Monetarism and the Chicago School

Monetarism is a school of thought in economics that emphasizes the role of governments in controlling the amount of money in circulation. It was spearheaded by Milton Friedman and became a dominant theory in the late 20th century. Monetarism opposes the Keynesian view of economic management, advocating instead for strict control of the money supply as a tool to control inflation and stabilize economies.

1. Milton Friedman and the Theory of Monetarism

Milton Friedman was a leading figure in the development of monetarism and is considered one of the most influential economists of the 20th century. Friedman’s work challenged the Keynesian emphasis on government spending and demand-side management in favor of controlling inflation through monetary policy.

Key components of Friedman’s monetarism:

Stable Money Supply Growth: Friedman advocated for a fixed, steady increase in the money supply, arguing that erratic changes in money supply are the root cause of economic instability.
Natural Rate of Unemployment: Friedman introduced the concept of the “natural rate of unemployment,” which suggests that there is a level of unemployment that cannot be reduced by monetary policy without causing inflation.
Monetary Policy Over Fiscal Policy: Friedman believed that monetary policy—adjusting the money supply—is far more effective than fiscal policy (government spending and taxation) for managing economic stability.

Friedman’s ideas gained prominence, particularly in the late 1970s and early 1980s, as countries like the U.S. and the U.K. turned to monetarist policies to combat inflation.

2. The Quantity Theory of Money

The Quantity Theory of Money is a central idea in monetarism. It proposes a direct relationship between the amount of money in an economy and the level of prices of goods and services. The theory is often expressed through the equation:

M×V=P×QM \times V = P \times QM×V=P×Q

Where:

M = Money Supply
V = Velocity of Money (the rate at which money is exchanged)
P = Price Level
Q = Real Output (quantity of goods and services produced)

Key insights:

Direct Relationship Between Money Supply and Price Level: If the velocity of money and real output are constant, an increase in the money supply will lead to a proportional increase in the price level, i.e., inflation.
Inflation as a Monetary Phenomenon: Friedman famously stated that “inflation is always and everywhere a monetary phenomenon,” meaning that inflation is caused by an increase in the money supply rather than demand-side factors like wage increases or government spending.

Monetarists argue that excessive money supply growth leads to inflation, while controlling money supply can effectively control inflation.

3. The Role of Monetary Policy in Controlling Inflation

Monetarists argue that the primary role of central banks, such as the Federal Reserve in the U.S., should be to control the growth of the money supply to prevent inflation. Key points include:

Money Supply Targeting: Instead of using interest rates to influence the economy, monetarists advocate for targeting the growth rate of the money supply directly. Central banks should aim for a steady, predictable increase in the money supply that matches the growth of real output to avoid inflation.
Fighting Inflation: By controlling the money supply, central banks can reduce inflation. If the money supply grows faster than the economy’s productive capacity, inflation results. Limiting this growth curbs inflationary pressures.
Long-Term Effects: Friedman and other monetarists argue that while monetary policy can have short-term effects on employment and output, in the long run, its primary impact is on prices. This view is contrasted with Keynesian ideas that advocate using monetary and fiscal tools to boost demand and reduce unemployment.

4. Criticisms of Keynesian Economics

Monetarists are critical of Keynesian economics, particularly its focus on using fiscal policy to manage economic demand and stimulate growth. Key criticisms include:

Fiscal Policy is Ineffective: Monetarists argue that government intervention through fiscal policy (spending and taxation) is often counterproductive. Friedman believed that fiscal policies lead to excessive government debt, inefficient allocation of resources, and only provide temporary economic boosts.
Crowding Out: Keynesian stimulus measures, which involve increasing government spending to boost demand, can lead to the “crowding out” effect. This means that higher government spending drives up interest rates, reducing private investment and negating the intended stimulative effect.
Phillips Curve Critique: Keynesians believed in a stable trade-off between inflation and unemployment, as represented by the Phillips Curve. However, Friedman argued that this relationship breaks down in the long run. Once inflation expectations are built into the economy, attempting to lower unemployment further would only lead to higher inflation without reducing unemployment.
Short-Sightedness: Monetarists also argue that Keynesian demand management policies are short-sighted, focusing on short-term economic boosts at the expense of long-term stability. In contrast, monetarism emphasizes long-term price stability through controlling the money supply.

Conclusion

Monetarism and the Chicago School, led by Milton Friedman, provided an alternative framework to Keynesian economics, focusing on the control of the money supply as a way to stabilize economies and control inflation. The quantity theory of money and Friedman’s emphasis on the natural rate of unemployment shifted economic thinking towards using monetary policy as the main tool for managing inflation. Criticisms of Keynesian economics revolve around its focus on fiscal policy and its inefficacy in controlling long-term inflation without causing other economic issues.