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 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 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. As demand outstrips supply, prices will increase.

  (Source: "What Is Monetarism?" International Monetary Fund.)

Monetarists believe monetary policy is more effective than fiscal policy. That's government spending and tax policy. Stimulus spending adds to the money supply, but it creates a deficit. This adds to the 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.

Monetarists watch real interest rates rather than nominal rates. Most published rates are nominal rates. Real rates remove the effects of inflation. They give a truer picture of the cost of money.

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. They led to the 2001 recession and the Great Recession

Monetarism and Milton Friedman

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. That would reduce the money supply. Prices would have to fall as people had less money. 

Federal Reserve Chair Paul Volcker used that theory to end stagflation. He raised the Fed funds rate to 20 percent in 1980. But it was at a great cost. It created the 1980-82 recession. (Sources: “A Monetary Explanation of the Great Stagflation of the 1970s," NBER, February 2000.)

Milton also warned against increasing the money supply to fast. That would create inflation. But a gradual increase is necessary to prevent higher unemployment rates. If the money supply were properly managed, it would create a Goldilocks economy. That's low unemployment with an acceptable level of inflation. 

Fed Chair Ben Bernanke agreed with this. He was the first Fed chair to officially set an inflation target of 2 percent year-over-year. That's the core inflation rate that strips out volatile gas and food prices. (Source: "Monetarism," Econlib. "Milton Friedman," Econlib.)

Friedman blamed the Fed for the Great Depression. He said the Fed's tightened the money supply when it should have loosened it. The Fed raised interest rates to defend the value of the dollar.

It was sinking as people redeemed their paper currency for gold. At that time, the United States was still on the gold standard. By raising rates, the Fed made loans more difficult to get. That worsened the recession into a depression.

How Does It Work?

When the money supply is expanded, it lowers 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.

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.