# Monetarism Explained: Theory, Formula, and Keynesian Comparison

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*Economists meet to discuss their findings.*

## What Is Monetarism?

Monetarism, a notable [macroeconomic](https://www.investopedia.com/terms/m/macroeconomics.asp) theory, posits that the [money supply](https://www.investopedia.com/terms/m/moneysupply.asp) is a crucial determinant in economic stability. Advocated by economist Milton Friedman, this theory suggests that governments can stabilize economies by controlling money supply growth. In contrast, Keynesian economics emphasizes fiscal policy to manage economic demand. Understanding the differences between these approaches can offer insights into economic policy and stability.

### Key Takeaways

*    Monetarism is a macroeconomic theory stressing that the money supply is the main driver of economic growth and stability.  
    
*   Central to monetarism is the quantity theory of money, which suggests changes in the money supply affect prices, production, and employment.  
    
*   Milton Friedman, a leading proponent of monetarism, advocated for a steady increase in the money supply to support natural economic growth.  
    
*   Monetarism contrasts with Keynesian economics, which emphasizes government spending and fiscal policy as tools for managing the economy.  
    
*   While monetarism fell out of favor in later decades, some of its concepts, like the importance of controlling inflation, remain relevant in modern economic analysis.

## How Monetarism Impacts Economic Growth

Monetarism is an economic school of thought which states that the supply of money in an economy is the primary driver of economic growth. More money in the system boosts the demand for goods and services. An increase in aggregate demand encourages job creation, which reduces the [rate of unemployment](https://www.investopedia.com/terms/u/unemploymentrate.asp) and stimulates economic growth.

[Monetary policy](https://www.investopedia.com/terms/m/monetarypolicy.asp), an economic tool used in monetarism, is implemented to adjust [interest rates](https://www.investopedia.com/terms/i/interestrate.asp) that, in turn, control the money supply. Higher interest rates encourage saving over spending, which reduces the money supply. Lower interest rates reduce borrowing costs, encouraging more spending and boosting the economy.

## Monetarism's Evolution Under Milton Friedman

Monetarism is closely associated with economist [Milton Friedman](https://www.investopedia.com/terms/m/milton-friedman.asp), who argued, based on the [quantity theory of money](https://www.investopedia.com/terms/q/quantity_theory_of_money.asp), that the government should keep the money supply fairly steady, expanding it slightly each year to allow for the natural growth of the economy. Friedman argued that because too much money expansion causes inflation, monetary policy should control the money growth rate for stability.

In "A Monetary History of the United States 1867–1960," Friedman suggested a fixed growth rate, the [K-percent rule](https://www.investopedia.com/terms/k/k-percent-rule.asp), linking money supply growth to [nominal gross domestic product](https://www.investopedia.com/terms/n/nominalgdp.asp) (GDP). This way, the money supply woud be expected to grow moderately, businesses would be able to anticipate the changes to the money supply every year and plan accordingly, the economy would grow at a steady rate, and inflation would be kept at low levels.

## Exploring the Quantity Theory of Money

Central to monetarism is the [quantity theory of money](https://www.investopedia.com/insights/what-is-the-quantity-theory-of-money/), which monetarists adopted from earlier economic theories and integrated into the general [Keynesian](https://www.investopedia.com/terms/k/keynesianeconomics.asp) framework of macroeconomics. The quantity theory of money can be summarized in the [equation of exchange](https://www.investopedia.com/terms/e/equation_of_exchange.asp), formulated by John Stuart Mill, which states that the money supply, multiplied by the rate at which money is spent per year, equals the nominal expenditures in the economy. The formula is given as:

$\begin{aligned} &MV = PQ \\ &\textbf{where:} \\ &M = \text{money supply} \\ &V = \text{velocity (rate at which money changes hands)} \\ &P = \text{average price of a good or service} \\ &Q = \text{quantity of goods and services sold} \\ \end{aligned}$

A key point to note is that monetarists believe that changes to M (money supply) are the driver of the equation. In short, a change in M directly affects and determines employment, inflation (P), and production (Q). In the original version of the quantity theory of money, V is held to be constant, but this assumption was dropped by [John Maynard Keynes](https://www.investopedia.com/terms/j/john_maynard_keynes.asp) and is not assumed by the monetarists, who instead believe that V is easily predictable.

[Economic growth](https://www.investopedia.com/terms/e/economicgrowth.asp) is a function of economic activity (Q) and inflation (P). If V is constant (or at least predictable), then an increase (or decrease) in M leads to an increase (or decrease) in either P or Q.

An increase in P denotes that Q remains constant, while an increase in Q means that P remains relatively constant. According to monetarism, variations in the money supply affect price levels over the long term and economic output in the short term. A change in the money supply, therefore, directly determines prices, production, and employment.

## Comparing Monetarism to Keynesian Economics

The view that [velocity](https://www.investopedia.com/terms/v/velocity.asp) is constant is a source of contention among Keynesians, some of whom believe that velocity is not so since the economy is volatile and subject to periodic instability. Instead, Keynes' [liquidity preference theory](https://www.investopedia.com/terms/l/liquiditypreference.asp) emphasizes how changes in money demand (and thus velocity) influence the price level and aggregate demand.

Monetarism builds on the Keynesian theory by assuming the same macroeconomic framework and integrating the equation of exchange (with V swinging cyclically, as Keynes argued), but instead focuses on the role played by money supply. Because they believe that V can be relatively easily predicted, monetarists argue that the equation of exchange could be resuscitated as an approach to [stabilization policy](https://www.investopedia.com/terms/s/stabilization-policy.asp), and they favor the use of monetary policy to do so.

