[[File:CPI 1914-2022.webp|thumb|alt=CPI 1914-2022|261px|
]]
Monetarism is a school of thought in monetary economics that emphasizes the role of policy-makers in controlling the amount of money in circulation. It gained prominence in the 1970s, but was mostly abandoned as a direct guidance to monetary policy during the following decade because of the rise of inflation targeting through movements of the official interest rate.
The monetarist theory states that variations in the money supply have major influences on national output in the short run and on price levels over longer periods. Monetarists assert that the objectives of monetary policy are best met by targeting the growth rate of the money supply rather than by engaging in discretionary monetary policy.
Monetarism is mainly associated with the work of Milton Friedman, who was an influential opponent of Keynesian economics, criticising Keynes's theory of fighting economic downturns using fiscal policy (e.g. government spending). Friedman and Anna Schwartz wrote an influential book, A Monetary History of the United States, 1867–1960, and argued that inflation is "always and everywhere a monetary phenomenon".
Although opposed to the existence of the Federal Reserve, Friedman advocated, given its existence, a central bank policy aimed at keeping the growth of the money supply at a rate commensurate with the growth in productivity and demand for goods. Money growth targeting was mostly abandoned by the central banks who tried it, however. Central banks struggled to identify stable relationships between traditional monetary aggregates and inflation, though some researchers argue that theoretically grounded measures like Divisia aggregates may reveal more consistent patterns. Starting in the early 1990s, most major central banks turned to direct inflation targeting, relying on steering short-run interest rates as their main policy instrument.
Monetary history of the United States
400px|thumb|right| Money supply decreased significantly between [[Black Tuesday and the Bank Holiday in March 1933 in the wake of massive bank runs across the United States.]]
Monetarists argued that central banks sometimes caused major unexpected fluctuations in the money supply. Friedman asserted that actively trying to stabilize demand through monetary policy changes can have negative unintended consequences. In part he based this view on the historical analysis of monetary policy, A Monetary History of the United States, 1867–1960, which he coauthored with Anna Schwartz in 1963. The book attributed inflation to excess money supply generated by a central bank. It attributed deflationary spirals to the reverse effect of a failure of a central bank to support the money supply during a liquidity crunch. In particular, the authors argued that the Great Depression of the 1930s was caused by a massive contraction of the money supply (they deemed it "the Great Contraction"), and not by the lack of investment that Keynes had argued. They also maintained that post-war inflation was caused by an over-expansion of the money supply. They made famous the assertion of monetarism that "inflation is always and everywhere a monetary phenomenon."
Fixed monetary rule
Friedman proposed a fixed monetary rule, called Friedman's k-percent rule, where the money supply would be automatically increased by a fixed percentage per year. The rate should equal the growth rate of real GDP, leaving the price level unchanged. For instance, if the economy is expected to grow at 2 percent in a given year, the Fed should allow the money supply to increase by 2 percent. Because discretionary monetary policy would be as likely to destabilise as to stabilise the economy, Friedman advocated that the Fed be bound to fixed rules in conducting its policy. Studies using theoretically-grounded Divisia monetary aggregates have found more stable relationships between money growth, inflation expectations, and economic activity, suggesting that properly measured money can provide clearer guidance for monetary policy implementation. Moreover, incorporating money into forward-looking macroeconomic models with proper measurement can enhance the transmission mechanism of monetary policy and improve the effectiveness of rules-based approaches.
Opposition to the gold standard
Most monetarists oppose the gold standard. Friedman viewed a pure gold standard as impractical. For example, whereas one of the benefits of the gold standard is that the intrinsic limitations to the growth of the money supply by the use of gold would prevent inflation, if the growth of population or increase in trade outpaces the money supply, there would be no way to counteract deflation and reduced liquidity (and any attendant recession) except for the mining of more gold. But he also admitted that if a government was willing to surrender control over its monetary policy and not to interfere with economic activities, a gold-based economy would be possible.
Rise
Clark Warburton is credited with making the first solid empirical case for the monetarist interpretation of business fluctuations in a series of papers from 1945.
Thus, according to Friedman, when the money supply expanded, people would not simply wish to hold the extra money in idle money balances; i.e., if they were in equilibrium before the increase, they were already holding money balances to suit their requirements, and thus after the increase they would have money balances surplus to their requirements. These excess money balances would therefore be spent and hence aggregate demand would rise. Similarly, if the money supply were reduced people would want to replenish their holdings of money by reducing their spending. In this, Friedman challenged a simplification attributed to Keynes suggesting that "money does not matter."
In May 1979, Margaret Thatcher, Leader of the Conservative Party in the United Kingdom, won the general election, defeating the sitting Labour Government led by James Callaghan. By that time, the UK had endured several years of severe inflation, which was rarely below the 10% mark and stood at 10.3% by the time of the election. Thatcher implemented monetarism as the weapon in her battle against inflation, and succeeded at reducing it to 4.6% by 1983. However, unemployment in the United Kingdom increased from 5.7% in 1979 to 12.2% in 1983, reaching 13.0% in 1982; starting with the first quarter of 1980, the UK economy contracted in terms of real gross domestic product for six straight quarters.
Decline
Monetarist ascendancy was brief, however. The period when major central banks focused on targeting the growth of money supply, reflecting monetarist theory, lasted only for a few years, in the US from 1979 to 1982.
The money supply is useful as a policy target only if the relationship between money and nominal GDP, and therefore inflation, is stable and predictable. This implies that the velocity of money must be predictable. In the 1970s velocity had seemed to increase at a fairly constant rate, but in the 1980s and 1990s velocity became highly unstable, experiencing unpredictable periods of increases and declines. Consequently, the stable correlation between the money supply and nominal GDP broke down, and the usefulness of the monetarist approach came into question. Many economists who had been convinced by monetarism in the 1970s abandoned the approach after this experience. Among them are the belief that controlling inflation should be a primary responsibility of the central bank.