Monetarism: An Overview When Dealing

Monetarism: An Overview

When dealing with highs and lows of the business cycle, economists have two basic tools on hand to cushion the effects of recessions and inflation -- that of monetary and fiscal policy. Monetarists stress the need to have a 'hands off' policy in regards to both the intervention of the federal government and the central bank when dealing with either economic extreme. Although monetarism has its roots in the early 1800s, its most famous exponent is that of the Nobel-prize winning economist Milton Friedman. Friedman believed that the government "should keep the money supply steady, expanding it slightly each year only to allow for the natural growth of the economy and a few other basic factors. Market forces would cause inflation, unemployment and production to adjust themselves automatically and efficiently around this fixed amount of money" (Kangas 2010).

The most obvious critique of monetarism until the 1970s, of course, was that government intervention had been highly effective in dealing with the Great Depression. Keynesian economists stated that, when confronted with a recession, people would fearfully hoard money unless the Federal Reserve infused money into the economy through lower interest rates for borrowers and lenders, and the government spent money at a deficit. Friedman responded "that past economic slumps had not started by people spontaneously hoarding money. Instead, these slumps were caused when nations withdrew money from their money supply…Friedman argued that if the money supply were simply held steady, nations wouldn't suffer from depressions in the first place" (Kangas 2010). Friedman believed that there is no trade-off between inflation and unemployment, as stated by Keynesians, provided if the market is allowed to correct itself over time. The danger with infusing the market with cash, Friedman wrote, was that this could result in an overcorrection and inflation. The apparent success of Keynesian economists was not really due to fiscal expending and aggressively expansionist monetary policies, but the general trend of the market to sustain itself at equilibrium. Ultimately, expansionary monetary policies hurt the economy, stated Friedman, and steady monetary growth would produce low inflation and low unemployment.

Friedman's brand of monetarism, because of its obsession with stemming inflation, even during times of recession, made his philosophy particularly attractive in America during 1970s, when inflation was at a historic peacetime high yet economic growth lagged (contrary to Keynesian wisdom, which stated that the two almost never occurred together). Under Paul Volcker's chairmanship of the Federal Reserve from 1979-1987, to uphold a philosophy Volcker identified as monetarist, the Fed would try to hit specified monthly targets for the growth rate of the monetary supply, "with operating procedures that emphasized control over a narrow and controllable monetary aggregate, non-borrowed reserves (i.e., bank reserves minus borrowings from the Fed)" (McCallum 2008).

After an initial painful period of recession, Volcker's actions had the desired effect upon inflation rates. However, both monetarists and non-monetarists were quick to point out that despite the attempt to hit monthly targets, "because growth rates of M1 fluctuated very widely on a month-to-month basis; the operating procedures in place were, because of lagged reserve requirements, extremely poorly designed for the control of M1; and the Fed never forswore discretionary responses to current cyclical conditions" (McCallum 2008). In fact, "Volcker's strategy to defeat double-digit inflation had been classically Keynesian: reign in the money supply, and accept a deep recession in the process" to bring down interest rates (Kangas 2010).