Sophie Trobitzsch
Department of Politics, University of California Santa Cruz

Monetarism is a macroeconomic theory stating that monetary policy is the primary driver of economic growth and controls the business cycle. According to monetarist theory, governments maintain economic stability by controlling the rate at which the money supply increases and decreases. Therefore, monetarists argue that central banks should aim to maintain a stable growth rate of the money supply (Mathai).

Monetarists believe that during an economic upswing, central banks should adopt deflationary monetary policies such as increasing the interest rate, selling or lending securities, or increasing the reserve ratio. Accordingly, during a recession, central banks should adopt inflationary monetary policies by lowering interest rates and buying or borrowing government securities in order to stimulate activity (Mathai).

Monetarism first appeared in 1959 and is mainly associated with Milton Friedman and his critique of John Maynard Keynes’ theory of inflation (Blyth 2002, 139). According to Keynesian economics, governments should use contractionary or expansionary fiscal policy to regulate unemployment and inflation. Friedman, however, contends that Keynesian demand management underestimates the importance of a stable supply of money (Jones 2012, 201). Friedman's ideas reject the core ideas of embedded liberalism, which include full employment and social welfare primarily shaped by government intervention (Blyth 2002, 141). Friedman argued that fluctuations in the money supply had been a major influence on business cycles in the United States (Bleaney 1985, 135). Specifically, Friedman explains that the Great Depression was not due to a fall in aggregate demand, but was instead caused by the Federal Reserve System (Friedman and Schwartz 1963, 44). Thus, although Friedman emphasizes the importance of controlling the money supply as a tool to create economic stability, he highlights that it would be inefficient for central banks to pursue a positive stabilization policy by varying the money supply in a contra-cyclical manner (as Keynes and his followers argued). Instead, central banks should maintain a steady expansion of the money supply at a fixed rate (Kaldor 1970, 3). As highlighted by Friedman in “The Role of Monetary Policy,” “the precise rate of growth, like the precise monetary total, is less important than the adoption of some stated and known rate” (Friedman 1995, 16).Friedman concludes that a steady rate of growth promotes economic stability.

Furthermore, monetarism offers an alternate conception of the natural rate of unemployment that differs from the Keynesian view by focusing on the supply of labor, rather than the demand (Hoover 1984, 62). Friedman argued that after a monetary expansion, the price of goods would rise, causing money wages to rise, but real wages would fall proportionately due to wages being essentially a fixed cost. Hence, due to the rise in money wages, unemployment would fall in the short term because more people would be willing to work at the apparent higher wages. However, because only moneywages would rise, and real wages remain the same, this would either cause employed workers to force up wages to equilibrate the real and money wage rate, or it wouldcause newly employed workers to withdraw their labor (Blyth 2002, 140). Furthermore, while the money supply determines prices and incomes, it does so with a time lag that can vary substantially (Kaldor 1970, 3). This argument counters the embedded liberal idea that unemployment is a function of the failure of demand. Therefore, Friedman assumed that unemployment was voluntary and that there was a natural rate of unemployment (Blyth 2002, 140). Friedman’s argument also challenges the assumptions of the Phillips Curve, which suggests that there is an inverse relationship between inflation and unemployment (Del Negro et al. 2020, 304). Friedman argued that policymakers could not permanently trade higher inflation for lower unemployment. Instead, he contends, the Phillips curve only shows the supply curve of labor (Blyth 2002, 140).

One of the most recent applications of monetarism could be observed during the global COVID-19 pandemic. As highlighted by Pinter (2022), “Central banks around the world have resorted to unconventional monetary policies on an unprecedented scale to deal with the economic risks associated with the COVID-19 pandemic crisis” (2). Starting in March 2020, entire sectors of the American economy were closed, and people temporarily withdrew from many kinds of social and economic activity to help slow the spread of the virus (Powell 2022). As a result, 115 million Americans experienced a loss in employment income from March 2020 through February 2021 (Monte 2021). This economic downturn, attributable to the steps taken to slow the spread of the virus, was distinct from post-World War II recessions which were often linked to a cycle of high inflation. As a response, the U.S. central banking system (Fed) reduced interest rates to close to zero and facilitated the flow of credit in the economy by purchasing securities, implementing liquidity and funding measures, and enforcing temporary regulatory adjustments to encourage and allow banks to expand their balance sheets to support their household and business customers (Powell 2022).

