Monetarism

Monetarism is the theory that the proper control of a country's monetary supply is the primary determinant of that country's economic health and stability.

In the history of mankind, the role of gold as a value carrier has changed somewhat. In the beginning, gold was money in a very literal sense - it was used to make coins, and its value was determined by the content of the metal. The need for convenience and practicality resulted in the later appearance of banknotes that were receipts for gold deposited in the state treasury. In theory, a citizen could take the receipt to the bank and collect the gold.

What Is Monetarism in Economics?

Monetarism is a macroeconomic school of thought that gained popularity during the 1970s. The monetarist theory asserts that monetary supply (the amount of money in an economy) and the way it is managed via governmental monetary policy determine a nation’s economic stability as gauged by metrics like GDP and the rate of inflation.

One of the most important theories to explain inflation is the monetarist view that, according to Milton Friedman, “Inflation is always and everywhere a monetary phenomenon.” In other words, inflation occurs because there is too much money available to buy the same amount of goods and services produced in the economy. This view can also be represented by the so-called “quantity theory of money,” which relates the general price level, the total goods and services produced in a given period, the total money supply, and the speed (velocity) at which money circulates in the economy in facilitating transactions in the following equation:

What Is the Equation of Exchange?

• M is the monetary supply.?
• V is the velocity (how often the average dollar changes hands per year).?
• P is the price level (the average price of all goods and services).?
• Q is the total quantity of goods and services sold.?

Monetarists believe in the long-run there is no trade-off between inflation and unemployment. An increase in the money supply only causes an increase in nominal GDP, but not real GDP.? The quantity theory of money is central to the monetarist school of thought. The theory states that monetary supply multiplied by velocity (the average rate at which money changes hands in an economy) always equals the price level (the average price of all goods and services) multiplied by the total quantity of goods and services sold.?

Declining Velocity

The issue has to do with the velocity of money, which has never been constant.f for some reason the money velocity declines rapidly during an expansionary monetary policy period, it can offset the increase in money supply and even lead to deflation instead of inflation.

?The velocity of money can be calculated as the ratio of nominal gross domestic product (GDP) to the money supply (V=PQ/M), which can be used to gauge the economy’s strength or people’s willingness to spend money. When there are more transactions being made throughout the economy, velocity increases, and the economy is likely to expand. The opposite is also true: Money velocity decreases when fewer transactions are being made; therefore the economy is likely to shrink.

Start of spending?

And why then would people suddenly decide to hoard money instead of spending it??

• An answer lies in the combination of two issues:
• A glooming economy after the financial crisis

The dramatic decrease in interest rates has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds. In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand by pursuing an excessively low-interest rate policy (i.e., the zero-interest rate policy). In addition, the continuous printing of money began, in the pandemic, it reached its peak.

?Since 10-year interest rates declined by about 0.5 percentage points between 2008 and 2013, the velocity of the monetary base should have decreased by about 0.085 points. But the actual velocity has gone down by 5.85 points, 69 times larger than predicted. This happened because the nominal interest rate on short-term bonds has declined essentially to zero, and, in this case, the best form of risk-free liquid asset is no longer the short-term government bonds, but money.

?Criticisms of monetarism

• The link between the money supply and inflation is often very weak in practice.
• The velocity of circulation (V) is not stable but can vary significantly due to confidence, changes in the use of credit cards, decline in the use of cash. e.t.c
• Targetting arbitrary money supply targets can cause a severe recession and high unemployment. For example, the UK targeted money supply growth in the early 1980s, but this caused the recession of 1981 with many economists arguing it was deeper than necessary.
• The large increase in the monetary base following the 2009 recession did not cause any inflationary pressures. Why not target inflation directly? If you want to control inflation, it makes more sense to target inflation directly rather than through the intermediary of the money supply.
• Monetarists say that income can vary in the short run, but the short run could be a long time and therefore make monetary policy ineffective.

What Are the Limitations of Monetarism?

Is It Still Popular Today?

Monetarism was well regarded during the 1970s when its ideas were successfully implemented by both the U.S. and Britain to curb inflation. As the 20th century drew toward a close in the 80s and 90s, however, it became clear to many economists that money supply and GDP were not as inextricably tied to one another as monetarist thought proposed. That being said, the rise of monetarism did highlight the importance of regulating the monetary supply in maintaining economic stability. However economies are more complex than ever, and a larger network of more nuanced financial instruments fosters an economic climate that cannot be simplified to the degree that the quantity theory of money proposes.