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Monetarism: Definition & Overview

Instructor: Shawn Grimsley
Economists are like most people: they don't always agree on how things work or should work. Monetarism is one of several schools of thought in economics. In this lesson, you'll learn about monetarism and its policy approach. A short quiz follows.

Definition

Monetarism is an economic school of thought that posits that most economic fluctuations in the economy can be explained by the money supply. Monetarists also believe that government intervention in the economy should be minimal and is often counterproductive. Monetarism is a direct challenge to the Keynesian school of thought, which advocates aggressive fiscal intervention by a government to stimulate a declining economy, which itself was a challenge to the classical school of economics. Probably the most famous contemporary monetarist is economist Milton Friedman.

It's All About Money Supply

Monetarists believe that the supply of money is the most important factor that determines national income and growth. They base this proposition on the quantity theory of money. Harvard economist N. Gregory Mankiw explains that the quantity theory of money is 'a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate.'

The theory is not nearly as confusing as it may first appear. The theory basically says that prices for goods and services, as well as the rate at which prices rise (called inflation), are based upon how much money is in the economy and how fast that supply of money is increasing. If the supply of money increases quickly enough, prices will increase as the supply of money outpaces the supply of goods and services provided in the economy. Why?

When people have excess money, they have two options: save or spend. If people decide to buy more stuff, they are competing with other people that are also trying to buy more stuff. Remember that the injection of more money in the economy does not mean that the quantity of goods and services has increased. Consequently, as consumers compete for the limited amount of goods and services available in an economy, the price of goods increases, leading to inflation.

The same thing will happen if you decide to save instead of buy. If you save your money, you'll usually, like most people, park the money in a bank. The banks make money by loaning money. Since they have more money to lend out, they will do it. The people who borrow money go out and compete with other buyers, which of course increases the price of goods and services because the quantity of goods and services in the economy has not changed just because the money supply has increased.

When do rising prices stabilize? As prices increases, you need more money to purchase goods and services. Eventually, the money demanded by consumers to purchase stuff will equal the quantity of money supplied. This is called the equilibrium price, and it is where supply equals demand. In order to avoid inflation, monetarists argue that the rate of growth in the money supply must not exceed the growth rate of the economy in the long run.

Most economists agree with the principle of monetary neutrality, which states that in the long run, changes in the money supply influence nominal economic variables but not real economic variables. Nominal variables are variables that are measured in terms of money, while real variables are measured in physical units. For example, just because nominal gross domestic product, or GDP (a measure of national output), rose by a certain amount of money, doesn't mean that the economy increased its output of goods and services - the increase in nominal GDP may been caused entirely by rising prices rather than more goods and services being produced. Monetarists, however, argue that increasing or decreasing the supply of money in the short run can have significant effects on output and employment.

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