What’s Monetarist Theory?
Monetarist theory posits that fluctuations in money supply are the primary drivers of economic growth and business cycles. By managing the money supply, central banks wield substantial influence over economic expansion rates.
Contrasting Theory: Keynesian economics proposes that active government intervention in the marketplace and monetary funds are essential to achieve economic stability.
Key Insights
- Monetarist theory emphasizes the critical role of the money supply in determining economic growth rates.
- The foundational equation is MV = PQ, where M represents money supply, V is the velocity of money, P stands for the price level, and Q indicates the quantity of goods and services.
- In the United States, the Federal Reserve adjusts the money supply using three levers: reserve ratio, discount rate, and open market operations.
Understanding Monetarist Theory
Monetarist theory holds that an increase in a nation’s money supply will spur economic activity, whereas a reduction will slow it down.
The theory’s core formula, MV = PQ, implies that changes in the money supply (M) will affect either the price level (P), the quantity of goods and services produced (Q), or both, assuming a constant velocity of money (V).
When the economy is near full employment, price levels (P) generally rise more rapidly than production (Q). However, when there is slack in the economy, production (Q) tends to increase quicker than price levels (P) under monetarist principles.
In the U.S., the Federal Reserve operates independently from the government, implementing a monetarist approach focused on stabilizing prices (low inflation), achieving full employment, and promoting steady GDP growth.
Controlling Money Supply
The Federal Reserve in the U.S. controls the money supply using three primary tools:
- The Reserve Ratio: This is the percentage of a bank’s deposits required to be held as reserves. Lowering the reserve ratio increases lending capacity, thus boosting the money supply.
- The Discount Rate: The interest rate charged by the Fed to commercial banks for borrowing additional reserves. Lowering the discount rate encourages more borrowing from the Fed and subsequently more lending to the public, thereby increasing the money supply.
- Open Market Operations: This involves buying or selling government securities. Purchasing securities injects money into the economy, increasing the money supply, while selling securities does the opposite.
Inspiring Example of Monetarist Theory
One notable advocate of monetarist theory was former Federal Reserve Chair Alan Greenspan. In 1988, Greenspan raised interest rates to curb excessive growth and rising inflation, nearing 5%.
The U.S. economy tipped into a recession in the early 1990s, prompting Greenspan to revive economic prospects by cutting interest rates, which led to the longest economic expansion in U.S. history. However, the sustained low-interest rates under loose monetary policies eventually contributed to the financial bubbles that triggered the 2008 financial crisis and the Great Recession.
Related Terms: Keynesian Economics, Economic Growth, Money Supply, Inflation, Gross Domestic Product (GDP), Full Employment, Reserve Ratio, Discount Rate, Open Market Operations
