Monetarism

Monetarism in Theory

The theory of monetarism is derived from a range of neoclassical thinkers, the most prominent of which are Milton Friedman and Friedrich von Hayek. Monetarist theorists contend that inflation is the result of an excessive growth in the supply of money in relation to the growth of economic output. This is based on the assumption that a free market capitalist economy will tend toward a stable and harmonious equilibrium if left undisturbed. On this basis, monetarists argue that any political interference that produces an artificial expansion of the money supply to achieve social objectives, such as a lower rate of unemployment or faster economic growth, will prove to be self-defeating and will lead to rising economic and political instability.

In its simplest form, the inflationary process is typically thought to begin when the government initiates an unsound monetary expansion, such as an unwarranted reduction in interest rates or an excessive rise in public expenditure. If such measures are not anticipated by the market, then this monetary expansion will lead to a rise in consumption and to a subsequent increase in trade, output, and employment as the economy grows to meet the extra level of demand. As this process continues, however, a growing scarcity of labor eventually leads to rising wage costs as workers seek to capitalize on their improved bargaining position. This undermines profit margins, so businesses respond by curtailing their activities or by raising prices. As a result, inflation grows, consumption falls, the economy contracts, and output and employment both start to decline.

According to monetarists, this course of events will continue until the economy restabilizes at its previous level of economic activity and employment, though now with higher prices and wages, or until the government embarks on another monetary expansion in an attempt to engineer renewed economic growth. However, because inflationary expectations will have now risen, any subsequent expansion will have to be progressively larger than that anticipated by the market if it is to produce the desired effects, thus leading to escalating inflation and increased macroeconomic instability.

Given the apparent futility of political intervention in the operation of the market, monetarists therefore argue that the government should restrict its economic policy objectives to the provision of a sound and stable monetary framework by keeping the growth of the money supply in line with the growth of output. To achieve this, monetarists contend that the government needs to establish a credible policy “rule” that binds their future economic policy behavior, such as a self-imposed constraint on the growth of the money supply, or inflation targeting by an independent central bank. By limiting the government's discretionary control of monetary issues in this way, monetarists argue that such measures can help preclude any political manipulation, can constrain market expectations, and can thereby help maintain macroeconomic stability and avoid an unwarranted rise in inflation.

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