General knowledge · Economics & society

Monetarism

Term coined 1968; at its height c. 1975–1985

Economics — the Chicago school and the money supply

The school of thought, associated above all with Milton Friedman and the University of Chicago, which holds that the quantity of money in circulation is the dominant influence on the price level and on nominal income, and that discretionary demand management does more harm than good. Its best-known claim is that inflation is always and everywhere a monetary phenomenon; its best-known historical argument, made with Anna Schwartz, is that the Federal Reserve turned an ordinary recession into the Great Depression by letting the money supply collapse. Governments in Britain and the United States adopted money-supply targets around 1980, abandoned them within a few years as the relationship between money and income proved unstable, and kept the framework's core lesson: that controlling inflation is a central bank's job.

How to spot them

▸Chicago, and a small, combative economist who presented a television series called Free to Choose
▸'Inflation is always and everywhere a monetary phenomenon'
▸A rule that the money stock should grow at a fixed percentage every year, whatever happens
▸The natural rate of unemployment, and the claim that there is no lasting trade-off with inflation

Key facts

The 1963 history, written with Anna Schwartz, blaming the Federal Reserve for the Great Depression (1963)

A Monetary History of the United States, 1867–1960; the money stock fell by about a third between 1929 and 1933

The 1967 presidential address to the American Economic Association introducing the natural rate of unemployment (1968)

Delivered December 1967, published 1968; Edmund Phelps reached the same conclusion independently

The proposal that the money stock simply grow at a constant percentage each year, removing discretion entirely

The k-per-cent rule — the policy conclusion that follows from distrusting central bankers' judgement

The 1980 television series and book made with his wife Rose, arguing for markets over government (1980)

Free to Choose; his 1962 book Capitalism and Freedom had made the case academically

Charles Goodhart's 1975 observation that a statistical regularity collapses once it is used as a policy target (1975)

Goodhart's law — a warning aimed directly at money-supply targeting

Geoffrey Howe's Medium Term Financial Strategy of 1980, setting out falling targets for sterling M3 (1980)

The British attempt at the doctrine; targets were repeatedly overshot and quietly dropped by the mid-1980s

Paul Volcker's decision in October 1979 to target reserves and let interest rates go where they would (1979)

US rates reached around 20 per cent; inflation was broken at the cost of a severe recession

Key ideas

The quantity theory in its modern form: MV = PY. If velocity is reasonably stable and real output is determined by real factors, changes in the money stock feed through to prices.
Money affects the economy with 'long and variable lags', which is why Friedman thought fine-tuning was futile and a rule preferable to discretion.
The expectations-augmented account: any trade-off between inflation and unemployment is temporary, lasting only while people are fooled. In the long run unemployment returns to its natural rate whatever the inflation rate — the vertical long-run relationship.
What is contested: the stability of velocity, which broke down in the 1980s as financial deregulation changed what counted as money, and the direction of causation between money and income. Most economists now accept the long-run link between money growth and inflation, and the natural-rate argument, while rejecting money-supply targeting as a practical rule.

Quick-fire facts

•Milton Friedman lived from 1912 to 2006 and received the Nobel Memorial Prize in Economic Sciences in 1976
•The term 'monetarism' was coined by Karl Brunner in 1968
•A Monetary History of the United States, 1867–1960 (1963) was written with Anna Schwartz
•Friedman's natural-rate argument was made in his 1967 AEA presidential address; Edmund Phelps arrived at it independently and won the prize in 2006
•Goodhart's law — that a measure ceases to be a good measure once it becomes a target — was stated by Charles Goodhart of the Bank of England in 1975
•Margaret Thatcher's government pursued targets for sterling M3 under the Medium Term Financial Strategy announced in 1980
•Paul Volcker's Federal Reserve adopted a reserve-targeting approach in October 1979; US interest rates peaked near 20 per cent in 1981
•Friedman also gave economics the permanent income hypothesis and popularised the idea of a negative income tax and of school vouchers
•He is often credited with the line 'there is no such thing as a free lunch', which he used as a book title in 1975
•By the late 1980s most central banks had abandoned money-supply targets in favour of inflation targeting

Drill it — 8 cards

1 / 8new card

Sources

Milton Friedman and Anna J. Schwartz — A Monetary History of the United States, 1867–1960 1963
Milton Friedman — The Role of Monetary Policy American Economic Review, March 1968; the AEA presidential address. Cited without URL.