Monetarist Theory

Monetarist Theory

Definition
Monetarist theory holds that changes in the money supply are the primary determinant of a nation’s economic growth and the behavior of the business cycle. In this view, monetary policy—especially central-bank control of the money supply—exerts decisive influence over inflation, output, and employment.

Key takeaways
* Money supply is the most important driver of economic growth and inflation under monetarist theory.
* The relationship is summarized by MV = PQ (M = money supply; V = velocity of money; P = price level; Q = real output).
* Central banks influence M through tools such as reserve requirements, the discount rate, and open market operations.
* When the economy is near full employment, increases in M tend to raise prices more than output; when there is slack, increases in M are likelier to boost output.

The MV = PQ framework
Monetarists use the equation MV = PQ to link money to nominal economic activity:
* M (money supply) × V (velocity of money) = P (price level) × Q (real output).
Assuming V is relatively stable in the short run, changes in M will affect the right-hand side. If M rises:
* P, Q, or both must increase.
* With significant unused capacity (slack), Q is more likely to expand.
* Near full employment, further increases in M tend to manifest mainly as higher P (inflation).

How central banks control money supply
Central banks influence M with several primary tools:
* Reserve requirements: The fraction of deposits banks must hold as reserves. Lowering the reserve ratio frees banks to lend more, expanding M.
* Discount rate (or policy interest rate): The rate at which banks borrow from the central bank. Lowering this rate encourages borrowing and lending, increasing M.
* Open market operations: Buying government securities injects reserves into the banking system (increasing M); selling securities withdraws reserves (decreasing M).

Monetarism in practice
Monetarist ideas influenced policymakers who prioritize price stability and control of inflation through monetary aggregates. In practice:
* Expansions of the money supply and sustained low interest rates can stimulate growth and prolong expansions.
* However, overly loose monetary policy can encourage asset bubbles and financial imbalances, increasing the risk of severe corrections.

Historical example
Policymakers at various times have followed monetarist-inspired approaches. For example, easing policy and prolonged low interest rates helped extend the U.S. expansion in the 1990s and 2000s, but critics argue that excessively loose policy contributed to the asset bubbles that preceded the 2008 financial crisis.

Monetarism versus Keynesianism
Monetarism emphasizes control of the money supply and price stability as the main policy objectives. Keynesian economics places greater weight on fiscal policy and aggregate demand management, particularly when unemployment is high or during deep recessions. In policy debates, the two perspectives inform different prescriptions for stabilizing the economy.

Conclusion
Monetarist theory links monetary growth to inflation and output through a simple, influential framework. It highlights the central bank’s role in shaping macroeconomic outcomes via control of the money supply, while also recognizing that the effects depend on economic slack and the velocity of money.