monetary policy

Monetarism is an economic theory formulated by Milton Friedman and mainly focuses on the macroeconomic effects and importance of the role of government in maintaining money supply in circulation. This theory proposes that the amount of money in circulation impacts the overall economy in terms of output, inflation and price level of commodities. The sources of information for this paper are secondary in nature. The secondary resources are websites, books, journal articles and opinion papers pertaining to the theoretical concepts. The scope of the paper confines to the academic application and should be used only in the consideration of the practical variables applicable to the industry.

The monetarists believe that monetary policy should be made by the government and should always be based on the targeting the growth rate rather than the discretionary monetary policy. This theory argues that the central bank plays an important role in maintaining the money supply and it should focus on the maintaining the price stability while making the monetary policy because that excessive money supply always results in inflation.

Monetarism is basically rooted into the hard money policies in 19th century and the monetary policies of John Maynard Keynes. Keyes mainly focused on the value stability of money according to which sufficient supply of money led to the alternate currency and collapse leading to panic. Friedman mainly focused on stability of price which is attained when there is equilibrium between demand and supply of money.

According to Friedman, the money supply should automatically be increased according to a fixed percentage per year which is also called as fixed monetary rule or Friedman k-percent rule. According to this rule, the increase in money supply could be determined by software application and that can anticipate all the money supply changes.

The active manipulation of money supply or increase will cause more destabilization than stabilize it. In 1965 Milton Friedman restated the quantity theory of money according to which demand for money is governed by the certain number of variables. When the money supply expands the people of the country do not hold the money in bank balances but would put that money into the economy which will increase the money spent on every commodity disturbing the price balance. This is because the commodity will hold less value as compared to when people had less money. The price of the commodity will rise and aggregate demand will increase. Similarly, when the money supply reduces people save the money and the overall spending decreases leading to decrease in demand and fall in price.

The application of theory of Monetarism was seen in 1979 when Federal Chief Paul Volker fought inflation by reducing the money supply and in result he was able to create price stability. The historical application of Monetarism could have been in the Great Depression of 1930 which was a result of contraction of money supply and not the lack of investment as opposed to what Keynes proposed and thus the inference of the theory was that the inflation is almost always caused by the money supply and hence fundamental challenge to Keynesianism was presented in 1970s.

The Friedman’s model suggests that the fiscal spending creates slows down the economy by increases interest rates as it creates present consumption. It does not have any real effect on total demand and there is no real effect on demand because demand mainly shifts from investment area to the consumer sector.

The current conclusion of the theory has been that central bank policy has been the main reason behind major inflationary episodes in the history and the primary drive behind the excessive easing of federal bank policy is to finance the fiscal deficits by the federal government. Hence, reduction of government spending is the single most important target to govern the limitless economic growth.

During the great Recession of 2007, Alan Greenspan came under scanner for handling the monetary policy and he argued that the Monetarism cannot applied in the doctrinaire form and there should be some flexibility in approach when handling the crisis situations. In 2000, Greenspan raised interest rates many times and these were believed to be causing the dot com bubble burst. In 2004-2006 the excessive liquidity caused the lending standards to deteriorate and thus there was another crisis of housing bubble. Current application of the theory is followed as a modified form of monetarism where the broader range of intervention is possible along with the short term instability in the market.

In European economy, the mare traditional approach to the monetarism is follows with much tighter control on the inflation and spending targets which are mandatory as per the Economic and Monetary Union of European Union to support Euro.

The main argument against Monetarism is the liquidity trap which is experienced by Japan. The formal Federal Chief Ben Bernanke argued that expansion of money supply can be used as a response to zero interest rate conditions.

 

References

Brunner, Karl, and Allan H. Meltzer, (1993). Money and the Economy: Issues in Monetary Analysis, Cambridge.

Friedman, Milton, and David Meiselman, (1963). The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States.  Stabilization Policies, pp. 165–268.

Johnson, Harry G., (1971) The Keynesian Revolutions and the Monetarist Counter-Revolution, American Economic Review, 61(2), p. p. 1–14. p. p. 72 – 88.

 

 

 

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