Monetarism

Monetarism draws its roots from the quantity theory of money, a centuries-old theory put forward by economists such as Irving Fisher and Alfred Marshall: when the quantity of money rises, prices rise. Milton Friedman restated the theory in 1956. In his account people hold only as much money as they need, so when the money supply expands they spend the surplus balances and aggregate demand rises; when it contracts they cut their spending to replenish their holdings. This challenged a simplification attributed to Keynes, that "money does not matter", and the word "monetarist" was coined.

Friedman supplied the historical case in A Monetary History of the United States, 1867–1960 (1963), written with Anna Schwartz. The book attributed inflation to excess money supply generated by a central bank, and deflationary spirals to the failure of a central bank to support the money supply in a liquidity crunch. In particular it argued that the Great Depression of the 1930s was caused not by the lack of investment that Keynes had stressed but by a massive contraction of the money supply, "the Great Contraction".

The prescription was a rule. Friedman proposed a "k-percent rule" under which the money supply would rise automatically each year by a fixed percentage equal to the growth of real GDP: if the economy was expected to grow by 2 percent, the money supply would rise by 2 percent. Because discretionary monetary policy was as likely to destabilise as to stabilise the economy, the Fed should be bound by fixed rules. Most monetarists also opposed the gold standard, since there would be no way to counteract deflation if population or trade outgrew the supply of gold.

Monetarism became popular in political circles when Keynesian economics seemed unable to explain the combination of rising unemployment and inflation after the Nixon shock of 1971 and the oil shock of 1973. Paul Volcker, whom President Carter made chairman of the Federal Reserve in 1979, restricted the money supply to tame inflation, and interest rates rose sharply not only in the United States but worldwide. This "Volcker shock", lasting from 1979 to the summer of 1982, lowered inflation and raised unemployment. Margaret Thatcher, who won the British general election in May of the same year, also made monetarism her weapon against inflation. Inflation fell to 4.6 percent by 1983, but unemployment rose from 5.7 percent in 1979 to 13.0 percent in 1982.

Monetarist ascendancy was brief. A money-supply target is useful only if the relationship between money and nominal GDP, the velocity of money, is stable. Velocity had seemed to rise at a fairly constant rate in the 1970s but became highly unstable in the 1980s and 1990s; when the correlation between the money supply and nominal GDP broke down, many economists who had been convinced by monetarism abandoned it. In Britain the Thatcher government overshot many of the money-supply targets of the Medium Term Financial Strategy issued in the 1980 budget and revised them upwards in 1982. From the early 1990s most major central banks turned to inflation targeting, using the short-run interest rate as their main instrument.

Its legacy remained. The belief that controlling inflation should be a primary responsibility of the central bank, and the recognition that monetary as well as fiscal policy can affect output in the short run, were absorbed into the new neoclassical synthesis, the consensus view of macroeconomics that emerged in the 2000s. Writers on neoliberalism count monetarism among the key economic theories of neoliberalism, one that puts price stability ahead of other macroeconomic goals.