver standard.
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.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.
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." 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, President Jimmy Carter appointed a Federal Reserve chief Paul Volcker, who made inflation fighting his primary objective, and restricted the money supply (in accordance with the Friedman rule) to tame inflation in the economy. The result was the creation of the desired price stability.
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 1930 was caused by a massive contraction of the money supply 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.
Many monetarists sought to resurrect the pre-Keynesian view that market economies are inherently stable in the absence of major unexpected fluctuations in the money supply. Because of this belief in the stability of free-market economies they asserted that active demand management (e.g. by the means of increasing government spending) is unnecessary and indeed likely to be harmful. The basis of this argument is an equilibrium between "stimulus" fiscal spending and future interest rates. In effect, Friedman's model argues that current fiscal spending creates as much of a drag on the economy by increased interest rates as it creates present consumption: that it has no real effect on total demand, merely that of shifting demand from the investment sector (I) to the consumer sector (C).
When Margaret Thatcher, leader of the Conservative Party in the United Kingdom, won the 1979 general election defeating the incumbent Labour Party led by James Callaghan, Britain had endured several years of severe inflation, which was rarely below 10% and by the time of the election in May 1979 stood at 5.4%. Thatcher implemented monetarism as the weapon in her battle against inflation, and succeeded at reducing it to 4.6% by 1983.
James Callaghan himself had adopted policies echoing monetarism while serving as prime minister from 1976 to 1979, adopting deflationary policies and reducing public spending in response to high inflation and national debt. He initially had some success, as inflation was below 10% by the summer of 1978, although unemployment now stood at 1,500,000. However, by the time of his election defeat barely a year later, inflation had fallen to 5.4%.
According to Alan Blinder and Robert Solow, fiscal policy becomes impotent only when an interest-elasticity of the demand for money is zero. Empirically, such a perfect inelasticity does not occur. However, there are limited policy options when the interest rate is at or near the zero lower bound .
Although Milton Friedman believed that wealth effects make deficit spending contractionary, Blinder and Solow believed that in reality fiscal stimulus is effective. To see this, they used a government budget constraint equation which includes interest on government bonds:
where B is the number of bonds whose face value per unit bond is 1 dollar. T is the tax function. In the long-run stationary state,
Immediately, it turns out that under money financing the fiscal multiplier becomes
because in this case . Both monetarists and Keynesians agree with the idea that money-financed deficit spending has an expansionary impact on the economy. If deficits are financed by bonds, the long-run fiscal multiplier becomes larger than that by money-creation:
Thus their research shows that, in the long run, bond-financed government spending increases the income level more than money-financed deficit spending does.
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A realistic theory should be able to explain the deflationary waves of the late 19th century, the Great Depression, and the stagflation period beginning with the uncoupling of exchange rates in 1972. Monetarists argue that there was no inflationary investment boom in the 1920s. Instead, monetarist thinking centers on the contraction of the M1 during the 1931–1933 period, and argues from there that the Federal Reserve could have avoided the Great Depression by moves to provide sufficient liquidity. In essence, they argue that there was an insufficient supply of money.
From their conclusion that incorrect central bank policy is at the root of large swings in inflation and price instability, monetarists argued that the primary motivation for excessive easing of central bank policy is to finance fiscal deficits by the central government. Hence, restraint of government spending is the most important single target to restrain excessive monetary growth.
With the failure of demand-driven fiscal policies to restrain inflation and produce growth in the 1970s, the way was paved for a new policy of fighting inflation through the central bank, which would be the bank's cardinal responsibility. In typical economic theory, this would be accompanied by austerity shock treatment, as is generally recommended by the International Monetary Fund: such a course was taken in the United Kingdom, where government spending was slashed in the late 1970s and early 1980s under the political ascendance of Prime Minister Margaret Thatcher. In the United States, the opposite approach was taken and real government spending increased much faster during President Ronald Reagan's first four years (4.22%/year) than it did under Carter (2.55%/year).
