Game of Theories: The Monetarists

♪ [music] ♪

- [Tyler] Monetarism is
another framework

for thinking about business cycles.

Nobel laureate Milton Friedman
of the University of Chicago --

he was the most famous proponent
of monetarism.

And, as the name suggests,
monetarism emphasizes

the importance of the money supply,

and it emphasizes the decisions
central banks make

about what to do
with the money supply.

Now monetarism is based
on something called

the quantity theory of money.

That means, in the long run,

the absolute amount of money
in an economy doesn't matter,

doesn't influence real output
or real employment.

But in the short run, changes
in the rate of inflation can matter.

So there are two potential dangers
in monetarism:

too much inflation,
and too little inflation.

Let's think first
about too much inflation,

because this is a big part

of how monetarism
became more popular.

In the 1970s, in America,

rates of inflation
were considered to be too high,

and monetarism had a way
to explain this.

It said the Federal Reserve
was creating too much new money

for the economy,

and that means
prices will be rising

and inflation tends to distort

the allocation
of economic resources.

Individuals cannot tell
which prices are going up

because of the inflation,

and which prices are going up

because something is
more or less valuable,

and that what we should do
is lower the rate of inflation

and bring about
more economic stability.

So at the time, a lot
of Keynesian economists

were accepting
this higher rate of inflation.

But monetarism was saying that, yes,

at first more inflation is going
to get you higher economic output,

but pretty quickly people figure out
that there's inflation going on,

and that inflation
ceases to be effective

in stimulating the economy.

On the other side of the ledger,

there's the danger that
monetary growth will be too low,

and that means the rate
of price inflation will be too low

or there may be
deflation altogether.

And in that setting,
according to monetarism,

aggregate demand will be too low.

In this case, monetarist
and Keynesian doctrine --

they're actually pretty similar.

Monetarists, like Keynesians,

believe that a lot
of nominal wages are sticky --

that is they can't be readjusted
or renegotiated all the time.

This may be a matter of contract,
or a matter of law, minimum wages,

or maybe just a matter
of workplace morale.

But when you have sticky wages,

and that flow
of nominal purchasing power,

that flow of money
through an economy,

when it declines, well,
wages cannot just fall in tandem,

and employers will lay off
some workers,

and you will get
a business cycle downturn.

So for monetarists,
there's a kind of Goldilocks rule.

It's desired that there be
a constant rate

of money supply growth.

Sometimes that's been given
as about 2 to 3% --

not too high, not too low.

In general, monetarists believe
in constraining the central bank

through rules.

They don't trust the central bank
to have a lot of discretion,

and to turn on a dime and make
a lot of very complicated,

precise decisions.

Monetarists emphasize
that lags are long and variable.

The information of policy makers
can be unreliable,

so they simply want the stable rule,
which rules out the two cases

of inflation too high
and inflation too low.

So, so far, so good.

Monetarism has had a huge impact,

and because of Milton Friedman
and other monetarists,

economists now look much,
much more at money supplies

and central bank policies.

But, that said, monetarism
still has some important problems.

First, monetarism is quite
an incomplete account

of business cycles.

A lot of business cycles
can be caused by, say,

the bursting of bubbles,
or problems in credit markets,

or negative real shocks,
or other factors.

And monetarism just doesn't have
a lot to say about these cases.

Second, monetarism assumes
that there's this notion

of "the money supply"
as a single, well-defined thing.

But, in fact, empirically there are

many different
money supply measures.

There are narrow measures,

such as currency
plus bank reserves held at the Fed.

Or you could add in
demand deposits, savings deposits,

different kind
of credit relationships.

Which of those is the true
real money supply?

Which of those should we stabilize?

It turns out
those different measures

of the money supply --

they don't always
move together so closely.

And if we stabilize one of them,
well, other measures

of the money supply
may not be that stable at all.

Finally, there's another problem
with monetarism.

If the central bank really does
fix a rate of growth

for the money supply,

this can make it harder to respond
to other kinds of shocks.

What if there's
a negative real shock,

such as an oil price hike?

Some economists think
the central bank

should then be more expansionary.

What if interest rates
turn volatile?

Maybe then, again, the central bank
should expand credit a bit more.

There may be a shock to velocity.

The rate at which
that money turns over

in the economy may change.

And, at least under
simple forms of monetarism,

again, the central bank
cannot easily adjust for that.

It's the case, in fact --

there's now an offshoot doctrine
of monetarism,

sometimes called market monetarism
or nominal GDP targeting,

that says, yes,
we start with monetarism,

but we actually want
to allow the central bank

the ability to respond
to those changes in velocity.

Now monetarists, who generally
do not trust in discretion,

are willing to put up
with these shocks,

but in the real world
there's a big debate --

many people believe
the central bank actually should go

beyond the confines
of this very limited rule

and try to offset some
of these other kinds of shocks

hitting an economy.

So, in sum, monetarism
is really important,

but still it is considered

a somewhat incomplete doctrine
of business cycles.

- [Narrator] You're on your way
to mastering economics.

Make sure this video sticks
by taking a few practice questions.

Or, if you're ready
for more macroeconomics,

click for the next video.

Still here?

Check out Marginal Revolution
University's other popular videos.

♪ [music] ♪