Milton Friedman's Economic Theory of Monetarism Explained

Nobel Prize-winning economist Milton Friedman attends a 1986 Beverly Hills charity dinner in his honor. Duringthe 1980s, Friedman's monetarist policies ruled.
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Monetarism is an economic theory that says the money supply is the most important driver of economic growth. As the money supply increases, people demand more. Factories produce more, creating new jobs. 

Monetarists (believers of the monetarism theory) warn that increasing the money supply only provides a temporary boost to economic growth and job creation. Over the long run, increasing the money supply increases inflation. As demand outstrips supply, prices will rise to match. 

Some Background on Monetarism

Monetarists believe monetary policy is more effective than fiscal policy (government spending and tax policy). Stimulus spending adds to the money supply, but it creates a deficit adding to a country's sovereign debt. That will increase interest rates.

Monetarists say that central banks are more powerful than the government because they control the money supply. They also tend to watch real interest rates rather than nominal rates. Most published rates are nominal rates, while real rates remove the effects of inflation. Real rates give a truer picture of the cost of money.

Money Supply

Monetarism has recently gone out of favor. Money supply has become a less useful measure of liquidity than in the past. In this case, liquidity (cash, or the ability to quickly turn assets into cash) includes cash, credit, and money market mutual funds where credit covers loans, bonds, and mortgages.

However, the money supply does not measure other assets, such as stocks, commodities and home equity. People are more likely to save money by investing in the stock market because they receive a better return. 

That means the money supply does not measure these assets. If the stock market rises, people feel wealthy and are inclined to spend more. An increase in spending increases demands, which boosts the economy.

Stocks, commodities and home equity created economic booms that the Fed (the Federal Reserve) ignored. The Great Recession was fueled in part by the creation of a housing market bubble (home values rising, loans being approved for people who couldn't afford them, and money being made by investors on the loans), which burst and took much of the economy with it.

How It Works

When the money supply expands, it lowers interest rates. This is due to banks having more to lend, so they are willing to charge lower rates. That means consumers borrow more to buy items like houses, automobiles, and furniture. Decreasing the money supply raises interest rates, making loans more expensive—this slows economic growth.

In the United States, the Federal Reserve manages the money supply with the Federal funds rate. This is a targeted rate the Fed sets for banks to charge each other for overnight loans, and it impacts all other interest rates. The Fed uses other monetary tools, such as the excess reserves requirement, which tells banks how much of their money they must have on reserve each night.

The Fed reduces inflation by raising the federal funds rate or decreasing the money supply. This is known as contractionary monetary policy. However, the Fed must be careful not to tip the economy into recession. To avoid recession, and the resultant unemployment, the Fed must lower the fed funds rate and increase the money supply. This is known as expansionary monetary policy.

Milton Friedman Is the Father of Monetarism

Milton Friedman created the theory of monetarism in his 1967 address to the American Economic Association. He said that the antidote to inflation was higher interest rates, which in turn reduces the money supply. Prices then fall as people would have less money to spend. 

Milton also warned against increasing the money supply too fast, which would be counter-productive by creating inflation. But a gradual increase is necessary to prevent higher unemployment rates.

The belief is that if the Fed were to properly manage the money supply and inflation, it would theoretically create a Goldilocks economy, where low unemployment and an acceptable level of inflation are prevalent.

Friedman (and others) blamed the Fed for the Great Depression. As the value of the dollar fell, the Fed tightened the money supply when it should have loosened it. They raised interest rates to defend the value of the dollar as people redeemed their paper currency for gold. Money supply dwindled, and loans became harder to get. The recession then worsened into a depression.

Examples of Monetarism

Federal Reserve Chair Paul Volcker used the concept of monetarism to end stagflation (high inflation, high unemployment, and stagnant demand). By raising the federal funds rate to 20% in 1980, the money supply was reduced drastically, consumers stopped purchasing as much, and businesses stopped raising prices. That ended the out-of-control inflation, but it created the 1980-82 recession. 

Former Fed Chair Ben Bernanke agreed with Milton's suggestion that the Fed cultivate mild inflation. He was the first Fed chair to set an official inflation target of 2% year-over-year. The intent behind this is to keep a core inflation rate that strips out volatile gas and food prices.