Monetarism is an economic school of thought that stresses the primary importance of the money supply in determining nominal GDP and price levels. It challenges Keynesian economics by arguing that monetary policy, not fiscal policy, should be used to stabilize the economy. Monetarists believe the central bank should target money supply growth and follow fixed rules, rather than have discretion, as monetary factors are more important than fiscal interventions in impacting economic outcomes.

1. monetarism
MS Salma Shaheen

2. • Monetarism is an economic school of thought
that stresses the primary importance of the
money supply in determining nominal GDP
and the price level.
• Monetarism is a theoretical challenge to
Keynesian economics that increased in
importance and popularity in the late 1960s
and 1970s.

3. © OnlineTexts.com p. 3
Characteristics of Monetarism
1. The theoretical foundation is the Quantity
Theory of Money.
2. The economy and financial markets are
inherently stable.
3. The Fed should be bound to fixed rules in
conducting monetary policy.
4. Fiscal Policy is often bad policy. A small role
for government is good.

4. Continue
• Monetarism is very closely allied with the
classical school of thought.
• An extension of classical theory
• which was developed in the 1960s and 1970s
• Try to explain a new economic phenomenon -
stagflation .

5. Continue
• Much of the Monetarists' work revolved
around the
• Role of expectations in determining inflation,
Development of the expectations-augmented
Phillips Curve .
• Milton Friedman is considered the father of
modern monetarism.

6. •Late 1960s developing macro instability:
Persistent BOT deficit
Inflation edging up
BOP crisis and devaluation 1967.
•Response of government of 1970-4:
•‘Free market’ policies
•But these go wrong.
•In particular, intensified the inflationary
pressures.

7. • The challenge to the traditional Keynesian theory
strengthened during the years of stagflation
following the 1973 and 1979 oil shocks.
• Keynesian theory had no appropriate policy responses
to the supply shocks.

8. • Inflation was high and rising through the 1970s and
Friedman argued convincingly that the high rates of
inflation were due to rapid increases in the money
supply.
• He argued that the economy may be complicated, but
stabilization policy does not have to be.
• The key to good policy was to control the supply of
money.

9. •Monetarist critique:
•‘Monetarists’’ known as Friedman, Chicago
school
•Criticised view that monetary policy is relatively
unimportant / secondary / ‘accommodating’ role
only, i.e. the Keynesian view that:
–ΔM → Δr → Δi, BUT this effect quite weak:
Flattish LM
Steep IS / I r-inelastic
•Called for more debate on monetary policy /
‘money matters’.

10. 10
The Effects of Money Supply Changes on
the Real Economy
Keynesian View Monetarist View
IS LM1 LM2
ISLM1
LM2
? Y Y
rr

11. 11
The Effects of Fiscal Changes
on the Real Economy
Keynesian View Monetarist View
IS1
LM
IS1
LM
?Y Y
rr
IS2
IS2

12. • Characteristics of Monetarism
• Monetarism is a mixture of theoretical ideas,
philosophical beliefs, and policy prescriptions.
Here we list the most important ideas and policy
implications and explain them below. The
theoretical foundation is the Quantity Theory of
Money.
• The economy is inherently stable. Markets
work well when left to themselves. Government
intervention can often times destabilize things
more than they help. Laissez faire is often the best
advice.

13. • The Fed should be bound to fixed rules in
conducting monetary policy.
• They should not have discretion in conducting
policy because they could make the economy
worse off.
• Fiscal Policy is often bad policy. A small role
for government is good.

14. 14 of 38
Monetarism
• The monetarist analysis of the economy
places emphasis on the velocity of money, or
the number of times a dollar bill changes
hands, on average, during a year; the ratio of
nominal GDP to the stock of money (M):
V
GDP
M
 or
V
P Y
M


M V P Y  
GDP P Y since
then,

15. 15 of 38
The Quantity Theory of Money
• The quantity theory of money is a
theory based on the identity
M x V = P x Y and the assumption
that the velocity of money (V) is
constant (or virtually constant).
Then, the theory can be written as
the following equality:
M V P Y  

16. Friedman’s restatement of QTM.
Keynesianism made simplifying assumption:
M and B the only two assets affecting money demand.
i.e. Bonds the only alternative to holding M.
Friedman: No -- other assets apart from bonds also need to be
taken into account, e.g.
residential and other property
consumer-durables
equities, etc.
These are also held as alternatives to money.

17. Cambridge:
MD = kPY
k is factor of proportionality / ‘Marshallian’ or
‘Cambridge’ k.
Reformulates QTM as theory of money demand.
Keynes:
MD = k(r).PY
Not compatible with QTM.
k not constant – cyclical fluctuations, etc.
Friedman:
MD = k(rB, r1 . . . rn).PY
rB: return on bonds
r1 . . . rn : rates of return (explicit or implicit) on
other assets besides bonds. These net out → k = k
i.e. Restatement of QTM.

