In October 1979 the US central bank changed how it fought inflation. What did it start to steer by?
The Federal Reserve said it would control bank reserves, the money banks hold at the central bank, to get a firmer grip on the growth of money.
- Began
- Grew from work on money by Milton Friedman and other Chicago economists in the 1950s. A Monetary History of the United States (1963), written with Anna Schwartz, led economists to take it seriously
- Key figures
- Milton Friedman (1912 to 2006), its leading figure, Anna Schwartz, Karl Brunner and Allan Meltzer
- Where it shaped policy
- The US Federal Reserve from 1979 to 1982, and Britain's Medium Term Financial Strategy from 1980
- Main rivals
- Keynesian economics, which had guided Western policy since the Second World War
What it was reacting to
Monetarism grew up as a challenge to Keynesian economics, the prevailing approach to policy in most Western governments. Many Keynesians judged whether policy was tight or loose by the level of interest rates, and gave the money supply a small role.
Inflation in the US had been rising since the late 1960s, and it climbed higher in the 1970s. Monetarists argued that inflation comes from money growing faster than output, so only slower money growth could bring it down for good. They opposed controls on wages and prices.
The key ideas
Can you name the four key ideas of monetarism?
Summed up as MV = PQ: the money supply (M) times velocity (V) equals the price level (P) times output (Q). Monetarists read it from left to right, so faster money growth raises spending, and prices rise if output cannot keep up.
Can you think of an example?
The money supply grows by 10 per cent in a year, velocity holds steady and output grows by 2 per cent. The equation points to prices rising by about 8 per cent.
Velocity is the number of times a year the average pound is spent on goods and services. Monetarism assumed it was steady and predictable, which made money growth a reliable guide to spending.
Can you think of an example?
If each pound is spent twice a year, £1 trillion of money supports £2 trillion of spending.
In the long run, money growth changes only prices. In the short run, and after a lag, it also moves output and jobs.
Can you think of an example?
Faster money growth lets firms sell more and hire for a year or two. Then prices catch up.
The central bank announces how fast a chosen measure of money should grow, and runs policy to keep it on that path. Monetarists argued against using government spending and taxes to steady demand, and left that job to money growth.
Can you think of an example?
A central bank sets a target range for money growth of 7 to 11 per cent this year and a lower range next year, to bring inflation down step by step.