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.

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93 thoughts on “Business Cycles Explained: Monetarist Theory”

  1. Nope. It's fiat money. SO long as the Fed buys US debt – which is largely independent from the money supply – they can always choose whether they want to sterilize or sell those bonds. Your last statement is totally non-sensical. Defaults will be a by-product, but more due to the FDIC and other regulation than due to the Fed itself.

  2. What this professor leaves out is that while it's true that sudden deflationary downturns lead to recessions/depressions, you wouldn't have had that sudden deflation if you hadn't had an inflationary boom in the first place. The bust is merely the correction that must happen after a boom is created out of artificially low interest rates and money-printing.

    A far better explanation of economic Booms and Busts comes from the Austrian School of Economics.

  3. This is a classic Austrian stance that I believe it mostly correctly, but the over-expansion of credit to related to fractional-reserve lending. Since banks create the majority of our money supply, there is little or no real-world "check" on the expansion of money. Friedman actually supported a full-reserve banking system, with a rules-based monetary framework. In Friedman's ideal system, there would be no artificial expansion of credit, and the malinvestment that follows =)

    Great points! =)

  4. Well, money IS debt, right? It's an IOU. When you have a dollar in your pocket, It's a liability of the Fed. When you take out a home mortgage, its a liability of the bank. Explain to me how money could not be a debt?

    Just because money is accounted for as liabilities, doesn't mean it guarantees a default. There is a whole industry of risk management, and banks don't always win. Remember 2008?

    Besides, you don't pay interest on your savings, they pay interest to you πŸ˜‰

  5. didnt friedman eventually renounce this? saying there is no incentive for central banks to behave in this way.

  6. The problem with Monetarism is that it predicts downturns in the midterm, not long term. The problem with Keynesianism is that it is entirely short term. The problem with ABCT is that it predicts it in the long term.

    There's no way to combine all of these policies though. Because this is about trade-offs over time.

  7. I'm very familiar with reserve lending, and all aspects of our monetary structure. Fractional reserve lending allows for an artificial expansion of credit without a corresponding increase in savings. It is essentially legal counterfeiting, although banks are liable for the deposits they create. It is definitely is a problem.

    Did you know that Milton Friedman advocated for full-reserve banking, coupled with a rules-based monetary framework? =)

  8. Very true, most economists can't explain money very clearly because it consists of so many things besides Federal Reserve notes. Even our measures of the money supply varies greatly (m1,m2,m3,etc.)

    I guess in its most generic form, money is just a promise to pay something for something, which is why I see it all as debt (deposits, bills, notes, loans, securities, etc). Which makes sense to me. =)

  9. In this I agree with the Austrian School and advocate gold and silver as a monetary system. Although as a whole I'm directly in the middle between the Austrian and the Chicago schools of economic theory. Milton and Mises.

  10. "Friedman actually supported a full-reserve banking system, with a rules-based monetary framework."

    One of the biggest problems with Friedman was the fact that he was an extreme positivist, and his economics, i.e., the mathematical economics, has a pretense of knowledge built into it. Take for example what you pointed out, that Friedman wanted full-reserve banking (amen) with a rules-based monetary framework. How would he or anyone else know how much credit there should be in the economy?

  11. In an interview in 2006 the year he died. He actually said that the Federal Reserve system needed to go because it was a system doomed to cause poor monetary policy. Even though he had high esteem for Ben Bernanke who was and still is running the Federal Reserve he expressed his belief that it was a flawed system doomed to cause problems for the economy.

  12. "How would he or anyone else know how much credit there should be in the economy?"

