Monetarism

Definition

Monetarism is an economic theory that emphasizes the role of governments in controlling the amount of money in circulation. It asserts that variations in the money supply have major influences on national output in the short run and the price level over longer periods. This theory connects closely with monetary policy and highlights the importance of the transmission mechanism, showing how changes in the money supply can affect interest rates, investment, and ultimately economic growth.

5 Must Know Facts For Your Next Test

1. Monetarism was popularized by economist Milton Friedman, who argued that controlling the money supply is essential to managing inflation.
2. According to monetarists, long-term economic stability is best achieved through a steady, predictable increase in the money supply rather than through active government intervention.
3. Monetarism posits that changes in the money supply have a more immediate effect on real GDP than on prices in the short run.
4. The transmission mechanism of monetary policy under monetarism illustrates how shifts in the money supply influence interest rates, which subsequently affect consumer spending and investment.
5. Monetarists argue that central banks should focus on long-term goals for money supply growth instead of short-term fluctuations, advocating for a rule-based approach to monetary policy.

Review Questions

• How does monetarism explain the relationship between the money supply and economic output?
  • Monetarism explains that changes in the money supply can significantly affect economic output in the short term. When the money supply increases, it generally leads to lower interest rates, which encourages borrowing and spending by consumers and businesses. This boost in demand can stimulate production and increase GDP. However, over time, if too much money is injected into the economy without corresponding growth in output, it may lead to inflation.
• Evaluate the effectiveness of monetarism in managing inflation compared to Keynesian economics.
  • Monetarism is often viewed as more effective than Keynesian economics when it comes to controlling inflation. Monetarists argue that inflation is primarily a monetary phenomenon driven by excessive growth in the money supply. In contrast, Keynesian economics emphasizes fiscal policy and government intervention to manage demand. While Keynesians might advocate for increasing government spending during downturns, monetarists would stress maintaining a stable money supply to prevent inflationary pressures over time.
• Analyze how monetarism reshapes our understanding of central banking and its role in economic policy.
  • Monetarism reshapes our understanding of central banking by emphasizing the importance of a controlled approach to managing the money supply as opposed to reactive policies based on current economic conditions. It suggests that central banks should adhere to a consistent growth rate for the money supply to foster economic stability. This approach contrasts with more discretionary methods that respond dynamically to economic indicators. By prioritizing rules over discretion, monetarism advocates for a clear framework that guides monetary policy decisions, ultimately shaping how central banks approach their dual mandates of promoting maximum employment and stabilizing prices.

Related terms

Money Supply: The total amount of monetary assets available in an economy at a specific time, including currency and demand deposits.

Inflation: The rate at which the general level of prices for goods and services rises, eroding purchasing power.

Interest Rates: The amount charged by lenders to borrowers for the use of money, typically expressed as a percentage of the principal.