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July 04 2008 | Filed Under Banking , Economics
Picture yourself as the host of an economists' dinner party where no one is having any fun (perhaps not a hard thing to imagine). There are two competing schools of thought on what should be done to fix the party. The Keynesian economists in the room would tell you to break out the party games and snacks, and then force people into a rousing game of Twister. Meanwhile, Milton Friedman and his monetarist pals, have a different solution. Control the booze, and let the party take care of itself.
Of course, the economy is slightly more complicated than a dinner party gone bad, but the fundamental question is the same: Is it better to intervene when things go wrong, or attempt to prevent problems before they start? This article will explore the rise of the laid-back monetarist approach to controlling inflation, touching upon its proponents, successes and failures.
The Basics of Monetarism
Monetarism is a macroeconomic theory borne of criticism of Keynesian economics. It gets its name because of its focus on the role of money in the economy. This differs significantly from Keynesian economics, which emphasizes the role that the government plays in the economy through expenditures, rather than on the role of monetary policy. To monetarists, the best thing for the economy is to keep an eye on the money supply and let the market take care of itself: in the end, the theory goes, markets are more efficient at dealing with inflation and unemployment. (For more on the Keynesian theory, read Formulating Monetary Policy.)
Milton Friedman, a Nobel Prize winning economist who once backed the Keynesian approach, was one of the first to break away from commonly accepted principles. In his work "A Monetary History of the United States, 1867-1960" (1971), a collaborative effort with fellow economist Anna Schwartz, Friedman argued that the poor monetary policy of the Federal Reserve was the primary cause of the Great Depression in the United States, not problems within the savings and banking system. He argued that markets naturally move toward a stable center, and that it was an incorrectly set money supply that caused the market to behave erratically. With the collapse of the Bretton Woods system in the early 1970s and the subsequent increase in both unemployment and inflation, governments turned to monetarism to explain their predicaments. It was then that this economic school of thought gained more prominence. (To learn more about Friedman, read Nobel Winners Are Economic Prizes and How Influential Economists Changed Our
History.)
Monetarism has several key tenets:
The control of the money supply is the key to setting business expectations and to fighting the effects of inflation.
Market expectations about inflation influence forward interest rates.
Inflation always lags behind the effect of changes in production.
Fiscal policy adjustments do not have an immediate effect on the economy. Market forces are more efficient in making determinations. (For related reading, see What Is Fiscal Policy?)
A natural rate of unemployment exists; trying to lower the unemployment rate below that rate causes inflation.
Quantity Theory of Money
The approach of classical economists toward money states that the amount of money available in the economy is determined by the equation of exchange:
MV=PT
Where:
M = the amount of money currently in circulation over a set time period
V = the "velocity" of money (how often money is spent or turned over during the time period)
P = the average price level
T = the value of expenditures or the number of transactions
Economists tested the formula and found that the velocity of money, V, often stayed relatively constant over time. Because of this, an increase in M resulted in an increase in P. Thus, as the money supply grows, so too will inflation. Inflation hurts the economy by making goods more expensive, which limits consumer and business spending. According to Friedman, "inflation is always and everywhere a monetary phenomenon". While economists following the Keynesian approach did not completely discount the role that the supply of money has on the gross domestic product (GDP), they did feel that the market would take more time to react to adjustments. Monetarists felt that markets would readily adapt to more capital being available. (To learn more, read What Is The Quantity Theory Of Money?)
Money Supply, Inflation and the K-Percent Rule
To Friedman and other monetarists, the role of a central bank should be to limit or expand the supply of money in the economy. "Money supply" refers to the amount of hard cash available in the market, but in Friedman's definition, "money" was expanded to also include savings accounts and other on-demand accounts.
If the money supply expands quickly, then the rate of inflation increases. This makes goods more expensive for businesses and consumers and puts downward pressure on the economy, resulting in a recession or depression. When the economy reaches these low points, the central bank can exacerbate the situation by not providing enough money. If businesses - such as banks and other financial institutions - are unwilling to provide credit to others, it can result in a credit crunch. This means there is simply not enough money to go around for new investment and new jobs. According to monetarism, by plugging more money into the economy, the central bank could incentivize new investment and boost confidence within the investor community.
Friedman originally proposed that the central bank set targets for the rate of inflation. To ensure that the central bank met this goal, the bank would increase the money supply by a certain percentage each year, regardless of the economy's point in the business cycle. This is referred to as the k-percent rule. This had two primary effects: it removed the central bank's ability to alter the rate at which money was added to the overall supply, and it allowed businesses to anticipate what the central bank would do. This effectively limited changes to the velocity of money. The annual increase in money supply was to correspond to the natural growth rate of GDP.
Expectations
Governments also had their own set of expectations. Economists had frequently used the Phillips curve to explain the relationship between unemployment and inflation, and expected that inflation increased (in the form of higher wages) as the unemployment rate fell. The curve indicated that the government could control the unemployment rate, which resulted in the use of Keynesian economics in increasing the inflation rate to lower unemployment. During the early 1970s, this concept ran into trouble as both high unemployment and high inflation were present. (For more insight, read Examining The Phillips Curve.)
Friedman and other monetarists examined the role that expectations played in inflation rates; specifically, that individuals would expect higher wages if inflation increased. If the government tried to lower the unemployment rate by increasing demand (through government expenditures) it would lead to higher inflation and eventually to firms firing workers hired to meet that demand bump. This would occur any time the government tried to reduce unemployment below a certain point, commonly known as the natural rate of unemployment.
This realization had an important effect: monetarists knew that in the short run, changes to the money supply could change demand, but that in the long run, this change would diminish as people expected inflation to increase. If the market expects future inflation to be higher, it will keep open market interest rates high.
Monetarism in Practice
Monetarism rose to prominence in the 1970s, especially in the United States. During this time, both inflation and unemployment were increasing, and the economy was not growing. Paul Volcker was appointment as chairman of the Federal Reserve Board in 1979, and faced the daunting task of curbing the rampant inflation brought on by high oil prices and the collapse of the Bretton Woods system. He limited the growth of the money supply (lowering the "M" in the equation of exchange) after abandoning the previous policy of using interest rate targets. While the change did help the rate of inflation drop from double digits, it had the added effect of sending the economy into a recession as interest rates increased.
Since monetarism's rise in the late 20th century, one key aspect of the classical approach to monetarism has not evolved: the strict regulation of banking requirements. Friedman and other monetarists envisioned strict controls on the reserves held by banks, but this has mostly gone by the wayside as deregulation of the financial markets took hold and company balance sheets became ever more complex. As the relationship between inflation and the money supply became looser, central banks stopped focusing on strict monetary targets and more on inflation targets. This practice was overseen by Alan Greenspan, who was a monetarist in his views during most of his near-20-year run as Fed chairman. (To learn more about this famed Fed chairman, read A Farewell To Alan Greenspan.)
Criticisms of Monetarism
Economists following the Keynesian approach were some of the most critical opponents to monetarism, especially after the anti-inflationary policies of the early 1980s led to a recession. Opponents point out that the Federal Reserve failed to meet the demand for money, which resulted in a decrease in available capital.
Economic policies, and the theories behind why they should or shouldn't work, are constantly in flux. One school of thought may explain a certain time period very well, then fail on future comparisons. Monetarism has a strong track record, but it is still a relatively new school of thought, and one that will likely be refined further over time.
by Brent Radcliffe