    Because demand deposits and term deposits would be kept in different institutions. Available credit would be based entirely on savings, which is the free-market method of determining interest rates. =)

    In full-reserve banking, as you already know, there little or no need for the Fed to constantly interfere in open market operations, or discount window operations. =)

  13. Mr. Friedman determined the Fed system a failure much earlier than that. In his 1959 book, "A Program for Monetary Stability," He presents a compelling case for ending the Fed and moving to full-reserve banking. He also argues very well against commodity backed currency in favor the more inclusive and flexible fiat system. It is a quick read, and very interesting. If you'd like a copy, i digitized mine, let me know πŸ˜‰

    Excellent points! =)

  14. But the central problem with the idea that some central institution can actually know how much credit should be in the economy is silly because that is saying that they can accurately plan lending and investment for the economy, when in fact they can do anything but. Also they neglect the fact that interest rates on the free-market are determined by subjective time-preference. There is no way that they can plan lending and investment for millions of people acting on their subjective perceptions.

  15. I'm not promoting the idea of a central bank constantly manipulating interest rates, a rules-based system is a non-discretionary monetary policy, and full-reserve banking allows for market forces to set interest rates. I am essentially trying to achieve the vision that Austrians want so that the business cycle is not manipulated. =)

    Our current monetary policy is like a game of ping-pong, with the Fed buying or selling bonds at each side of the table. I'm not advocating for that at all =(

  16. That begs the question; what about the central bank? The entire point of the Federal Reserve is to be the lender of last resort, and that by itself, without direct manipulation from the Federal Reserve, pushes interest rates lower than they would be naturally. The mere existence of the Central Bank distorts interest rates. The market can't determine interest rates without being hampered unless you have no Central Bank.

  17. Seems to me some people define monetarism to just mean "money matters," others think it applies specifically to advocating constant money growth.

  18. um, no the Austrian School doesn't explain anything. The money supply in the 20s was at a constant rate from 1920 to 1928. Hardly any change. Mises, Rothbard, Peter Schiff, Ron Paul are all WRONG. Friedman is the answer.

  19. I'm not an Economics major, but up until now all the videos were easy enough to understand for the layman, but in this video, I'm getting so much vocab being thrown at me without an explanation, I'm having a hard time following. And the problem is that the vocab isn't something you can just look up, or at least I feel that way.

  20. Yes you can. Google is your friend. In fact there are several websites with explanations behind economic terms.

  21. Mises predicted the Great Depression in 1926 when everyone said that the boom wouldn't end. We have Rothbard's account of the Great Depression in his book, "America's Great Depression," so what do you mean the Austrian School is wrong? If anything they've been proven to be far superior to the mainstream Keynesian/Monetarist schools.

  22. What should the supply of money be? This is as foolish as asking what the supply of corn or oil should be. No one could possibly know.

  23. he did another video on the strengths and weaknesses of the austrian theory. he shows many of the flaws in the austrian theory,of which there are many. austrian theory says that inflation tricks a lot of people into making investments they wouldn't make if the price level had been more stable. it assumes people are stupid, which they are of course, but it fails in many respects. dont take the austrian theory as gospel just b/c ron paul talks about it–monetarism excels in areas austrian fails.

  24. Agreed, but this is the arrogance of econometrics and mathematical economics. They scream that they can solve this mathematically, but all of their calculus and equations is just a pretense of knowledge. In reality, they have absolutely no clue what they're talking about.

  25. I just got through watching that video, and the only thing this guy did was fail harder than 1929. The criticisms he raised against Austrian Economic Theory have been answered in detail by many Austrian Economists. Oh, and I don't agree with Austrian Economics just because Ron Paul talked about them (I'm note even a fan of him except when he's handing Keynesian Financial Analysts their asses). I've actually read the works of the Austrian Economists.

  26. The bigger problem with classic Monetarism is that it looks only at the money supply whilst ignoring the demand for holding money assets. The price of money, which is of course the inverse of the price of everything else, is determined by supply and demand. Friedman did not fully appreciate that central banks affect the economy more by changing the demand for money by changing people's expectations about future levels of spending.

