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What Is Monetarism? Definition, Explanation & Example

Monetarism is the theory that the proper control of a country's monetary supply is the primary determinant of that country's economic health and stability.
Darkened cropped image of late economist Milton Friedman with text overlay that reads "What Is Monetarism?"

Milton Friedman championed monetarism along with co-author Anna Schwartz in their 1963 book, "A Monetary History of the United States, 1867–1960." 

What Is Monetarism in Economics?

Monetarism is a macroeconomic school of thought that gained popularity during the 1970s. Monetarist theory asserts that monetary supply (the amount of money in an economy) and the way it is managed via governmental monetary policy determines a nation’s economic stability as gauged by metrics like GDP and the rate of inflation.

In other words, monetarism suggests that governments should maintain economic stability by controlling the rate at which monetary supply increases. In the U.S., this job falls on the Federal Reserve, or the Fed for short. The Fed meets periodically to decide whether to raise or lower the federal funds rate (the range of interest rates at which banks lend money to one another), which affects interest rates in general, and in turn, how much money is in circulation throughout the economy. When the rate is increased, monetary supply is tightened; when the rate is decreased, monetary supply typically increases.

Monetarism is based on the quantity theory of money, which can be summarized by the equation of exchange.

What Is the Quantity Theory of Money?

The quantity theory of money is central to the monetarist school of thought. The theory states that monetary supply multiplied by velocity (the average rate at which money changes hands in an economy) always equals the price level (the average price of all goods and services) multiplied by the total quantity of goods and services sold. This formula is known as the equation of exchange.

What Is the Equation of Exchange?

M * V = P * Q

Where: 

  • M is the monetary supply. 
  • V is velocity (how often the average dollar changes hands per year). 
  • P is the price level (the average price of all goods and services). 
  • Q is the total quantity of goods and services sold. 

The main takeaway here is that price levels should increase with monetary supply and vice versa. Milton Friedman, the best-known proponent of monetarism, even went so far as to assert that governments should increase monetary supply at a rate that matches the growth of their real GDP.

What Are the Main Assumptions of Monetarist Theory?

Monetarist theory is characterized by a number of assumptions and assertions, all of which tie in to some degree with quantity theory and the equation of exchange:

  • If all other factors remain static, an increase in monetary supply should cause an increase in price levels.
  • Wages and prices take time to adjust to changes in monetary supply.
  • Organizations like the Fed should follow set rules when adjusting interest rates. Namely, governments should increase monetary supply at a rate that matches their increase in GDP so that prices remain relatively stable.
  • Markets should remain relatively stable so long as major fluctuations in monetary supply do not occur.
  • Interest rates should be flexible so that they can account for inflation.

Who Popularized Monetarist Theory and When Did It Come About?

A Monetary History of the United States, 1867–1960 is considered to be among the most influential works of Nobel Prize-winning economist Milton Friedman. In the book, he and co-author Anna Schwartz championed monetarism and argued that the disastrous Great Depression of the 1930s came about as a result of poorly conjured monetary policy by the Federal Reserve. The pair suggested that monetary supply should have been increased by the Fed in response to the crisis instead of restricted.

What Are Some Examples of Monetarist Policy in History?

Friedman's monetarist ideas gained widespread popularity in the 1970s during a period of growing inflation. In the U.S., Fed Chair Paul Volcker raised the Fed funds rate to restrict monetary supply, and this successfully ended the period of stagflation that had been plaguing the U.S. economy. Similarly, British Prime Minister Margaret Thatcher used monetarist principles to lower the rate of inflation across the pond. 

After the late 70s and early 80s, monetarist thought gradually fell out of favor as more complex and nuanced economic theories emerged to explain and react to the modern economy. Nevertheless, some facets of monetarism—namely, the importance of regulating monetary supply—remain influential in modern economics.

Monetarism vs. Keynesianism: What’s the Difference?

Monetarism can be thought of as somewhat reactionary to Keynesian economic thought. Keynesianism suggests that regulation of government spending in order to manipulate demand is the key to maintaining a healthy economy. Monetarism, on the other hand, emphasizes the importance of controlling the supply of money in an economy but takes a laissez-faire (i.e., “leave it alone”) approach to most other aspects of economics.

Monetarism was well regarded during the 1970s when its ideas were successfully implemented by both the U.S. and Britain to curb inflation. As the 20th century drew toward a close in the 80s and 90s, however, it became clear to many economists that monetary supply and GDP were not as inextricably tied to one another as monetarist thought proposed.

Economies are more complex than ever, and a larger network of more nuanced financial instruments fosters an economic climate that cannot be simplified to the degree that the quantity theory of money proposes. That being said, the rise of monetarism did highlight the importance of regulating monetary supply in maintaining economic stability, and regulating monetary supply in the U.S. remains one of the most important responsibilities of the Federal Reserve to this day.