In the ensuing short term, unemployment in both countries remained stubbornly high while central banks raised interest rates to restrain credit. These policies dramatically reduced inflation rates in both countries (the United States' inflation rate fell from almost 14% in 1980 to around 3% in 1983), allowing liberalisation of credit and the reduction of interest rates, which led ultimately to the inflationary economic booms of the 1980s. Arguments have been raised, however, that the fall of the inflation rate may be less from control of the money supply and more to do with the unemployment level's effect on demand; some also claim the use of credit to fuel economic expansion is itself an anti-monetarist tool, as it can be argued that an increase in money supply alone constitutes inflation.
Monetarism re-asserted itself in central bank policy in western governments at the end of the 1980s and beginning of the 1990s, with a contraction both in spending and in the money supply, ending the booms experienced in the US and UK.
In the late 1980s, Paul Volcker was succeeded by Alan Greenspan. His handling of monetary policy in the run-up to the 1991 recession was criticised from the right as being excessively tight, and costing George H. W. Bush re-election. The incoming Democratic president Bill Clinton reappointed Alan Greenspan, and kept him as a core member of his economic team. Greenspan, while still fundamentally monetarist in orientation, argued that doctrinaire application of theory was insufficiently flexible for central banks to meet emerging situations.
The crucial test of this flexible response by the Federal Reserve was the Asian financial crisis of 1997–1998, which the Federal Reserve met by flooding the world with dollars, and organising a bailout of Long-Term Capital Management. Some have argued that 1997–1998 represented a monetary policy bind, just as the early 1970s had represented a fiscal policy bind, and that while asset inflation had crept into the United States (which demanded that the Fed tighten the money supply), the Federal Reserve needed to ease liquidity in response to the capital flight from Asia. Greenspan himself noted this when he stated that the American stock market showed signs of irrationally high valuations.
In 2000, Alan Greenspan raised interest rates several times. These actions were believed by many to have caused the bursting of the dot-com bubble. In late 2001, as a decisive reaction to the September 11 attacks and the various corporate scandals which undermined the economy, the Greenspan-led Federal Reserve initiated a series of interest rate cuts that brought the Federal Funds rate down to 1% in 2004. His critics, notably Steve Forbes, attributed the rapid rise in commodity prices and gold to Greenspan's loose monetary policy, and by late 2004 the price of gold was higher than its 12-year moving average; these same forces were also blamed for excessive asset inflation and the weakening of the dollar. These policies of Alan Greenspan are blamed by the followers of the Austrian School for creating excessive liquidity, causing lending standards to deteriorate, and resulting in the housing bubble of 2004–2006.
Currently, the American Federal Reserve follows a modified form of monetarism, where broader ranges of intervention are possible in light of temporary instabilities in market dynamics. This form does not yet have a generally accepted name.
In Europe, the European Central Bank follows a more orthodox form of monetarism, with tighter controls over inflation and spending targets as mandated by the Economic and Monetary Union of the European Union under the Maastricht Treaty to support the euro. This more orthodox monetary policy followed credit easing in the late 1980s through 1990s to fund German reunification, which was blamed for the weakening of European currencies in the late 1990s.
Since 1990, the classical form of monetarism has been questioned. This is because of events that many economists interpreted as being inexplicable in monetarist terms: the disconnection of the money supply growth from inflation in the 1990s and the failure of pure monetary policy to stimulate the economy in the 2001–2003 period. 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 linking monetarism and macroeconomics, and treat monetarism as 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." Progressive economist Paul Krugman has advanced the counterargument that this would have a corresponding devaluationary effect, like the sustained low interest rates of 2001–2004 produced against world currencies.
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.
- Chicago school of economics
- Demurrage (currency)
- Fiscalism (usually contrasted to monetarism)
- Inflation targeting
- Market monetarism
- Modern Monetary Theory
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