  27. For instance, there was a sharp global rise in demand for US dollars in early 2008, unmatched by an increase in their supply. Sure enough, spending of dollars in the US economy promptly fell. And only then did the banking system implode. Meanwhile, the housing sector, which had been declining steadily and coming to a stop without causing much unemployment or recession, underwent a fresh collapse. But Friedman was right in advocating a rulebound Fed, as rules stabilize the demand for money.

  28. Austrian business cycle theory has been completely debunked. Get real. Its taken seriously by no one in economics.

  29. Full-reserve banking almost entirely eliminates the need for a central bank. Since banks can only lend dollars that they have in their "vault," it is impossible to have a run on the bank. Not only does it eliminate the need for central banking,but also FDIC, and other gov insurance solutions.

    The market absolutely determines the interest rates based on the available savings that is set aside for investment.

    You could totally end the fed if you wanted,and have it absorbed by the treasury =)

  30. "Its taken seriously by no one in economics."

    Are you so sure? Austrian Economics has been on the rise since 2008, and the political/economical world is taking notice. Look at the video of Krugman getting schooled by a Spanish economist.

  31. "You could totally end the fed if you wanted,and have it absorbed by the treasury =)'

    That really worries me. I wouldn't want the assets of the Fed under any sort of control from the Treasury. If you come to the conclusion that you must have a central bank, it is best to be independent. I'll put it to you this way. Would you rather have Ben Bernanke controlling the printing press, or Nancy Pelosi, Bernie Sanders, Mitch McConnel, etc?

  32. I mention it only as an elaboration of my point (No need for market interference by a central bank), I too support an institutional separation between the central bank and the treasury.

    Most of my ideas are regurgitations of Friedman's work. I'll send you a copy of his book, "A Program for Monetary Reform." It is a quick read, and would dispel any confusion you may have as to the system he advocated. =)

    send me your email in a PM. You are civil and thoughtful, and worth the time. =)

  33. Austrian Economics is called that simply because the founders of this school of thought were Austrian. There's no other reason behind the term.

  34. Then check out his explanation of Austrian business cycle theory. He gives this impartial treatment to several schools of thought (Keynesian, Real BC Theory, Austrian, and this Monetarist theory). His tone seems to suggest that each have kernels of truth within them, though some more than others.

  35. You're confused.
    The money a bank loans out _is_ the deposits of their account holders. So if you require a full reserve (that 100% of a deposit be held in the banks vaults) then the bank will have _no_ available money with which to offer loans. If you allowed them to loan anything, then they would not have a full reserve with which to obviate a "run on the bank". In that scenario, no bank would be interested in operating (unless they managed to charge exorbitant fees for "processing").

  36. In a full-reserve banking systems, banks are strictly separated into savings, commercial, and investment banks. Savings banks are literally money-vaults for checking accounts and demand-deposits. Commercial and Investment banks hold term-deposits that can be lent out. Because term-deposits are held for a specific time, like a bond, the currency is only used once in circulation. If the loan money is deposited, it becomes a demand-deposit and can't be loaned again.

    I'm not confused at all. πŸ˜‰

  37. "In that scenario, no bank would be interested in operating"

    Ignoring Commercial and Investment banks. In a full-reserve scheme depository institutions earn money in two ways. One, they earn money as depository fees, and second they earn interest on the treasury securities that they hold as collateral for the deposits. πŸ˜‰

    These are not my ideas, they're taken from Friedman's book, "A Program for Monetary Stability." If you'd like a copy,send me a PM with your email, it's a great read. =)

  38. But he did talk about Austrian theory and the idea that after creating inflation, it's pretty much impossible to undo it. Isn't the point of the vid to summarize each theory in its own video?

  39. Well, actually, there's no such thing as "intrinsic value" since all value is subjective anyway. Read Carl Menger's "The Principles of Economics."

  40. That doesn't mean that all money is based on debt, that just shows that all credit is debt. Money and credit are not the same thing.