18. Neutrality of money – LR / SR distinction:
‘Old’ QTM:
ΔM → ΔP only, with ΔY = 0.
i.e. ΔP / ΔM = 1.
Friedman: M is neutral in LR, as in old QTM:
i.e. ΔLRP / ΔM = 1.
BUT: ΔM may have SR effect on Y:
ΔM → ΔP, but also ΔSRY > 0.
i.e. ΔSRP / ΔM < 1.
This SR effect gradually unwinds till we have
ΔLRP / ΔM = 1.

19. Friedman’s Adaptive Expectations Hypothesis / ‘fooling’ model
/ effect of SR changes in MS:
Wage-earners’ expectations of movements in P take time to
adapt.
P↑ and wage-earners underestimate change.
→ they supply more labour than if they had realised how much
their real wage has been eroded by inflation.
Model works symmetrically in reverse / overestimation.

20. P0
Y*
AD0
Y
P
P’
AD1
Y’
SRAS (Pe = P0)
LRAS
Workers supply more
labour → Y↑ because
they think their real
wage has increased
more than it actually
has.
Friedman’s monetarism:
adaptive expectations, and the LR-SR distinction, contd
MS ↑
→ AD ↑

21. Workers realise they
have overestimated their
real wage and adjust it
over successive time
periods, so they reduce
LS, i.e. AS shifts left.P0
Y*
AD0
AD1
Y
P
Y’
SRAS (Pe = P0)
LRAS (Pe = P)
P1
SRAS (Pe = P1)
Friedman’s monetarism:
adaptive expectations, and the LR-SR distinction, contd
(1)
(2)
Eventually Y returns to
Y*

22. Net result is just
inflation and
instability.
P0
P1
YNR
AD0
AD1
Y
P
SRAS (Pe = P0)
LRAS (Pe = P) SRAS (Pe = P1)
P has risen, and Y falls
back to its original level –
the ‘Natural Rate’.
Y returns to YNR --
net result is ΔP only
Friedman’s monetarism:
adaptive expectations, and the LR-SR distinction, contd

23. ‘Natural rate’
‘Old’ classical:
Unique point of equilibrium / self-regulating level.
This is YFE.
Friedman: This is unrealistic.
→ redefined LR sustainable level as ‘natural rate’:
(1) Will always be some unemployment.
At equilibrium / self-sustaining level:
‘natural rate’ – NRU.
(2) NRU is not constant.
Changes with changing labour market conditions.

24. Expectations-augmented Phillips
Curve
• The Phillips Curve showed a trade-off between
unemployment and inflation.
• Friedman then put his mind to whether the
Phillips Curve could be adapted to show
• why stagflation was occurring,
• Include the role of expectations in the Phillips
Curve .
• Hence the name 'expectations-augmented'
Phillips Curve.

25. Continue
• Friedman argued that there were a series of
different Phillips Curves for each level of
expected inflation.
• Friedman was therefore assuming no 'money
illusion'

27. • The Rules vs. Discretion Debate
• Because monetarists believe that the money
supply is the primary determinant of nominal
GDP in the short run, and of the price level in
the long run, they think that control of the
money supply should not be left to the
discretion of central bankers.
• Monetarists believe in a set of "rules" that the
Federal Reserve must follow. In particular,
Monetarists prefer the Money growth rule:

28. • The Fed should be required to target the
growth rate of money such that it equals 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. Monetarists wish to take much of
the discretionary power out of the hands of
the Fed so they cannot destabilize the
economy.

29. • Keynesians start at this proposed money
growth rule. Keynesians believe that velocity
is inherently unstable and they do not believe
that markets adjust quickly to return to
potential output.
• Therefore, Keynesians attach little or no
significance to the Quantity Theory of
Money.
• Because the economy is subject to deep swings
and periodic instability, it is dangerous to take
discretionary power away from the Fed.
• .

30. • The Fed should have some leeway or
"discretion" in conducting policy.
• So far, Keynesians have won this debate.
There has not been serious talk in some time of
tying the Fed to a fixed money growth rule

31. • Fiscal Policy
• Because Monetarist dislike big government and
tend to trust free markets, they do not like
government intervention and believe that fiscal
policy is not helpful.
• Where it could be beneficial, monetary policy
could do the job better.
• Excessive government intervention only
interferes in the workings of free markets and
can lead to bloated bureaucracies, unnecessary
social programs, and large deficits. Automatic
stabilizers are sufficient to stabilize the economy.

32. © OnlineTexts.com p. 32
Keynesians vs. Monetarists:
Key Differences
Monetarists Keynesians
secure monetary policy to
rules
Give policymakers discretion.
Fiscal policy is not useful. Fiscal policy may be useful.
AS curve has a steep slope. Economy can be unstable.
Economy is inherently stable. AS curve can be flat.