The American economy is a complex system with heavy influence on the overall financial health of the nation. Understanding what affects the economy in both a positive and negative manner is essential to exhibiting the most control possible over a system that is so critical and that touches basically every life within national boarders, as well as nations that do business with America. The effects of a suffering economic system have been well documented over the course of U.S. history. The Great Depression as well as the recession of the last decade serves as examples of the impact that shifts in the economy can have. Various economic schools have been developed in an effort to not only understand how this complex system works, but also understand how it can be influenced. One of the earlier schools of economic thought is Monetarism.
History of Monetarism
Most people associate the development of the Monetarism school of thought with Milton Friedman. While it is true that he is essentially the leading exponent in the further development of the model, it did not exactly originate with him. Instead, the story of this model begins first with Irving Fisher. Fisher wrote several books in the late 1800 and early 1900 that began what is now known as Monetarism. Specifically, Irving provided knowledge regarding the use of the equation of exchange as well as the transformation of the quantity theory of money as tools that can be used to make quantitative analyses and predictions of inflation, interest rates, and the price level (Bradford 85). From a holistic perspective, Monetarism posits that the money supply is the main determinant on the demand side of economic activity. This determinant primarily affects short run economic activity; however, it is understood that the short run activity comprises and affects the long run activity of an economic system. The “money supply” is understood to be the total amount of coin, currency, and bank deposits.
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"Monetarism".
The very first subspecies of Monetarism sought to explain business cycle fluctuations in both output and employment. The first Monetarist perspective was generally revered as sophisticated in nature. Many economists became exasperated with the way that Monetarism was used by economists. Amongst those exasperated economists was Milton Friedman. Friedman created what is now known as the Chicago School of Monetarism. This approach differed from the original because it focused primarily on the variability of velocity and the impact of velocity on the rate of inflation. From this perspective, economic events such as depressions could be blamed on monetary forces (Bradford 86).
Evolution of the School of Thought
As previously mentioned, the equation of exchange was one of the tools used in this effort. The equation of exchange is expressed as MV=PQ. M is the supply of money; V is the velocity of the turnover of money; P is the average price level; and Q is the quantity of goods and services that are produced. According to monetarists, the direction of causation moves from left to right which means that as the money supply increases (represented by V), it can be expected for either P or Q to increase as well. When Q increases P will remain constant, while P can increase with no corresponding increase in the quantity of goods and services provided (Q).
Based on this understanding, changes within the money supply both affect and determine employment, price levels, and production that will eventually manifest after a significant period of time (Bradford 86). The cure to economic hardships such as depression would require governmental involvement by means of stimulative monetary expansion, large government deficits, and policies that balances deflation. Following World War II, when the U.S. economy was guided predominately by Keynesian policies, the popularity of Monetarism began to spread rapidly. The Federal Reserve even adopted the school of thought for a short period of time believing the arguments of Friedman and supporters of the school that Keynesian policy was unstable and harmful. This was something that a post war nation actively sought to avoid because it wanted to ensure growth and stability. Friedman’s Monetarism was simplistic and provided a perception of a simplistic and broad range of control over the economy. Eventually, Monetarism was discovered to not be the economic answer that America was in search of.
Growing Past Its Use
Although Monetarism continued to evolve over time, the Monetarist model soon proved to not be viable for growing American economy. It was regarded as vague and amorphous. Further, it was proven to be incorrect in the 1980s as the U.S economy began to change. The kinds of savings that were once used by economists to calculate the money supply were overshadowed by newer and hybrid forms of bank deposits. The 1980s economy also saw a decline in the inflation rate because people began to spend less. Based on the Monetarist school, this would have decreased the velocity. The result was a lessened ability to predict how nominal GDP was affected by monetary growth.
The standard deviation of the central bank’s target variables like inflation and nominal gross domestic product (GDP) declined substantially; however, at the same time, the standard deviation of monetary aggregates has increased. This unique macroeconomic phenomenon is also associated with the disappearance of correlation between inflation and money growth (Kishor & Kochin 56).
There is always a threat of macroeconomic failure. Monetarism failed to take this into consideration which makes it inappropriate for use today.
Conclusion
In conclusion, Monetarism was one of the earlier economic perspectives to understanding the economy and how to affect the economy. Monetarists posited that the money supply is the main determinant on the demand side of economic activity which basically means that economic hardships such as depression could be cured by governmental involvement by means of stimulative monetary expansion, large government deficits, and policies that balance deflation. While holistic understanding of the school focused on the impact of velocity, which may have proven to be a part of an effective means of understanding and measuring the previous U.S economy, as the economy evolved, Monetarism proved to be invalid. In the end, Monetarism implied that free-market economies were basically stable and not subject to the ever recurring threat of macroeconomic failure (Palley 71). History has taught America differently and the result has been a shift to New Classical macroeconomics.
