Understanding Monetarism

IMG_0131 Tower of LondonMany people confuse monetary policy with monetarism. Therefore they conclude that everything that goes wrong with monetary policy is a failure of monetarism.

Monetary policy is managing the overall/aggregate level of monetary demand in the economy whereas monetarism provides a set of principles which should be observed when pursuing monetary policy.

Without meaning to, it is reasonable to conclude that in the 50’s/60’s the UK, inadvertently, pursued a monetary policy that was much closer to the principles of monetarism than at any other time. The reason that it was inadvertent was the fact that the world observed the rules of the gold exchange standard. This meant that the money supply and monetary demand expanded sufficiently to avoid deflation or a rate of inflation that was not in line with our main trading partners. If any country on the gold exchange standard, with a fixed rate of exchange, allowed monetary demand to expand too fast, then they risked pressure on their exchange rate to devalue.

Having said this, and before coming up to date, it is necessary to establish two important propositions of monetarism.

Firstly, as Friedman stated in the First Wincott Memorial Lecture in 1970 “there is a consistent though not precise relation between the rate of growth in the quantity of money and the rate of growth of nominal income”. The reason it is not precise is that to convert money supply into monetary demand there is another variable to be added, and that is the velocity of circulation of money.

Secondly, there is a time lag between the change in money supply, which comes first, and the impact on nominal national income and this lag may be as long as one to two years. This means that what is happening to the money supply/monetary demand today will not impact on prices for more than a year.

Together these propositions mean that the money supply/monetary demand needs to expand fast enough to accommodate the growth in real output in the economy, and any rate of change faster than that requirement will manifest itself as inflation.

In addition to this, inflation is always seen as caused by excessive growth in monetary demand. It is not possible for there to be such a thing as cost push inflation. After all, any measure of inflation is always a monetary phenomenon i.e. more units of money used in the same number of transactions.

If all of this is correct, then every single measure of inflation tells you what has been happening to monetary growth in the past. It is never caused by those prices which are described as going up the most in the basket of goods used to measure inflation. In fact the B of E uses those numbers to deflect your attention away from their role in not achieving their target. The Bank knows that it can control the rate of inflation which is why it accepted a target for inflation when it became independent in 1997. It knew it could control the average level of prices even when it could not control oil prices, food prices, wages etc.

The propositions of monetarism, therefore, establish the rules for a sound monetary policy: the money supply and monetary demand need to grow at a rate slightly faster than the rate of growth of output. This is why we have a 2% inflation target. It is not possible for the CB to know precisely the rate of growth in output in the future. If it could, then it would target the ideal inflation number which is 0%. As it knows that deflations have damaging effects, it targets a positive number that it may overshoot or undershoot and therefore it gives itself a range between 1% and 3% before it is required to explain its mismanagement to the Treasury.

Any number for the change in the average level of prices which is outside 1% or 3% shows that the principles of monetarism have not been pursued. Any number close to 2% shows that monetarism is working.

N.B.

In “Understanding monetary policy: a synthesis of the old and new” I explain that the principles of monetarism are best followed by controlling the volume of money, not the price of money (interest rate), so you may like to read that blog, together with this.

J B Hearn 8/6/15

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5 thoughts on “Understanding Monetarism

  1. Hi, so I don’t understand how targeting money supply in aggregate works without regard for how money is used.

    So a monetary policy that targets core inflation but ignores asset booms will, as we have seen, lead to a bust and recession. One that includes assets may be too tight for the general more productive economy.

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    1. Monetary policy that misuses interest rates and moves them too far away from market rates creates damaging bubbles. It it possible to manage the quantity of money and monetary demand without using interest rate policy. Have a look at “understanding monetary policy” and “understanding and misunderstanding QE”

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      1. Hi, thanks for reply.

        So I’ve just read those and if I understand correctly you propose the BoE impose a quantity limit on private bank credit creation by specifying a cash to credit ratio?

        So private banks will create and allocate credit up to this ratio, would this be enough to prevent bubbles, e.g. lets say they their usual profit/risk calculations leads them to see mortgages as their main profit source. Each private sector bank creates credit up to their allowed ratio, profits on that feed back into their cash position which they allows them to lend more, which feeds back into their cash position etc. Eventually you have a self sustaining bubble feedback.

        It seems to be you have to care *how* credit is used just as much as the quantities created.

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  2. Yes in answer to your first question.
    And in response to your second paragraph: cash is limited in supply and can be precisely managed by the Central Bank. Interest rates will no longer be distorted and lending will be available under market forces to produce a more efficient allocation of resources. Real investment takes place rather than just shifting around the ownership of second hand assets which were/are inflating because of low rates of interest.

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