Monetarism

The Basics of Monetarism The key features of monetarist theory are as follows: o o o The main cause of inflation is an excess supply of money leading to in the words of the late Monetarist economist Milton Friedman, too much money chasing too few goods. Tight control of money and credit is required to maintain price stability Attempts by the government to use fiscal and monetary policy to fine-tune the rate of growth of aggregate demand are often ineffective. Fiscal policy has a role to play in stabilising the economy providing that the government is successfully able to control its own borrowing. The key is for monetary policy to be credible perhaps in the hands of an independent central bank so that peoples expectations of inflation are controlled.

An increase in the money supply / supply of credit

Increased demand for goods and services

Increased demand for financial assets including housing and bonds

Higher bond prices pushes down long term interest rates

Rising house prices stimulate wealth effect Higher level of AD C+I+G+(X-M)

AD may rise above the economys potential output positive output gap

Rise in inflationary pressure

A simple way of explaining how a surge in the amount of money in circulation can feed through to higher inflation is shown in the flow chart above. 1. Excess money balances held by households and businesses can affect demand and output in several directions. Consumers will often increase their own demand for goods and services adding directly to aggregate demand (although a high proportion of this extra spending may go on imports). 2. Secondly some of the excess balances will be saved in bonds and other financial assets, or invested in the housing market. An increase in the demand for bonds causes a downward

movement in bond interest rates (there is an inverse relationship between the two) and this can then stimulate an increase in investment. 3. Similarly money that flows into housing will push house prices higher, and we know understand quite well how a booming housing market stimulates consumer wealth, borrowing and an increase in spending. The Quantity Theory of Money The Quantity Theory was first developed by Irving Fisher in the inter-war years, as is a basic theoretical explanation for the link between money and the general price level. The quantity theory rests on what is sometimes known as the Fisher identity or the equation of exchange. This is an identity which relates total aggregate demand to the total value of output (GDP). MxV=PxY Where o o o o M is the money supply V is the velocity of circulation of money P is the general price level Y is the real value of national output (i.e. real GDP)

Money supply (M) multiplied by the velocity of circulation (V) = the value of national output (price level (P) x volume of transactions (Y)) The velocity of circulation represents the number of times that a unit of currency (for example a 10 note) is used in a given period of time when used as a medium of exchange to buy goods and services. The velocity of circulation can be calculated by dividing the money value of national output by the money supply. In the basic theory of monetarism expressed using the equation of exchange, we assume that the velocity of circulation of money is predictable and therefore treated as a constant. We also make a working assumption that the real value of GDP is not influenced by monetary variables. For example the growth of a countrys productive capacity might be determined by the rate of productivity growth or an increase in the capital stock. We might therefore treat Y (real GDP) as a constant too. If V and Y are treated as constants, then changes in the rate of growth of the money supply will equate to changes in the general price level. Monetarists believe that the direction of causation is from money to prices (as we saw in the flow chart on the previous page). The experience of targeting the growth of the money supply as part of the monetarist experiment during the 1980s and early 1990s is that the velocity of circulation is not predictable indeed it can suddenly change, partly as a result of changes to peoples behaviour in their handling of money. During the 1980s it was found that direct and predictable links between the growth of the money supply and the rate of inflation broke down. This eventually caused central banks in different countries to place less importance on the money supply as a target of monetary policy. Instead they switched to having exchange rate targets, and latterly they have become devotees of inflation targets as an anchor for the direction of monetary policy. Measuring the money supply There is no unique measure of the money supply because it is used in such a wide variety of ways. M0 (Narrow money) - comprises notes and coins in circulation banks' operational balances at the Bank of England. Over 99% of M0 is made up of notes and coins as cash is used mainly as a medium of exchange for buying goods and services. Most economists believe that changes in the amount of cash in circulation have little significant effect on total national output and inflation. At best M0 is seen as a co-incident indicator of consumer spending and retail sales. If people increase their

cash balances, it is mainly a sign that they are building up these balances to fund short term increases in spending. M0 reflects changes in the economic cycle, but does not cause them. M4 (Broad money) is a wider definition of what constitutes money. M4 includes deposits saved with banks and building societies and also money created by lending in the form of loans and overdrafts. M4 = M0 plus sight (current accounts) and time deposits (savings accounts). When a bank or another lender grants a loan to a customer, bank liabilities and assets raise by the same amount and so does the money supply. Again M4 is a useful background indicator to the strength of demand for credit. The Bank takes M4 growth into account when assessing overall monetary conditions, but it is not used as an intermediate target of monetary policy. Its main value is as a signpost of the strength of demand which can then filter through the economy and eventually affect inflationary pressure. The Money Supply and Velocity during the Credit Crunch Quantitative easing is a deliberate policy to boost the money supply and provide a stimulus to demand in a bid to avoid damaging price deflation. Central banks both in the UK and the USA have certainly created a lot of money. The so-called monetary base, consisting of cash and the central banks deposits, has roughly doubled in the US and Britain since 2007. However, shrinking private bank credit as the lending freeze brought about by the credit crunch has continued longer than expected has offset this. Private sector credit accounts for a much larger part of the total money supply. As a result, growth in total money the world over has been slow. Put another way, most of the money created by quantitative easing is sitting in banks reserves, rather than finding its way to businesses and consumers. We are seeing a contraction in the money supply because of the credit crunch / fall in lending. If velocity of circulation is stable then this will lead to a fall in the value of GDP. Matters are made worse if velocity is also declining households are starting to hoard cash as are companies worried about insolvency and the lack of credit and hedge funds holding onto cash because of fears over investors wanting to redeem their money. A fall in the velocity of circulation of money significantly increases the risks of a deflationary recession. It means that quantitative easing may not be having the impact on the economy that the Bank of England wishes to see. Suggestions for further reading on monetarism and inflation Obituary of Milton Friedman (BBC, November 2006) Death of the High Priest of Monetarism (BBC news, November 2006) Milton is dead, but we are all Friedman now (The Times, November 2006) Monetarists warn of crunch across Atlantic economies (Telegraph, July 2008)