Monetarism is a theory suggested by the American economist Milton Friedman (1912-2006) in the 60s of the last century, in “A Monetary History of the United States”, a book he co-wrote with Anna Schwartz. The theory was named so for its focus on money’s role in the economy.
Monetarism is an economic doctrine according to which the amount of money in circulation in the economy is the primary determinant of economic growth, so in order to maintain the economic stability, the authorities must control the money supply by targeting a growth rate.
Monetarism advocates tight control of money supply to suppress inflation, which, according to its supporters, is the root cause of disorder in an economy.
Friedman states that: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Which means that the money supply must be maintained at the same rate as production in order to avoid high inflation.
The quantity theory of money (QTM):
This theory originally formulated by Polish mathematician Nicolaus Copernicus in 1517 but has experienced a large surge in popularity with economists Anna Schwartz and Milton Friedman’s book A Monetary History of the United States, in 1963.
The QTM is actually one of the main foundations of monetarism
M×V=P×T where:
M= amount of money currently in circulation over a period of time.
V= Velocity (how often money is spent or turned over a period of time).
P= Average price level.
T= Value of expenditures or number of
transactions.
Considering V and T relatively fixed, an increase in M will directly lead to an increase in P. In other words, increasing money supply leads to inflation .
Changes in the money supply also affect employment and production levels, but the monetarist theory asserts that those effects are only temporary, while the effect on inflation is more long-lasting and significant
Monetary policy:
Monetary policy is an economic tool used in monetarism to control the money supply by adjusting the interest rates.
When interest rates increase people are more willing to save money than to spend and invest it, because the cost of borrowing decreases, this leads to a decrease in money supply which means a decrease in inflation rate as well.
On the other hand, when interest rates go down this encourages people to spend more and to invest their money rather than saving, this means an increase in money supply which in its turn leads to increasing inflation.
The K-Percent Rule :
The K-Percent Rule was proposed by Milton Friedman. He suggested that the central bank should increase the money supply by a constant percentage every year.
The K-Percent Rule proposes to set the money supply growth at a rate equal to the growth of real GDP each year.
This would be beneficial for businesses who could anticipate all monetary policy decisions.
Friedman was against giving governments any flexibility in setting money growth rates.
Monetarism has known important success, particularly in the United States, in the 1980s and 1990s, especially that the strategy suggested by Friedman was adopted by the Fed to fight the stagflation of the 70s, and it actually was quit successful.
During the same time period, When Margaret Thatcher was elected prime minister in 1979, she decided to implement a set of monetarist policies to deal with severe inflation her country was struggling with at that time .
And by 1983, inflation in Britain had been halved, from 10% to 5%.
Despite of the successful experiences some countries have had with monetarism, it is still criticized especially by Keynesians who accuse it of giving priority to the fight against inflation to the detriment of that against unemployment.
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Oeconomia 