MONETARISM

school of economic thought that maintains that the money supply is the chief determinant of economic activity. (The money supply is the total amount of money in an economy, in the form of coin, currency, and bank deposits.) The American economist Milton Friedman is generally regarded as monetarism's leading exponent. Friedman and his adherents advocate a macroeconomic theory and policy that diverge significantly from those of the long-dominant Keynesian school. Their conservative approach became influential during the 1970s and early 1980s. Underlying the monetarist theory is the equation of exchange, which is expressed MV = PQ. M is the supply of money; V is the velocity of turnover of money (i.e., the number of times per year that the average dollar in the money supply is spent for goods and services); P is the average price level at which each of the goods and services is sold; and Q represents the quantity of goods and services produced. The monetarists believe that the direction of causation is from left to right in the equation; that is, as the money supply increases with a constant and predictable V, one can expect either an increase in Q with P remaining relatively constant or an increase in P if there is no corresponding increase in the quantity of goods and services produced. In short, a change in the money supply directly affects and determines production, employment, and price levels. Its influence, however, becomes manifest only over a long and often variable period of time. Fundamental to the monetarist approach is the rejection of fiscal policy in favour of a monetary rule. In A Monetary History of the United States 18671960 (1963), Friedman, in collaboration with Anna J. Schwartz, attempts to show that government intervention in the form of fiscal measures such as tax-policy changes or increased spending has no significant effect on inflation, deflation, or other fluctuations of the business cycle. Moreover, virtually all discretionary actions on the part of the government to alter the money supply aggravate the economy rather than stabilize it, since the conditions to which the authorities are responding have in most cases changed by the time their actions take effect. This is particularly true when the monetary authorities try to counter inflation or recession by modifying interest rates. Friedman contended that the government should seek to promote economic stability, but only by controlling the rate of growth of the money supply. It could achieve this by following a simple rule that stipulates that the money supply be increased at a constant annual rate tied to the potential growth of the gross national product (e.g., 3 to 5 percent). Monetarism thus posited that the steady, moderate growth of the money supply could in many cases assure a steady rate of economic growth with low inflation. Monetarism's linking of economic growth with rates of increase of the money supply was belied by the actual performance of the economy of the United States during the 1980s, however. By this time monetarist theory had become somewhat problematic. The proliferation of new and hybrid types of bank deposits obscured the types of savings that had traditionally been used by economists to calculate the money supply, and it also appeared that declining inflation and declining interest rates could further distort the money supply's predicted impact on economic growth.