Monetarism

Monetarism is a school of macroeconomic theory emphasizing the causal role of the money stock in aggregate economic fluctuations, and holding that the key to aggregate economic stability lies with a steady, noncyclical growth path in the money supply. The aggregate economic system experiences upswings and downswings manifested in such statistics as the unemployment rate. These cyclical swings are a response to imbalances between the total demand for all goods and services relative to the total supply, as opposed to imbalances between supply and demand in individual markets, such as the market for automobiles.

According to monetarism, the aggregate economic system has strong intrinsic tendencies to gravitate toward a full-employment equilibrium, and these tendencies will assert themselves in the absence of shocks to the money stock growth rate. If the money stock growth rate is stable, the aggregate economic system will mirror that stability. Economists who adhere to the tenets of monetarism are called “monetarists.”

In policy terms, “monetarism” means that central bank monetary policy should set target rates of growth of money stock measures and rather single-mindedly pursue those targets. Keynesian monetary policy, the orthodox policy in the 1950s and 1960s, emphasized interest rates as a target of monetary policy, raising interest rates to slow down the economy and reducing interest rates to speed things up. Monetarists contended that the Keynesian policies took the focus off the money stock and replaced it with subjective ideas about what interest rates should be. According to monetarism, financial markets should determine interest rate levels.

Monetarism rose to prominence in the 1970s as inflation began to eclipse unemployment as the most dreaded economic problem. Monetarists contended that the relationship between inflation and money stock growth was virtually a one-to-one relationship, and that money stock growth was feeding the inflation. Monetarists clung to the money stock theory as the sole explanation of inflation, excluding the possible role of government budget deficits, powerful unions, monopolistic corporations, harvest failures, and shortages of key raw materials.

Although restricted money stock growth seemed a plausible antidote against inflation, the first effects of restricted money stock growth were seen in rising unemployment rates rather than falling inflation rates, making the tactic a touchy matter in democratic societies subject to the moods of voters. A president no less conservative than Richard Nixon preferred to give wage and price controls a try rather than put the economy on a prolonged diet of restricted money stock growth.

The decade of the 1980s saw what might be called a monetarist experiment. The governments of Margaret Thatcher in the United Kingdom and President Reagan in the United States imposed strict monetarist policies of restricted money stock growth in an effort to break the back of double-digit inflation. In the United States, the prime interest rate soared to 20 percent, and unemployment reached double-digit levels. Thatcher’s policies put the United Kingdom through similar rigors. The tight money policies put these economies through recessions deeper than any economic contraction since the 1930s.

Monetarist policies succeeded in bringing down inflation rates, and unemployment rates began to fall back, suggesting that monetarist policies were succeeding. Nevertheless, in October 1987, stock markets crashed in New York and London, and central banks began increasing money stock growth to reinflate world financial markets. Contrary to monetarists’ expectations, the added money stock growth did not trigger another round of inflation. During the 1990s, inflation was less than expected based on money stock growth, casting a bit of doubt on monetarism. Between 1999 and 2005 Japan reported deflation. Japan’s deflation persisted in the face of interest rates that stood near 0 percent, further undermining confidence in monetarism.

At the very least it can be said that monetarism brought a stoical quality to economic policy making that was needed to endure the pain of disinflating the economies of the world. Notwithstanding the departure in the 1990s from monetarist policies based on strict, steady growth rates in money stocks, inflation rates have steadily subsided, perhaps reflecting the policy effects of new knowledge gained from the monetarists’ theoretical explorations.