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Monetarists - Introduction Monetarists are a group of economists so named because of their preoccupation with money and its effects. The most famous Monetarist is Milton Friedman who developed much of the Monetarist theory we learn. Monetarism is very closely allied with the classical school of thought. It is essentially an extension of classical theory which was developed in the 1960s and 1970s to try to explain a new economic phenomenon - stagflation. Stagflation was an expression coined to try to explain two simultaneous economic problems - stagnation and inflation. It could perhaps have been called 'inflanation' but that sounds more like a medical problem than an economic one. Much of the Monetarists' work revolved around the role of expectations in determining inflation, and a key part of their theory was the development of the expectations-augmented Phillips Curve. For more details on this and other areas of monetarism, try the links below or at the foot of the page or in the side panel. * Beliefs * Theories * AS & AD * Policies * Virtual Economy policies Monetarists - Beliefs In their work Monetarists draw a lot on Classical economics. They re-evaluated the Quantity Theory of Money and argued that increases in the money supply would cause inflation. This view was backed up by a substantial body of empirical evidence. They would therefore argue that to reduce inflation, the growth in the money supply needs to be controlled. Monetarists vary in their precise beliefs on expectations. Some believe that expectations adjust so quickly that any policy change will immediately be taken into account by people, and there will therefore be no short-term adjustment. This school of Monetarism is known as 'rational expectations'. More moderate Monetarists accept that there may be an adjustment period, and so policy changes may have temporary or short-term effects on the level of output. Perhaps one of the best known quotes from Friedman's work is that: "Inflation is always and everywhere a monetary phenomenon" This quote is perhaps the best indication of the reason why Monetarists are called Monetarists! Monetarists - Theories Much of the Monetarists' theory is a development of earlier Classical theoretical work. Their main contribution is in updating many of these ideas to fit them into a more modern context. The two key areas of Monetarist work that we will look at are: * Quantity Theory of Money * Expectations-augmented Phillips Curve Quantity Theory of Money The Quantity Theory of Money was a bit of Classical theory based around the Fisher Equation of Exchange. This equation stated that: MV = PT where: M is the amount of money in circulation V is the velocity of circulation of that money P is the average price level and T is the number of transactions taking place Classical economists suggested that V would be relatively stable and T would (as we have seen above) would always tend to full employment. Friedman developed this and tested it further, coming to the conclusion that V and T were both independently determined in the long-run. The conclusion from this was that: [^] M [-->] P [^] If the money supply grew faster than the underlying growth rate of output there would be inflation. Inflation would be bad for the economy because of the uncertainty it created. This uncertainty could limit spending and also limit the level of investment. Higher inflation may also damage our international competitiveness. Who will want to buy UK goods when our prices are going up faster than theirs? Expectations-augmented Phillips Curve The Phillips Curve showed a trade-off between unemployment and inflation. However, the problem that emerged with it in the 1970s was its total inability to explain unemployment and inflation going up together - stagflation. According to the Phillips curve they weren't supposed to do that, but throughout the 1970s they did. Friedman then put his mind to whether the Phillips Curve could be adapted to show why stagflation was occurring, and the explanation he came up with was to include the role of expectations in the Phillips Curve - hence the name 'expectations-augmented' Phillips Curve. Once again the supreme logic of economics comes to the fore! Friedman argued that there were a series of different Phillips Curves for each level of expected inflation. If people expected inflation to occur then they would anticipate and expect a correspondingly higher wage rise. Friedman was therefore assuming no 'money illusion' - people would anticipate inflation and account for it. We therefore got the situation shown below: [Phillips curve]
Say the economy starts at point U, and the government decides that it want to lower the level of unemployment because it is too high. It therefore decides to boost demand by 5%. The increase in demand for goods and services will fairly soon begin to lead to inflation, and so any increase in employment will quickly be wiped out as people realise that there hasn't been a real increase in demand. So having moved along the Phillips Curve from U to V, the firms now begin to lay people off once again and unemployment moves back to W. Next time around the firms and consumers are ready for this, and anticipate the inflation. If the government insist on trying again the economy will do the same thing (W to X to Y), but this time at a higher level of inflation. Any attempt to reduce inflation below the level at U will simply be inflationary. For this reason the rate U is often known as the natural rate of unemployment. Monetarists - AS & AD Moderate Monetarists would argue, as Classical economists do, that the economy may behave slightly differently in the short run from in the long run. Short run In the short run any increase in the money supply may lead to an increase in aggregate demand. This may, in turn, lead to more employment, but before long people's expectations will catch up and as we saw with the expectations augmented Phillips Curve the effects of the boost will only be short-lived. Inflation picks up and wipes out any short-term gains. The following diagram shows this: [Short-run]
Output grows a bit, but inflation is pushed up and once the inflation is in the system people will begin to anticipate it. Long-run In the long run, any attempts to reduce unemployment below its natural rate will result in inflation. This means that there is no long-run trade-off between unemployment and inflation, and the long-run aggregate supply curve will be vertical. [Long-run]
Monetarists - Policies Since the work of Monetarists is mainly limited to their view of inflation, their policy recommendations are pretty much on inflation only as well. They tend to believe that if you control inflation as the main priority, then this will create stability and the economy will be able to grow at its optimum rate. The key policy is therefore control of the money supply to control inflation. The government should certainly not intervene to try to reduce unemployment as the economy will automatically tend to the natural rate of unemployment. The only way to change the natural rate is through the use of supply-side policies. All of this makes Monetarists' policy recommendations pretty similar to those of the classical economists. Supply-side policies Supply-side policies can be used to reduce market imperfections. This should have the effect of increasing the capacity of the economy to produce (in other words the long-run aggregate supply) They should therefore reduce the natural rate of unemployment. This will be the only non-inflationary way to get increases in output. [Supply-side policies]
Using supply-side policies has increased the level of output from Qfe1 to Qfe2, but the price level has remained stable. Supply-side policies as we have said are ones that reduce market imperfections. They may include: * Improving education & training to make the work-force more occupationally mobile * Policies to make people more geographically mobile (scrapping rent controls, simplifying house buying to speed it up, ......) * Reducing the power of trade unions to allow wages to be more flexible * Getting rid of any capital controls * Removing unnecessary regulations Money supply policies The real key to Monetarist policy though is the control of monetary growth. In this way (as predicted by the Quantity Theory of Money) the Monetarists would be able to maintain low inflation. Policies might include: * Open-market operations * Funding * Monetary-base control * Interest rate controlVisit the Virtual Economy Home page