Monetarism is one of the most influential approaches in the field of monetary economics, playing a decisive role in macroeconomic thought and policy design, particularly in the second half of the 20th century. Centered on the idea that the money supply has a determining impact on economic activity and the general price level, Monetarism was systematically formulated as a doctrine through the works of American economist Milton Friedman.
Conceptual Foundations of Monetarism
At its core, Monetarism is an economic theory that focuses on the relationship between the money supply and the general price level. At the heart of Monetarist theory lies the Quantity Theory of Money, encapsulated in the fundamental identity: MV = PT
In this formulation:
- M denotes the nominal money supply,
- V represents the velocity of money, i.e., the average frequency with which a unit of currency circulates in the economy over a given period,
- P stands for the general price level,
- T signifies the total volume of transactions or, in some interpretations, real output.
Monetarists emphasize the role of the money supply in ensuring price stability and fostering economic growth. They argue that increases in the money supply influence output and prices with a certain lag. Friedman maintains that while changes in the money supply affect production in the short run, they influence the general price level in the long run.
Historical Development of Monetarism
Classical Quantity Theory and Early Monetarists
The origins of Monetarism can be traced back to the analyses of thinkers such as David Hume, John Locke, and J.S. Mill, who explored the effects of money quantity on prices. However, it was Irving Fisher in the early 20th century who scientifically formalized the theory, making it subject to empirical testing.
Early Monetarism
In the early phase spearheaded by Fisher, Monetarism held that increases in the money supply directly influenced the price level. However, this theory proved insufficient in addressing issues such as unemployment and fluctuations in output. It was consequently criticized by John Maynard Keynes, who in his 1923 work Tract on Monetary Reform, famously stated: “In the long run we are all dead.”
Modern Monetarism: Friedman and the Chicago School
Monetarism became a systematic doctrine with Milton Friedman’s 1956 publication, The Quantity Theory of Money – A Restatement. This period is also referred to as “Classical Monetarism” or the “Modern Quantity Theory of Money.”
Friedman argued that the money supply and nominal income are strongly—albeit lagged—correlated. His main propositions include:
- There exists a positive relationship between the growth rate of the money supply and nominal income.
- The effects of changes in the money supply emerge with a time lag, generally ranging from 6 to 18 months.
- In the short run, money supply changes impact real output; in the long run, they affect the price level.
- The effects of money supply changes are not precise and may vary.
Friedman's most notable contribution was his critique of Keynesian policies that advocated for active monetary intervention. Instead, he proposed a rule-based approach, whereby the central bank should increase the money supply at a constant rate aligned with economic growth, thereby minimizing discretionary interventions.
Monetarism in Practice and the 1970s
The 1970s were marked by rising global inflation and stagflation, leading to widespread skepticism of Keynesian policies and increased interest in monetarist alternatives. The shift in U.S. monetary policy under Federal Reserve Chairman Paul Volcker in 1979, focusing on controlling money supply growth, is often viewed as a practical triumph of monetarism.
However, this triumph was short-lived. In the 1980s, fluctuations in the velocity of money and difficulties in effectively managing monetary aggregates such as M1 and M2 undermined monetarist prescriptions. Consequently, many central banks transitioned from targeting monetary aggregates to focusing on interest rates.
Criticisms of Monetarism
Hyman Minsky’s Critique
Minsky criticized the analyses of Friedman and Schwartz for excluding the roles of credit markets and the financial sector. According to Minsky, macroeconomic fluctuations cannot be adequately explained by money supply alone; instead, financial institutions, debt dynamics, and speculative behavior must also be considered.
Empirical Inconsistencies
Since the mid-1960s, the direct relationship between money supply, prices, and income has weakened. In countries like the United States, China, Japan, and Switzerland, rapid growth in the money supply has not always led to inflation. For instance, China’s high investment rates have mitigated inflationary pressures, while Switzerland and Japan have offset inflation through the accumulation of foreign assets in their open economies.
The Current State and Legacy of Monetarism
DeLong’s Classification of Monetarism
J. Bradford DeLong classifies Monetarism into four categories:
- First Monetarism: The classical approach led by Irving Fisher
- Old Chicago Monetarism: Expansionary monetary policy proposals by figures such as Viner and Simons during crisis periods
- Classic Monetarism: Systematic analyses by Friedman and his followers
- Political Monetarism: The rigid, often unsuccessful practical applications of monetary growth targets in the 1970s
According to DeLong, many of Friedman’s views are now embedded in modern New Keynesian thought. Concepts such as the natural rate of unemployment, the effectiveness of monetary policy, and the need for policy rules remain relevant today.
IMF Perspective
The International Monetary Fund (IMF) emphasizes that Monetarism has helped policymakers recognize the long-run importance of the money supply in controlling inflation. Nevertheless, due to practical challenges, monetarism in its pure form is no longer widely implemented. Many central banks now shape monetary policy around inflation targeting rather than strict monetary aggregate control.
Monetarism has been one of the most influential economic paradigms of the 20th century, institutionalized particularly through Milton Friedman’s efforts and leaving a profound impact on policy practices. Despite shortcomings in implementation and empirical limitations, its theoretical contributions remain integral to contemporary economic thought.
While the relationship between money supply and the general price level is now addressed within more flexible and multidimensional frameworks, the foundational principles of Monetarism continue to influence various strands of macroeconomic analysis.
