Business Cycles Explained: Monetarist Theory

Monetarism is a commonly known philosophy of macroeconomics often associated with Milton
Friedman, but it's actually centuries old. Monetarism is the view that money supply growth
really matters for the business cycle. Milton Friedman in particular advocated a regime
where money supply growth would be kept very stable. In his opinion, if money supply growth
was too rapid, you would get excess inflation. If money supply growth was too slow, you would
get a downturn because Friedman like John Maynard Keynes believed a lot of wages and
prices were sticky, and thus decreasing that nominal flow of expenditure would cause an
economy to contract. Friedman was famous for suggesting that the Great Depression was largely
caused because in the period 1929 through 1932 the Federal Reserve allowed the money
supply in this country to contract very radically.
[Example: 1970s Stagflation]
Here's a good example of an economic downturn that came about and can be partially explained
by monetarism. In 1979 in the United States, rates of price inflation and rates of interest
were very high. Paul Volcker, who was running the Federal Reserve System, decided inflation
was too high, and he applied the monetary brakes, so to speak. This was probably necessary,
but it meant strong deflationary pressures on the American economy, and from 1979 to
1982 we had a sharp downturn with a lot of unemployment and a lot of that can be explained
by monetarist doctrine.
[Strengths & Weaknesses]
What are the strengths and weaknesses of monetarism? The biggest strength of monetarism, I think,
is that it predicts a lot of cases where the central bank pulls back on money supply growth
and economies then slow down or go into recession, and monetarism is a fairly good explanation
of how that happens.
Monetarism however, has bigger weaknesses when trying to explain what we should do to
prevent this. The core recipe of monetarism is to control the rate of growth of the money
supply. But which money supply? There are different measures of the money supply; they
don't all move in tandem. And in practice, central banks have found it's not very easy
to follow some simple rule of saying, "The money supply should grow at 3 percent a year,"
or anything like that. That hasn't worked in practice. It tends to lead to too much
volatility. So in terms of policy prescriptions, monetarism is a bit naïve, but its core diagnosis,
that deflanationary pressures lead to downturns, is essentially correct.