Monetarist Definition Theory Examples How It Works

Monetarist Definition

As opposed to the Keynesian theory, monetarists do not believe in amending government expenditure or taxes for triggering economic growth. Instead, they believe in increasing or decreasing the money supply as a tool to influence overall consumption, demand and income generation.

Key Takeaways

Monetarists are individuals who believe in and embrace the theory of monetarism.Monetarism promotes utilization of monetary policies to control demand in the economy, inflation/deflation and overall economic growth.The theory sprang to prominence in 1970s when the United States and other countries struggled with excessive inflation. Conventional economic theories like the Keynesian concept struggled to offer solutions to stagnant growth and rising prices.

Understanding Monetarist

Monetarists believe that the money supply is the guiding force in economic development. As such, monetary policiesMonetary PoliciesMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more formulated and rolled out by central banks also function with this notion. Policymakers attempt to control events like unemployment, recession and inflation by adjusting the amount of money circulating in the economy through changes in the monetary policies.

For example, with a decrease in the interest rate initiated by the central bank, there tends to be an increase in the money supply as it is easier to borrow money. As a result, people can access money easily. Subsequently, purchasing power increases, and national output increases momentarily.

When this phenomenon continues uninterrupted, inflation occurs due to a greater supply of money in the economy. However, if this stage is prolonged, it may result in a recession. Resultantly, authorities gradually increase the interest rate which makes borrowing expensive. It leads to lesser demand for money thereby helping in cutting inflation rates.

Prior to the 1970s, the popularity of Keynesian economicsKeynesian EconomicsKeynesian Economics is a theory that relates the total spending with inflation and output in an economy. It suggests that increasing government expenditure and reducing taxes will result in increased market demand and pull up the economy out of depression.read more eclipsed the importance of monetarismMonetarismMonetarism is a macroeconomic thought that emphasizes the role of money supply in the growth and stability of an economy.read more. Keynesian economics promoted government expenditure and tax reformsTax ReformsTax reform refers to the changes and amendments made in the nation’s tax structure or system to fix the loopholes and make it more efficient. It even ensures that there are fewer chances of tax evasion and avoidance by the taxpayers.read more to manage economic development. However, Keynesian economics struggled to offer solutions to raging inflation in the 1970s following the oil price shock. As a result, it led economists and government authorities to explore other avenues such as the monetarist theory to establish economic stability.

Monetarist vs Keynesians

Below is a brief account of monetarist vs Keynesians, explaining the differences between the two.

Quantity Theory of Money

Monetarism embraces the Quantity Theory of MoneyQuantity Theory Of MoneyThe Quantity Theory of Money is an economic theory that defines the relationship between the money supply and the price of products. It states that an increase or decrease in the money supply will result in inflation or deflation, respectively.read more. The theory holds that changes in the money supply causes proportionate changes in the demand of goods and services. Thus, the equation of exchange or quantity theory of money forms the basis of monetarist theory. The equation follows as MV = PQ. Let us look at all these terms in detail.

Many economists believe that when velocity is constant and predictable, it helps in controlling monetary supply appropriately. This also points to the fact that from a long term perspective, increases in money supply increases the price level hence causing inflation.

MV=PQ

Monetarist Examples

Great Inflation in the US

From the mid-1960s to 1980, the US experienced poor economic growth, increased inflation, and high unemployment, all pointing to stagflationStagflationStagflation is an economic scenario where stagnation coincides with inflation.read more. The inflation rate was 14 percent in the 1980. Slow productivity and bear markets worsened the situation. The attempts of the US government to control the rampant inflation proved to be mostly ineffective.

Aside from oil price hikes, faulty policies were also criticised for triggering hyperinflationHyperinflationHyperinflation is merely an accelerated level of inflation that tends to quickly destroy the actual value of the local currency since there is a rise in the cost of all products and services, and it causes people to lower their holdings in that particular currency as they opt to participate in foreign currencies that are relatively more stable.read more. Monetarists blamed increased government spending to achieve full employment as one of the integral factors causing inflation as it had increased the money supply exponentially. At last, Paul Volcker, who became chairman of the Federal Reserve Board in 1979, effectively confronted this period of hardship. The effect brought by Paul Volcker strategy is famously known as ‘Volcker shock’.

Volcker implemented monetarism views by increasing the Fed rate to nullify inflation rather than exhibiting inclination towards fiscal policiesFiscal PoliciesFiscal policy refers to government measures utilizing tax revenue and expenditure as a tool to attain economic objectives. read more like government spending and taxation. However, the absence of prompt expansionary monetary policyExpansionary Monetary PolicyThe central bank uses expansionary monetary policy to increase the supply of money while lowering the interest rate and increasing demand. This is done to boost a country’s economy.read more resulted in a recession in 1981.

UK inflation 1970s-1980s

Margaret Thatcher was another dignitary who had embraced monetarism to battle inflation. The UK was experiencing prolonged inflation before the 1980s, hitting 25% in the mid-1970s. As a result, there was heavy unemployment, adding to the economic crisis.

After becoming the prime minister, Thatcher made decisions in line with monetarism, free-market concept, privatizationPrivatizationPrivatization refers to transferring ownership, operation, and control of a government or public entity to a non-government or private enterprise.read more and minimal government intervention. The base rate was increased to 17% to arrest inflation and it did eventually. Thatcher successfully brought down inflation by the early 1980s. However, while some sectors boomed terrifically, unemployment went up and manufacturing declined, decreasing the GDP.

Monetarist Theory Limitations

Maintaining steady and moderate growth of the money supply is impossible because money circulates in many forms. Therefore, spotting and channelizing the money supply is very difficult.It seems as monetarist policies fall in place, it can also put pressure on the economy. Economic events are unpredictable and having a set growth rate could pressurize an economy when there is a massive gap between actual and estimated development.In economics, the evidence supporting monetarist’s beliefs is scarce.The monetary policy excludes non-monetary factors such political interference, unequal wealth distribution, corruption, etc.