Monetarism – whose chief architect was the American Milton Friedman (1912–2006) – states that governments should make minimal interventions in the economy aside from taking measures to control the money supply. Born out of a rejection of Keynesianism (see here), monetarism became the prevailing economic orthodoxy in much of the developed world during the 1970s and 80s.
The origins of monetarism may be traced to the 16th century, when the quantity theory of money was developed. This theory is summed up by the equation MV=PT, where M = the amount of money in circulation over a defined time period, V = the velocity of money (i.e. how often it is spent in that period), P = the average price level and T = the volume of transactions. It is generally acknowledged that the velocity of money is relatively constant over the long term; thus it is increases in the amount of money in circulation that result in increases in price. To put it another way, the more money that goes into the economy, the higher inflation will be over the long run, with knock-on effects for wages.
Stagflation
Monetarism’s central tenet is that while governments may look after money supply, the markets can deal with inflation and unemployment. Whereas many governments sought to lower unemployment by spending more and accepting the resultant inflation, Friedman suggested that inflation pushes up wage demands so that employers are forced to cut jobs. Therefore, he argued, a government might end up with the worst of all worlds – high inflation and high unemployment. Indeed, this situation – known as stagflation – took a grip in several major economies in the 1970s.
Friedman also warned against excessive tinkering with the money supply – one of the leading causes, he suggested, of the Great Depression. Governments should instead merely focus on making sure there is enough money in the system to meet consumer demand for it. A good rule of thumb for central banks, he contended, is to increase money supply roughly in line with GDP growth. Then let the markets take care of everything else.
From the 1950s, Friedman challenged many of the underlying assumptions of Keynesianism, namely that individuals alter their patterns of consumption to fit with their current income. Friedman insisted that in fact individuals recognize a difference between their secure, long-term income streams and their less stable, transitory income. It is their secure income, he said, that determines their spending habits in the long term. So while, say, government expenditure on a new infrastructure project may boost levels of transitory income for a while, it has limited effect in boosting the overall economy for any significant period of time. Much better, Friedman said, for governments to focus on controlling the money supply in order to have an influence on the level of long-term incomes and, as a result, expenditure, too.
Today, there is a perhaps more nuanced approach to the theory, given its failure to bring the equitable prosperity its adherents had hoped for. Nonetheless, it remains a key component in the macroeconomic strategies of many governments.