  41. This is because money and credit behave in the economy in very similar ways. When credit is created it is inflationary, when credit is destroyed we have a deflationary effect. This comes from the fact that Milton Friedman believed in the loanable funds model of the money supply. That banks would get the money and then make loans rather than the other way around.

  42. Friedman also misses out a lot of the structural aspects about capital. In a modern economy, a financial sector plays an essential role in the formation of capital and much of this capital is financed by debt. However, debt can also finance consumption and asset price speculation. When the debt is used to finance capital, it is beneficial and creates wealth. When debt is used to finance asset speculation(which doesn't increase the capital stock), it creates an artificial boom.

  43. "When the debt is used to finance capital, it is beneficial and creates wealth."

    This isn't always true. Capital accumulation creates wealth in the long term. That doesn't mean more capital is always better.

    Capital must be bought with real resources. If the money is created via credit expansion, then invested in new capital, resources will be pulled from somewhere else. That means less consumption in the present.

    Less consumption now instead of more consumption later is not always better.

  44. While not _all_ money is based on debt, most of our money is based on debt.

    Debt has been used as money for 100s of years. In a truly free banking system, it would probably still be used as much in many circumstances.

  45. The phrase "intrinsic value" as it applies to money is not really comparable to the use of the word "value" when it comes subjective value.

    So, you are correct, but it is merely a semantic issue.

    The better phrase is "commodity money." It means the same thing as money with "intrinsic value" but it is more semantically correct.

  46. Not in a modern financial system. They create spending power out of thin air. Banks don't have reserves and lend them out. They issue credit while creating deposits in the process and look for reserves later. When credit is issued, they create spending power while not taking away spending power or resources away from anything else. The idea of fractional reserve is really a myth.

    Banks actually add to demand when they create credit. This is why the booms feel so good.

  47. The only thing is that the debt has to be paid back. If you use it for something that doesn't have a cash flow to pay it back, the debt has to be terminated. Either by inflation or by liquidation.

    This is why asset bubbles create issues, because there's no real way to sustain them and people take on debt in the expectation of returns that aren't sustainable. This is why the bursting of debt creates so many issues.

  48. Well it isn't exactly the "not having intrinsic value" since there is no such thing, as much as the fact that fiat money is 1) not chosen by a market, 2) has a supply controlled by some central power. Other than this "intrinsic value" mishap you are correct about the way fractional reserve banking works, the most broad measures of the money supply (like m2 or m3) grow in proportion to debt/credit growth.

  49. I'm accounting major not a economics major and I forgotten quiet a bit of macroeconomics, but cash is merely a derivative for a tangible commodity which in turn produces an output or GDP, (I will only talk about USA) the US government's job is to pass bills and enforce them as long as its constitutionally sound, the government levies taxes to cover its expeditures, government spending creates inflation without any GDP growth, (to be cont)

  50. It is not the governments job to put citizens to work, to give a citizen healthcare,or to fund education, it merely passes and enforces laws and uphold the constitution, I feel that this sense of government dependency came from the New Deal and FDR, now everyone on this forum knows that the Fed is privately held and it increases and decrease monetary supply by the reserve requirement a bank should have, the discount rate charged by the fed,and the Fed purchasing US t-bills(con't)

  51. And also the Fed controls the monetary supply with the federal rates, with that being said the Fed can do a process called fractional reserve banking which the bank prints out more money then their reserves in order to make a profit, so since many huge banks like JP Morgan conducting banking on an investment scale as well as commercial scale sometimes the bank in mixes the 2 practices to trade derivatives, and when they report losses guess who takes the flack? The fed ( to be con't)

  52. The fed catches the loss, because any money that was lent out to that specific bank by the fed has to take loss because of bad bank practices by the commercial bank, this is why the glass steagall act is vital, so private central banking is one big Ponzi scheme making our us debt larger,similar to Greece, For anyone that believes Keynesism and Monetarist either they are going by graphs that are over simplified or they are just evil , (to be con't)

  53. Economics is too broad, an economist should have an understand for law,tax, political science, calculus, and history, I have a strong feeling there will be a number people that will disagree with me and re-comment, I very much encourage debate as long as it is clean and about economics,

  54. No, you're ignorant of economics and philosophy of science. The terms "soft" and "hard" science are pejorative terms. The real terms are "social" and "natural" sciences.

