Visit the Virtual Economy Home page

 Monetarists - Introduction                                   

 Monetarists are a group of economists so named because of   
 their preoccupation with money and its effects. The most  
 famous Monetarist is Milton Friedman who developed much of    
 the Monetarist theory we learn.                             
 Monetarism is very closely allied with the classical school   
 of thought. It is essentially an extension of classical       
 theory which was developed in the 1960s and 1970s to try to   
 explain a new economic phenomenon - stagflation.               
 Stagflation was an         expression coined to try to explain 
 two simultaneous economic problems - stagnation and inflation.
 It could perhaps have been called
 'inflanation' but that sounds more like a medical problem
 than an economic one.

 Much of the Monetarists' work revolved around the role of
 expectations in determining inflation, and a key part of
 their theory was the development of the expectations-augmented 
 Phillips Curve.  For more details on this and other areas of monetarism, 
 try the links below or at the foot of the page or in the side

    * Beliefs
    * Theories
    * AS & AD
    * Policies
    * Virtual Economy policies


 Monetarists - Beliefs                               

 In their work Monetarists draw a lot on Classical    
 economics. They re-evaluated the Quantity Theory of  
 Money and argued that increases in the money supply would  
 cause inflation. This view was backed up by a
 substantial body of empirical evidence. They would
 therefore argue that to reduce inflation, the
 growth in the money supply needs to be controlled.

 Monetarists vary in their precise beliefs on
 expectations. Some believe that expectations adjust
 so quickly that any policy change will immediately
 be taken into account by people, and there will
 therefore be no short-term adjustment. This school
 of Monetarism is known as 'rational expectations'.
 More moderate Monetarists accept that there may be
 an adjustment period, and so policy changes may
 have temporary or short-term effects on the level
 of output.

 Perhaps one of the best known quotes from
 Friedman's work is that:

      "Inflation is always and everywhere a
      monetary phenomenon"

 This quote is perhaps the best indication of the
 reason why Monetarists are called Monetarists!


 Monetarists - Theories                              

 Much of the Monetarists' theory is a development of  
 earlier Classical theoretical work. Their main       
 contribution is in updating many of these ideas to   
 fit them into a more modern context. The two key     
 areas of Monetarist work that we will look at are:

    * Quantity Theory of Money
    * Expectations-augmented Phillips Curve

 Quantity Theory of Money

 The Quantity Theory of Money was
 a bit of Classical theory based around the Fisher
 Equation of Exchange.  This equation stated that:

                       MV = PT

    M is the amount of money in circulation
    V is the velocity of circulation of that money
    P is the average price level and
    T is the number of transactions taking place

 Classical economists suggested that V would be
 relatively stable and T would (as we have seen
 above) would always tend to full employment.
 Friedman developed this and tested it further,
 coming to the conclusion that V and T were both
 independently determined in the long-run. The
 conclusion from this was that:

                  [^] M [-->] P [^]

 If the money supply grew faster than the underlying
 growth rate of output there would be inflation.
 Inflation would be bad for the economy because of
 the uncertainty it created. This uncertainty could
 limit spending and also limit the level of
 investment. Higher inflation may also damage our
 international competitiveness. Who will want to buy
 UK goods when our prices are going up faster than

 Expectations-augmented Phillips Curve

 The Phillips Curve showed a
 trade-off between unemployment and inflation.
 However, the problem that emerged with it in the
 1970s was its total inability to explain
 unemployment and inflation going up together -
 stagflation.  According to the Phillips curve they weren't
 supposed to do that, but throughout the 1970s they
 did. Friedman then put his mind to whether the
 Phillips Curve could be adapted to show why
 stagflation was occurring, and the explanation he
 came up with was to include the role of
 expectations in the Phillips Curve - hence the name
 'expectations-augmented' Phillips Curve. Once again
 the supreme logic of economics comes to the fore!

 Friedman argued that there were a series of
 different Phillips Curves for each level of
 expected inflation. If people expected inflation to
 occur then they would anticipate and expect a
 correspondingly higher wage rise. Friedman was
 therefore assuming no 'money illusion' - people
 would anticipate inflation and account for it. We
 therefore got the situation shown below:

 [Phillips curve]

 Say the economy starts at point U, and the
 government decides that it want to lower the level
 of unemployment because it is too high. It
 therefore decides to boost demand by 5%. The
 increase in demand for goods and services will
 fairly soon begin to lead to inflation, and so any
 increase in employment will quickly be wiped out as
 people realise that there hasn't been a real
 increase in demand. So having moved along the Phillips Curve 
 from U to V, the firms now begin to lay people off once again
 and unemployment moves back to W. Next time around
 the firms and consumers are ready for this, and
 anticipate the inflation. If the government insist
 on trying again the economy will do the same thing
 (W to X to Y), but this time at a higher level of

 Any attempt to reduce inflation below the level at
 U will simply be inflationary. For this reason the
 rate U is often known as the natural rate of


 Monetarists - AS & AD                                        

 Moderate Monetarists would argue, as Classical economists    
 do, that the economy may behave slightly differently in the  
 short run from in the long run.                              
 Short run

 In the short run any increase in the money supply may lead
 to an increase in aggregate demand. This may, in turn, lead
 to more employment, but before long people's expectations
 will catch up and as we saw with the expectations augmented
 Phillips Curve
 the effects of the boost will only be short-lived. Inflation
 picks up and wipes out any short-term gains. The following
 diagram shows this:


 Output grows a bit, but inflation is pushed up and once the
 inflation is in the system people will begin to anticipate


 In the long run, any attempts to reduce unemployment below
 its natural rate will result in inflation. This means that there is 
 no long-run trade-off between unemployment and inflation, and the
 long-run aggregate supply curve will be vertical.



 Monetarists - Policies                              

 Since the work of Monetarists is mainly limited to    
 their view of inflation, their policy                 
 recommendations are pretty much on inflation only     
 as well. They tend to believe that if you control     
 inflation as the main priority, then this will
 create stability and the economy will be able to
 grow at its optimum rate.

 The key policy is therefore control of the money
 supply to control inflation. The government should
 certainly not intervene to try to reduce
 unemployment as the economy will automatically tend
 to the natural rate of unemployment.
 The only way to change the natural rate is through
 the use of supply-side policies.

 All of this makes Monetarists' policy
 recommendations pretty similar to those of the
 classical economists.

 Supply-side policies

 Supply-side policies can be used to reduce market
 imperfections. This should have the effect of
 increasing the capacity of the economy to produce
 (in other words the long-run aggregate supply)
 They should therefore reduce the natural rate of
 unemployment. This will be the only
 non-inflationary way to get increases in output.

 [Supply-side policies]

 Using supply-side policies has increased the level
 of output from Qfe1 to Qfe2, but the price level
 has remained stable. Supply-side policies as we
 have said are ones that reduce market
 imperfections. They may include:

    * Improving education & training to make the
      work-force more occupationally mobile
    * Policies to make people more geographically
      mobile (scrapping rent controls, simplifying
      house buying to speed it up, ......)
    * Reducing the power of trade unions to allow
      wages to be more flexible
    * Getting rid of any capital controls
    * Removing unnecessary regulations

 Money supply policies

 The real key to Monetarist policy though is the
 control of monetary growth. In this way (as
 predicted by the Quantity Theory of Money) the
 Monetarists would be able to maintain low
 inflation. Policies might include:

    * Open-market operations
    * Funding
    * Monetary-base control
    * Interest rate control

Visit the Virtual Economy Home page