What Remains of Monetarism?

Monetarism – controlling the growth of the money supply and not interest rates, the Fed could better control inflation and foster stable economic growth.

Today monetary growth targets play no official role in the setting of U.S. monetary policy. This article addresses that question by discussing the development and apparent failure of monetarism as a guide to policy.

M = kY M = nominal money stock K = desired ratio of money holdings to nominal income Y = nominal income

If k is constant, then M and Y move proportionally. This is a simple money demand function, where money demand depends largely on income. Quantity of money balances demanded is equal to the quantity supplied. If this condition holds, then any increase in M leads to an increase in either k or Y. If the money stock is largely influenced by the actions of the monetary authority (Federal Reserve System), then policy actions have predictable effects on the economy.

M = k(yP) Y = yP Nominal income (Y) is the product of real income (y) and prices (P).

Following the Great Depression and WWII, the dominant view was that governments could successfully manage economies to achieve full employment. The tool by which such “demand management” could be conducted was fiscal policy. Monetary policy was considered important only in the sense that it would keep interest rates at levels necessary to maintain economic growth. Inflation was of little concern in the early postwar period.

The 1950s witnessed an increase in scholarly work on monetary theory and policy. Friedman posits in his essay that nominal income is closely related to monetary developments: simply put, the theory of money demand is really just a theory of nominal income determination. This view contrasted sharply with the Keynesian orthodoxy, one in which money had little or no role. Friedman’s models focused more on short-run dynamics, not long-run implications.

The publication in 1963 of Friedman and Schwartz’s massive A Monetary History of the United States: 1867 – 1960 provided even greater ammunition to the monetarist movement. In their study, Friedman documented the long-term, empirical relation between movements in the money supply, income, and prices. Money supply largely dictates observed changes in the economy. Friedman’s Monetary History helped to establish a foundation for monetary policy emphasizing control of the monetary aggregates, the nature of the analysis was decidedly long-run.

The Anderson-Jordan St. Louis model results provided support for a key element in the monetarist position: namely, money is not only important in affecting nominal income but has a more direct and manageable impact on the economy than fiscal policy actions. The St. Louis model helped push the monetarist agenda to the forefront of the short-run stabilization debate more forcefully than previous work had.

As the success of monetarist predictions mounted, monetarists began to shift from testing rival policies to arguing for the use of monetary aggregates as a short-run stabilization tool.

The most dramatic shift toward a monetarist-like policy occurred in October 1979. At that time the Fed announced that it would henceforth emphasize policy procedures aimed more at controlling non-borrowed reserves than at the federal funds rate. This shift was made to reduce inflation rates, which were then running in double digits. The restrictive policies enacted served to help lower inflation, but they also sent the economy into the deepest postwar recession on record. Whether the Fed truly embraced a monetarist policy agenda in 1979 remains debatable, but the Fed’s policies dealt a severe blow to monetarism.

In light of these events, policymakers quickly rejected monetary aggregates as a policy tool. In lieu of money, they once again returned to the manipulation of the federal funds rate to achieve policy objectives.

So what does remain of monetarism? Does money matter? The evidence presented in this article suggests that a blanket dismissal of monetary aggregates as uninformative for policy decisions is premature. The data from a variety of economies indicate that money growth is directly related to nominal income growth and inflation. Moreover, the evidence suggests a weaker relation between money growth and real output growth in the long run. These findings change as the time horizon moves from annual to multiyear averages.