Monetarism Notes

Monetarism is an economic framework that explains business cycles, primarily emphasizes the role of the money supply, and stresses the importance of decisions made by central banks regarding money supply.
Milton Friedman, a Nobel laureate from the University of Chicago, is the most well-known proponent of monetarism.

Monetarism is based on the quantity theory of money, which states that in the long run, the absolute amount of money in an economy does not affect real output or employment.
However, in the short run, changes in the rate of inflation can have consequences.
Monetarism identifies two potential dangers: too much inflation and too little inflation.

Explanation:
- Monetarism gained popularity in the 1970s when the United States experienced high inflation rates.
- Monetarists argued that the Federal Reserve was creating excessive amounts of new money, leading to rising prices.
- Inflation distorts the allocation of economic resources because individuals cannot distinguish between price increases due to inflation and those due to changes in the relative value of goods.
Monetarist Solution:
- Reduce the rate of inflation to promote economic stability.
Critique of Keynesian Economics:
- Monetarists argued that while inflation might temporarily increase economic output, people would eventually recognize the inflation, negating its stimulative effect.

Explanation:
- Monetarists, like Keynesians, acknowledge that many nominal wages are "sticky," meaning they cannot be easily or quickly readjusted due to contracts, laws (e.g., minimum wage), or workplace morale.
- When the money supply declines and wages are sticky, employers cannot reduce wages in tandem with the declining purchasing power, leading to layoffs and economic downturns.
Monetarist Position:
- When monetary growth is too low, it leads to a low rate of price inflation or outright deflation, which causes aggregate demand to be too low.

Monetarists advocate for a constant and moderate rate of money supply growth, often cited as being around 2-3%.
This rate should be "not too high, not too low" to avoid the pitfalls of excessive or insufficient inflation.

Monetarists generally favor constraining central banks with rules, as they are skeptical of discretionary monetary policy.
They believe that central bankers' information can be unreliable, and due to long and variable lags in the effects of monetary policy, a stable rule is preferable.
A fixed rule rules out the dangers of both inflation being too high and inflation being too low.

Incomplete Account of Business Cycles:
- Monetarism does not fully explain business cycles caused by factors such as bursting bubbles, credit market problems, or negative real shocks.
Defining the Money Supply:
- Monetarism assumes a single, well-defined "money supply," but in reality, there are various measures (e.g., currency plus bank reserves, demand deposits, savings deposits).
- These different measures do not always move in tandem, and stabilizing one measure may destabilize others.
Difficulty Responding to Shocks:
- If a central bank fixes a rate of growth for the money supply, it can be challenging to respond to other economic shocks.
- For example, a negative real shock like an oil price hike might require an expansionary monetary policy, or volatile interest rates might warrant increased credit.
- Changes in velocity (the rate at which money turns over) also pose challenges under simple forms of monetarism because the central bank cannot easily adjust.

An offshoot of monetarism that allows central banks to respond to changes in velocity.
Traditional monetarists generally oppose discretionary adjustments but market monetarists are more open to allowing central banks the flexibility to offset shocks.

Monetarism has significantly influenced economics, particularly regarding the importance of money supply and central bank policies.
However, it is considered an incomplete doctrine of business cycles due to the issues mentioned above.