    All economic value is subjective. There is no such thing as "intrinsic value." Gold is not intrinsically more valuable than fiat currency. Gold is valued based on the meeting of multiple market actor's subjective preferences. Same with fiat currency. Fiat currency is bad because it allows interest rate manipulation.

  55. You don't need to understand calculus, law, taxes, or political science to do economics. History is completely irrelevant to the work of other science, ie history must agree with the other sciences, not the other way around.

    Economics should not be treated as a quantitative study, and in theory it should not make any normative statements whatsoever, which means you don't need to understand the law to do it.

    Those things are needed to do econometrics.

  56. cont. Sorry, I just think your philosophy of science and epistemology is way off. Economics, like math, psychology, physics, etc is independent of social influences like positive law and politics. Economics does not need math because it is a science that studies the means needed to be used to achieve ends (a qualitative theory), rather than quantifying aggregate measures. History is the study of historical human behavior, not even experimental sciences engage in academic history.

  57. Yes except for very often the "wage stickiness" is due to government intervention like minimum wage laws, unemployment benefits, etc. The government offers a better alternative to workers, and the labor markets cannot clear. In other words, workers don't work for less because at a certain point, welfare benefits beat their market value.

  58. I agree with what you are saying. I don't mean to assume your position here, but I don't think Keynesian prescriptions to raise aggregate demand are therefore warranted though. Both fiscal and monetary (especially monetary) policy help to boost aggregate demand and solve short run labor issues, but they do also distort the allocation of capital in the short run which leads to a lot of long run problems. Absent business cycles (often caused by gov't policy), growth would occur more linearly.

  59. I'm personally an Austrian. I really don't think it is ever a good idea to attempt to inflate the money supply just to reduce real wages. It has more real effects on the economy than just that, but as a monetarist I'm sure you accept the neutrality of money. I accept that demand shocks do occur occasionally (without a credit bubble), but I just don't see how policies that create credit bubbles are a good way to solve such problems, since as we both agree they distort the capital structure.

  60. Wait! Monetarism explains why recessions happen, but we cannot use that to prevent them? That's what I got from the video. I'd think knowing why something happens is fundamental to preventing it from happening.

  61. I disagree with this to some extent. I believe wage stickiness is most due to human behavior. If you are suppose to make $15 an hour, your boss cannot just pay you $10 an hour at the end of the week without telling you. And its very difficult to give workers a pay cut, without causing all kinds of social problems. Employees tend to get very outraged at pay cuts. On the flip side, business owners are slow to increase pay, as they'd like to benefit from increased profit.

  62. Government intervention can cause issues as well, but the Great Depression started before the "New Deal." This meant many of the government intervention issues had not yet occurred. I do believe without the "New Deal" we would have got out of the depression faster. The biggest issue is that during a Boom, people act as though the Boom is the new normal and when it turns out to be short lived, people are unprepared for the Bust. You see this with lending policy the most.

  63. Why do we even goto school, if all the topics we learn are via youtube. This video is great. Most of the professor takes 30 to 45 mins to explain this, he did in approx 3 mins and better (Y)Β 

  64. so ina nutshell, Monetarist Theory, and the Keynesian are similar in that the dilute the value of money, increasing the money supply by some means? and the Austrians cycle would just let things take there course naturally through saving instead of low interest rates or creating more money etc???

  65. Doesn't trying to keep the money supply fixed while simultaneously growing an economy create a paradox? If you constrain the supply of money, then you arbitrarily inhibit growth.

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