Monetarism and How It Works

Nobel Prize-winning economist Milton Friedman attends a 1986 Beverly Hills charity dinner in his honor. Duringthe 1980s, Friedman's monetarist policies ruled. Creidt: George Rose/Getty Images

Definition: Monetarism is an economic theory that says a country's money supply is the most important driver of economic growth. When the money supply is expanded, it drives down interest rates, because banks have more on hand to lend, so they are are willing to charge lower rates. That means consumers borrow more to buy big ticket items like houses, automobiles, and furniture. Decreasing the money supply raises interest rates, making loans more expensive and slowing economic growth.

Monetarists believe monetary policy is more effective than fiscal policy, which is government spending and tax policy. Government stimulus spending does add to the money supply, but it is offset by a higher deficit. This adds to the county's sovereign debt, which sends interest rates higher. Therefore, monetarists say that central banks are much more powerful than a country's government, because they control the money supply.

Monetarists warn that increasing the money supply only provides a temporary boost to economic growth and job creation. Over the long run, it will increase inflation because the extra demand will outstrip supply, sending prices up.  (Source: "What Is Monetarism?" IMF)

Monetarists also argue that economy watchers need to pay attention to the difference between nominal and real interest rates. Most of the rates you see today are nominal rates. Real interest rates take out the effects of inflation.

These points are generally accepted by most economists.

Monetarism and Milton Friedman

Milton Friedman, the creator of monetarism, argued that to prevent inflation the money supply should never be rapidly increased However, a gradual increase is always necessary to offset a return to higher unemployment rates.

He also argued that, properly managed, an economy can have low unemployment with an acceptable level of inflation, creating a Goldilocks economy.

Past Federal Reserve Chairman Ben Bernanke obviously agreed with this, since he officially set an inflation target of 2%. That's the year-over-year rate for core inflation, which strips out volatile gas and food prices.  (Source: Econlib, Monetarism; Milton Friedman)

Friedman blamed the Great Depression on the Fed's steps to tighten the money supply when it should have created more money. The Fed raised interest rates to defend the value of the dollar, which was sinking as people redeemed their paper currency for gold. At that time, the United States was still on the gold standard.

How Does It Work?

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

The Fed reduces inflation by raising the Fed 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.

Today, money supply is a less useful measure of liquidity than in the past. Liquidity is the total amount of money, including cash, credit and money market mutual funds. The important part of liquidity is credit, which includes loans, bonds, mortgages, and other agreements to repay. That's because the money supply does not measure other assets, such as stockscommodities and home equity. These assets created booms that the Fed largely ignored, which led to the subsequent recessions of 2001 and 2009