Monetarism
Monetarism is a school of thought in monetary economics that emphasizes the role of policy-makers in controlling the amount of money in circulation. It gained prominence in the 1970s, but was mostly abandoned as a direct guidance to monetary policy during the following decade because of the rise of inflation targeting through movements of the official interest rate.
The monetarist theory states 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.[1] Monetarism is commonly associated with neoliberalism.[2]
Monetarism is mainly associated with the work of Milton Friedman, who was an influential opponent of Keynesian economics, criticising Keynes's theory of fighting economic downturns using fiscal policy (government spending). Friedman and Anna Schwartz wrote an influential book, A Monetary History of the United States, 1867–1960, and argued "that inflation is always and everywhere a monetary phenomenon".[3]
Though Friedman opposed the existence of the Federal Reserve,[4] he advocated, given its existence, a central bank policy aimed at keeping the growth of the money supply at a rate commensurate with the growth in productivity and demand for goods. Money growth targeting was mostly abandoned by the central banks who tried it, however. Contrary to monetarist thinking, the relation between money growth and inflation proved to be far from tight. Instead, starting in the early 1990s, most major central banks turned to direct inflation targeting, relying on steering short-run interest rates as their main policy instrument.[5]: 483–485 Afterwards, monetarism was subsumed into the new neoclassical synthesis which appeared in macroeconomics around 2000.
Decline[edit]
Monetarist ascendancy was brief, however.[10] The period when major central banks focused on targeting the growth of money supply, reflecting monetarist theory, lasted only for a few years, in the US from 1979 to 1982.[16]
The money supply is useful as a policy target only if the relationship between money and nominal GDP, and therefore inflation, is stable and predictable. This implies that the velocity of money must be predictable. In the 1970s velocity had seemed to increase at a fairly constant rate, but in the 1980s and 1990s velocity became highly unstable, experiencing unpredictable periods of increases and declines. Consequently, the stable correlation between the money supply and nominal GDP broke down, and the usefulness of the monetarist approach came into question. Many economists who had been convinced by monetarism in the 1970s abandoned the approach after this experience.[10]
The changing velocity originated in shifts in the demand for money and created serious problems for the central banks. This provoked a thorough rethinking of monetary policy. In the early 1990s central banks started focusing on targeting inflation directly using the short-run interest rate as their central policy variable, abandoning earlier emphasis on money growth. The new strategy proved successful, and today most major central banks follow a flexible inflation targeting.[5]: 483–485
Legacy[edit]
Even though monetarism failed in practical policy, and the close attention to money growth which was at the heart of monetarist analysis is rejected by most economists today, some aspects of monetarism have found their way into modern mainstream economic thinking.[10][17] Among them are the belief that controlling inflation should be a primary responsibility of the central bank.[10] It is also widely recognized that monetary policy, as well as fiscal policy, can affect output in the short run.[5]: 511 In this way, important monetarist thoughts have been subsumed into the new neoclassical synthesis or consensus view of macroeconomics that emerged in the 2000s.[18][5]: 518