Proponents of monetarism generally believe that controlling an economy through [fiscal policy](https://www.investopedia.com/terms/f/fiscalpolicy.asp) is a poor decision because it necessarily introduces microeconomic distortions that reduce economic efficiency. They prefer monetary policy as a tool to manage aggregate demand in a way that will be more neutral from a microeconomics standpoint and that avoids the [deadweight losses](https://www.investopedia.com/terms/d/deadweightloss.asp) and social costs that fiscal policy creates in markets.

## Tracing the History of Monetarism

Monetarism became popular in the 1970s due to high inflation and slow economic growth. The policies of monetarism were responsible for bringing down inflation in the United States and the United Kingdom. After U.S. inflation peaked at 20% in 1979, the Federal Reserve (the Fed) switched its operating strategy to reflect monetarist theory. During this time period, [economists](https://www.investopedia.com/terms/e/economist.asp), governments, and investors eagerly jumped at every new money supply statistic.

> **Important**
>
> In general, monetary policy can be characterized as contractionary or expansionary. Contractionary monetary policy is when the Fed reduces inflation by raising the federal funds rate or decreasing the money supply. Expansionary monetary policy works by expanding the money supply faster than usual or lowering short-term interest rates.

In the years that followed, however, monetarism fell out of favor with many economists, as the link between different measures of money supply and inflation proved to be less clear than most monetarist theories had suggested. In addition, monetarism's ability to explain the U.S. economy waned in the following decades. Today, many [central banks](https://www.investopedia.com/terms/c/centralbank.asp) focus on strict [inflation targets](https://www.investopedia.com/terms/i/inflation_targeting.asp), not just monetary goals.

While most modern economists dismiss the focus on money growth, some ideas from monetarism remain important. A key idea is that inflation can't last without money supply increases. In addition, it is the responsibility—although not the primary goal—of the central bank to control inflation.

Despite this, monetarist views on past economic events remain relevant today. Ben Bernanke, former Fed chairman, cited the work of Friedman in his decision to lower interest rates and increase the U.S. money supply in order to boost the economy during the global recession that began in 2007 in the United States.

## Case Studies: Monetarism in Action

In Friedman's seminal work, "A Monetary History of the United States, 1867–1960," which he wrote with fellow economist Anna Schwartz, the two economists argued that failed monetary policy executed by the Fed was responsible for the Great Depression in the U.S. in the 1930s. In the view of Friedman and Schwartz, the Fed failed to relieve downward pressure on the money supply, and their eventual actions to reduce the money supply were the opposite of what they should have done. Friedman and Schwartz believed markets stabilize unless the money supply is mismanaged.

In 1979, when Paul Volcker became the chairman of the Fed, he made combatting inflation the primary goal of the central bank. In keeping with Friedman and Schwartz's recommendations, Volcker restricted the money supply in order to do this. He raised the federal funds rate to 20% in 1980. This strategy effectively fought stagflation, which is high inflation and unemployment with stagnant demand. Volcker's policies drastically reduced the money supply, consumers stopped purchasing as much, and businesses stopped raising prices. However, while this caused inflation to greatly decline, it resulted in the [recessionary periods](https://www.investopedia.com/articles/economics/08/past-recessions.asp) between 1980 and 1982.

During the same time period, Britain was also struggling with severe inflation. When Margaret Thatcher was elected prime minister in 1979, she also implemented a set of monetarist policies to combat the rising prices in the country. By 1983, inflation in Britain had been halved, from 10% to 5%.

However, the popularity of monetarism was relatively brief. In the 1980s and 1990s, the link between the money supply and nominal GDP broke down, and the quantity theory of money—the backbone of monetarism—was called into question. Many economists who had recommended the policies of monetarism in the 1970s abandoned the approach.

## What Is the Main Idea of Monetarism?

The main idea in monetarism is that money supply is the central factor in determining demand in an economy. By extension, economic performance can be controlled by regulating monetary supply, such as by implementing expansionary monetary policy or contractionary monetary policy.

## What Is an Example of Monetarism?

As mentioned above, monetary policy can be expansionary or contractionary. When a central bank lowers interest rates or reduces reserve requirements, it is engaging in expansionary monetary policy. These moves increase the money supply, encouraging borrowing among individuals, companies, and banks. The opposite—increasing reserve requirements or raising rates—would be an example of contractionary monetary policy.

## What Is the Difference Between Monetarism and Keynesianism?

In simple terms, monetarism posits that policymakers can best control the economy through management of the money supply, whereas Keynesianism believes this is better achieved through government spending. In practice, governments use both monetary policy and fiscal spending to shape the economy.

## The Bottom Line

Monetarism, primarily associated with economist Milton Friedman, highlights the crucial role of monetary policy in economic stability and growth by targeting the money supply. Originating in the 20th century, it gained prominence through its application to address issues like inflation in the 1970s.

Unlike Keynesian economics, which focuses on government spending and aggregate demand, monetarism favors monetary policy as a more effective tool for managing economic performance. Although the strict application of monetarism has waned, its foundational idea—that inflation control is reliant on money supply management—persists as a key principle in economic analysis and policy-making.

> **Article Sources**
>
> 1.  International Monetary Fund. "[What Is Monetarism?](https://www.imf.org/external/pubs/ft/fandd/2014/03/basics.htm)"
>     
> 2.  Federal Reserve Bank of St. Louis. “[Effective Federal Funds Rate](https://fred.stlouisfed.org/series/FEDFUNDS).”