Monetarism and Other Schools of Thought

Is Controlling The Money Supply The Answer??

Schools of Thought…..Monetarist government policies in the early 1980’s starting with Milton Friedman earlier believed that changes in inflation was largely due to changes in the money supply some time before. To achieve our inflation goals, we simply need to control growth of the money supply.

Here we see the relationship between CPI inflation and money growth in the US 1910 onwards…….Some correlation of course

This follows the old ‘quantity theory of money’ school of thought, which dominated before the emergence of Keynesian economics. Both these schools of thought do not believe that people will have money illusion, hence it will be only prices which change if we change the money supply, not employment/output(which defies the Animal Spirits).

The believed in the Neutrality of Money. If the money supply changes, only prices will change with equal step, nothing else.

Friedman’s K Percent Rule: Milton Friedman, believing macroeconomic stability depended on suitble rises in the money supply, believed that the money supply should, independent of the stage of the economic cycle, increase by a suitable constant year on year. Increases should be around the trend rate of growth.

Skepticism: Goodhart’s Law

The resurrection of this school of thought was short lived, only a few years in the early 1980’s before the academic world became skeptical that money supply control answered all of our problems.

Despite a very strong correlation between money supply and inflation, it became known that if we controlled one form of money strictly, other mediums would take up the function of money which we couldn’t control. This was best shown with the mid 1980’s Goodharts Law.

Goodharts Law: Controlling the money supply is like chasing one’s shadow. If we try to control the growth of money in it’s strict form(narrow money), other forms of ‘money’ will take it’s function(broad money and more). We cannot control the rate of interest by one form of money supply, neither inflation.

Example 1980’s: Quantitative controls of lending and required reserve ratios in the 1980’s attempted to restrict the money supply. Limited banks, however, issued credit through firms on their behalf which was outside the restraints applied. The private sector seemed to have outwitted the controls imposed, not stemming the money supply.


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