Monetarism has achieved limited success in the past for a few reasons. Firstly, central banks do not have full power over the supply of money and credit. For example, the Fed can only implement certain measures in “unusual and exigent circumstances” and with the consent of the Secretary of the Treasury, such as extending credit directly to private nonfinancial businesses and state and local governments, which was implemented during the COVID-19 pandemic (Powell 2022). Secondly, electoral politics and economic theory do not always go hand in hand. During an inflationary period, monetarist theory calls for deflationary monetary policy, which might be electorally undesirable and socially costly (Blyth 2002, 144). Thirdly, implementing monetary policy bears the risk of causing severe recessions or inflations and creating high levels of unemployment. As highlighted by Friedman (1995) himself, “every major inflation has been produced by monetary expansion – mostly to meet the overriding demands of war which have forced the creation of money to supplement explicit taxation” (Friedman 1995, 12). Thus, monetary policy can often only achieve limited success. As emphasized by the Fed’s Chair Jerome Powell, “the Fed has lending powers, not spending powers” (2022). For this reason, monetary policy is usually combined with fiscal policy to regulate economic growth (Davig and Leeper 2011).

(See Economic Reason, Money, Neoliberalism, Variegated Neoliberalism)

Bibliography

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Blyth, Mark. Great Transformations: Economic Ideas and Institutional Change in the Twentieth Century. New York: Cambridge University Press, 2002.

Davig, Troy, and Eric M. Leeper. “Monetary-Fiscal Policy Interactions and Fiscal Stimulus.” European Economic Review 55, no. 2 (2011): 211–27.

Del Negro, Marco, Michele Lenza, Giorgio E. Primiceri, and Andrea Tambalotti. “What’s Up with The Phillips Curve?” Brookings Papers On Economic Activity 2020(1): 301–57.

Friedman, Milton. A Program for Monetary Stability. New York: Fordham University Press, 1959.

Friedman, Milton. “The Role of Monetary Policy.” In: Essential Readings in Economics, edited by S. Estrin and A. Marin. Palgrave, London, 1995.

Friedman, Milton, and Anna Jacobson Schwartz. A Monetary History of the United States, 1867-1960. Vol. 9. United States: Princeton University Press, 1963.

Hoover, Kevin D. “Two Types of Monetarism.” Journal of Economic Literature 22, no. 1 (1984): 58–76.

Jones, Daniel Stedman. Masters of the Universe: Hayek, Friedman, and the Birth of Neoliberal Politics. Princeton: Princeton University Press, 2012.

Kaldor, Nicholas. “The New Monetarism.” Lloyds Bank Review 97, no. 1 (1970): 18. Retrieved from: http://public.econ.duke.edu/~kdh9/Courses/Graduate%20Macro%20History/Readings-1/Kaldor.pdf

Mathai, Koshy. “Monetary Policy: Stabilizing Prices and Output.” International Monetary Fund: Finance & Development. Retrieved from: https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Monetary-Policy

Monte, Lindsay M. “Historical Look at Unemployment, Sectors Shows Magnitude of COVID-19 Impact on Economy.” United States Census Bureau: Putting Economic Impact of Pandemic in Context. Retrieved from: https://www.census.gov/library/stories/2021/03/putting-economic-impact-of-pandemic-in-context.html

Pinter, Julien. “Monetarist Arithmetic at COVID‐19 Time: A Take on How Not to Misapply the Quantity Theory of Money.” Economic Notes 51, no. 2 (2022): 1–17.

Powell, Jerome H. “Current Economic Issues.” Remarks at the Peterson Institute for International Economics. Retrieved from: https://www.federalreserve.gov/newsevents/speech/powell20200513a.htm