The monetarists argue that while it is not possible to have full employment of the labor . The quantity theory of money is used to establish the link between the. Monetarists believe that the objectives of monetary policy are best met by targeting The foundation of monetarism is the Quantity Theory of Money. The money supply is useful as a policy target only if the relationship between money and. Central to monetarism is the Quantity Theory of Money, which states that the Proponents of monetarism believe that controlling an economy through fiscal however, monetarism fell out of favor with economists, and the link.Business Cycles Explained: Monetarist Theory
Explanation of why money supply leads to inflation Monetarists believe that in the short-term velocity V is fixed This is because the rate at which money circulates is determined by institutional factors, e. Milton Friedman admitted it might vary a little but not very much so it can be treated as fixed Monetarists also believe output Y is fixed. They state it may vary in the short run but not in the long run because LRAS is inelastic and determined by supply-side factors.
The level of output Y is units. In year 2, if the output stays at 1, units, but money supply increases to 15, Consumers have more money to buy the same amount of goods. Therefore, firms put up prices to reflect this increase in money supply. Other points Milton Friedman predicted an increase in the money supply would take about months to lead to higher output.
What Is Monetarism? - Back to Basics - Finance & Development, March
Friedman placed great emphasis on the role of price expectations. If there are expectations of higher inflation, it becomes self-fulfilling — workers demand higher wages to meet rising living costs. Firms put up prices to meet rising costs.
Strict monetarist policies would help reduce expectations. In the early s, the UK and US adopted monetarist policies with mixed results.
This rate of increase should depend on institutional factors and be determined independently of policymakers. Friedman believed this rule would avoid the extremes of deflation Falling money supply, e.
Great Depression and inflation due to rising money supply. It would give business strong expectations of what would happen to money supply and inflation. Variations in nominal income reflect changes in real economic activity the number of goods and services sold and inflation the average price paid for them. The quantity theory is the basis for several key tenets and prescriptions of monetarism: An increase in the money stock would be followed by an increase in the general price level in the long run, with no effects on real factors such as consumption or output.
An increase in the stock of money has temporary effects on real output GDP and employment in the short run because wages and prices take time to adjust they are sticky, in economic parlance. Friedman, who died inproposed a fixed monetary rule, which states that the Fed should be required to target the growth rate of money to equal the growth rate of real GDP, leaving the price level unchanged.
If the economy is expected to grow at 2 percent in a given year, the Fed should allow the money supply to increase by 2 percent. The Fed should be bound to fixed rules in conducting monetary policy because discretionary power can destabilize the economy.
The money growth rule was intended to allow interest rates, which affect the cost of credit, to be flexible to enable borrowers and lenders to take account of expected inflation as well as the variations in real interest rates. They also assert that government intervention can often destabilize the economy more than help it. Keynesians, who took their inspiration from the great British economist John Maynard Keynes, believe that demand for goods and services is the key to economic output.
They contend that monetarism falters as an adequate explanation of the economy because velocity is inherently unstable and attach little or no significance to the quantity theory of money and the monetarist call for rules. Keynesians also do not believe that markets adjust to disruptions and quickly return to a full employment level of output. But the monetarist challenge to the traditional Keynesian theory strengthened during the s, a decade characterized by high and rising inflation and slow economic growth.
Keynesian theory had no appropriate policy responses, while Friedman and other monetarists argued convincingly that the high rates of inflation were due to rapid increases in the money supply, making control of the money supply the key to good policy. Volcker became chairman of the Fed and made fighting inflation its primary objective. The Fed restricted the money supply in accordance with the Friedman rule to tame inflation and succeeded.
Inflation subsided dramatically, although at the cost of a big recession.
Monetarist Theory of Inflation
When Margaret Thatcher was elected prime minister inBritain had endured several years of severe inflation. Thatcher implemented monetarism as the weapon against rising prices, and succeeded in halving inflation, to less than 5 percent by 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.
That is, if the supply of money rises, so does nominal GDP, and vice versa. To achieve that direct effect, though, the velocity of money must be predictable. The rate of growth of money, adjusted for a predictable level of velocity, determined nominal GDP. But in the s and s velocity became highly unstable with unpredictable periods of increases and declines. The link between the money supply and nominal GDP broke down, and the usefulness of the quantity theory of money came into question.