Monetarism is a commonly known philosophy
of macroeconomics often associated with Milton Friedman, but it’s actually centuries old.
Monetarism is the view that money supply growth really matters for the business cycle. Milton
Friedman in particular advocated a regime where money supply growth would be kept very
stable. In his opinion, if money supply growth was too rapid, you would get excess inflation.
If money supply growth was too slow, you would get a downturn because Friedman like John
Maynard Keynes believed a lot of wages and prices were sticky, and thus decreasing that
nominal flow of expenditure would cause an economy to contract. Friedman was famous for
suggesting that the Great Depression was largely caused because in the period 1929 through
1932 the Federal Reserve allowed the money supply in this country to contract very radically. [Example: 1970s Stagflation] Here’s a good example of an economic downturn
that came about and can be partially explained by monetarism. In 1979 in the United States,
rates of price inflation and rates of interest were very high. Paul Volcker, who was running
the Federal Reserve System, decided inflation was too high, and he applied the monetary
brakes, so to speak. This was probably necessary, but it meant strong deflationary pressures
on the American economy, and from 1979 to 1982 we had a sharp downturn with a lot of
unemployment and a lot of that can be explained by monetarist doctrine. [Strengths & Weaknesses] What are the strengths and weaknesses of monetarism?
The biggest strength of monetarism, I think, is that it predicts a lot of cases where the
central bank pulls back on money supply growth and economies then slow down or go into recession,
and monetarism is a fairly good explanation of how that happens. Monetarism however, has bigger weaknesses
when trying to explain what we should do to prevent this. The core recipe of monetarism
is to control the rate of growth of the money supply. But which money supply? There are
different measures of the money supply; they don’t all move in tandem. And in practice,
central banks have found it’s not very easy to follow some simple rule of saying, “The
money supply should grow at 3 percent a year,” or anything like that. That hasn’t worked
in practice. It tends to lead to too much volatility. So in terms of policy prescriptions,
monetarism is a bit naïve, but its core diagnosis, that deflanationary pressures lead to downturns,
is essentially correct.