Monetarism: Definition

Monetarism, a term first used by Brunner in 1968, can be understood in two ways. The first relates to the economic thought that sees in the quantity of money the major source of economic activity and its disruptions (especially inflation), as well as believing that targeting the growth of money supply is the best monetary policy. Secondly, it refers to a large group of economists adherent to these thoughts, lead by Milton Friedman and the Chicago School of economics.

This paradigm, which gained popularity in the 1960s, relates closely to neoclassical economics, believing that free flow of credit and interest rates, as well as a laissez faire attitude is the best way to go, since limited public intervention and a competitive economic system will grant better results than those resulting from Keynesian economics. However, since monetarists consider monetary policy more effective, government control over money supply is required. Also, since monetarists believed in the importance of the quantity of money, the equation of exchange regained popularity.

Monetarists view fiscal policy less effective than monetary policy because of the low interest elasticity of money demand. Therefore, when using the IS-LM model, monetarists consider the IS curve more elastic than the one used by Keynesians, and a LM curve more inelastic. This is the reason why, when using the monetarist’ IS-LM model, public investment created by fiscal policy creates a crowding out effect over private investment, reducing the effectiveness of public spending. However, even though monetary policy is more reliable, its effects may take a while to be noted in the economy, and therefore its implementation can be difficult.

Concerning the Phillips curve, monetarists criticise the money illusion implied in it, which is the basis for the relationship between inflation and unemployment. They believe that, given an unanticipated higher inflation and the subsequent decrease in unemployment, the trade-off shown in the Phillips curve will hold. However this will not be the case when monetary policies are anticipated, implying that the trade-off between inflation and unemployment does not apply in the long run. This is a clear example of the learning process introduced in the Adaptive Expectations hypothesis, firstly formulated (though not under its widely known name) by Irving Fisher in his article “The Purchasing Power of Money”, 1911, and popularized by Phillip Cagan in 1956 and by Friedman, in his paper “The Role of Monetary Policy”, 1968, where he also introduced the concept of natural rate of unemployment, which is the rate that the economy will reach after each movement along the Phillips curve. It must be highlighted that, contrary to New Classical Macroeconomics studies and its Rational expectations hypothesis, monetarists believe that the trade off can be systematically exploited in the short run, as long as each policy is unanticipated.

Given the low effectiveness of fiscal policy as well as the risks of high inflation caused by systematic monetary policies, monetarists defend a commitment by the monetary authorities to steady monetary growth, and reject discretionary and politically driven monetary policies, because of the uncertainty they create.