Monetarism

Monetarism is the school of macroeconomic thought, associated above all with Milton Friedman, which holds that changes in the money supply are the main cause of changes in total nominal spending, and that sustained inflation is "always and everywhere a monetary phenomenon", in Friedman's phrase. Its central policy advice was that central banks should aim for slow, steady and predictable growth in money rather than trying to fine-tune the economy.

Monetarism grew out of the Chicago school in the 1950s and 1960s as a challenge to Keynesian economics, which then stressed fiscal policy and treated money as secondary. It drew on the older quantity theory of money from classical economics. Its influence peaked around 1979–1985, and while strict money-supply targeting was later abandoned, its core ideas now sit inside mainstream monetary policy.

Imagine an auction where everyone is suddenly handed extra cash while the number of items for sale stays the same. Bidding goes up, and the same goods end up selling for higher prices. Monetarists argue that a whole economy behaves like this over time: if money grows much faster than the things it can buy, prices rise.

Their advice followed simply. Instead of a central bank stepping on the gas and the brakes based on guesses about the economy, it should let the money stock grow at a steady pace, roughly in line with the economy's ability to produce more, so that people can plan with confidence.

Monetarist reasoning starts from the equation of exchange:

• $M$ is the money supply.
• $V$ is the velocity of money, how many times a unit of money is spent in a year.
• $P$ is the price level.
• $Y$ is real output, so $P \times Y$ is nominal GDP.

The equation is an identity; monetarism adds the claims that $V$ is fairly stable and that $Y$ is set by real factors in the long run. Example: if money grows 10% a year, velocity is steady and real output grows 3%, prices must rise by roughly 10% − 3% = 7% a year. Friedman's "k-percent rule" proposed fixing money growth at a constant rate, such as 3–5% a year, to match long-run output growth.

• Money and the Great Depression. Friedman and Anna Schwartz's A Monetary History of the United States, 1867–1960 (1963) argued that the US money stock fell by about a third between 1929 and 1933 and that Federal Reserve failures turned a recession into the Great Depression.
• Long and variable lags. Monetary policy works with delays that are hard to predict, so activist policy can make the business cycle worse.
• The natural rate. Friedman's 1967 address to the American Economic Association, like Edmund Phelps's work, argued that there is no lasting trade-off between inflation and unemployment along the Phillips curve; unemployment tends back to a natural rate.
• Rules over discretion. Clear rules make policy credible and limit political pressure.

The stagflation of the 1970s gave monetarism its chance. West Germany's Bundesbank announced money-growth targets from 1975. In October 1979 the Federal Reserve under Paul Volcker switched to controlling bank reserves, letting interest rates rise sharply; inflation fell from double digits but the US went through deep recessions, and the Fed dropped the approach in 1982. In the UK, Margaret Thatcher's government set targets for broad money (£M3) under its Medium-Term Financial Strategy from 1980, but the targets were repeatedly missed and abandoned by the mid-1980s.

The European Central Bank kept a "monetary pillar" in its strategy from 1998 until its 2021 strategy review. Today most central banks, including the Fed, the ECB and the Bank of England, set a short-term interest rate under inflation targeting rather than a money target.

• Unstable velocity. From the 1980s financial deregulation made velocity and money demand unpredictable, so money targets lost their link to inflation; Charles Goodhart's observation that a measure breaks down once targeted became known as Goodhart's law.
• What is money? Choosing which aggregate to target proved difficult as new deposit products appeared.
• Endogenous money. Post-Keynesians and many central bankers argue that banks create money in response to loan demand, so central banks control interest rates, not money directly.
• A partial comeback. US broad money (M2) grew by more than 25% in the year to early 2021, before the 2021–23 inflation surge; some economists saw this as support for monetarist warnings, while others pointed to supply shocks.

• International Monetary Fund: What Is Monetarism? (Finance & Development, 2014)
• The Nobel Prize: Prize in Economic Sciences 1976 (Milton Friedman)