Question

The FED attempted to follow Monetarism in the 1980s to control inflation. Explain the theory of Monetarism. Explain why this theory failed in practice.

Answer 1

Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on national output in the short run and on price levels over longer periods. Monetarists assert that the objectives of monetary policy are best met by targeting the growth rate of the money supply rather than by engaging in discretionary monetary policy.

Monetarism is an economic theory that focuses on the macroeconomic effects of the supply of money and central banking. Formulated by Milton Friedman, it argues that excessive expansion of the money supply is inherently inflationary, and that monetary authorities should focus solely on maintaining price stability.

This theory draws its roots from two historically antagonistic schools of thought: the hard money policies that dominated monetary thinking in the late 19th century, and the monetary theories of John Maynard Keynes, who, working in the inter-war period during the failure of the restored gold standard, proposed a demand-driven model for money. While Keynes had focused on the stability of a currency’s value, with panics based on an insufficient money supply leading to the use of an alternate currency and collapse of the monetary system, Friedman focused on price stability.

In the late 1970s and early 1980s, after a decade of increasing influence, monetarism’s reputation began to decline for three main reasons. One was the growing belief, based on plausible interpretations of experience, that money demand is in practice highly “unstable,” shifting significantly and unpredictably from one quarter to the next. The second was the rise of rational expectations economics, which split analysts antagonistic to Keynesian activism into distinct camps.

During the 1970s, inflation rose in the United States, as well as in many other industrial nations, to levels unprecedented on a multiyear basis during periods of relative peace. This occurred as a consequence of various “shocks”—oil price increases, the Vietnam War, and especially the 1971–1973 demise of the Bretton Woods system of fixed exchange rates (itself caused largely by the failure of the United States to maintain the gold value of the dollar). This demise left central bankers with a major new responsibility; namely, to provide a nominal anchor for national fiat currencies to replace the gold standard. The Federal Reserve announced several times during the 1970s that it intended to bring inflation under control, but various attempts were unsuccessful. Then, on October 6, 1979, the Fed, under Paul Volcker’s chairmanship, announced and put into effect a new attempt involving drastically revised operating procedures that had some prominent features in common with monetarist recommendations. In particular, the Fed would try to hit specified monthly targets for the growth rate of M1, with operating procedures that emphasized control over a narrow and controllable monetary aggregate, nonborrowed reserves (i.e., bank reserves minus borrowings from the Fed). The M1 targets were intended to bring inflation down from double-digit levels to unspecified but much lower values.

In retrospect, the events that occurred from October 1979 to September 1982 are widely viewed as the crucial beginning of a necessary and successful attack on inflation that led, eventually, to the worldwide low-inflation environment of the 1990s. At the time, however, the “experiment” seemed anything but successful to many Americans. Short-term interest rates jumped dramatically in late 1979 under the tightened conditions, and 1980 witnessed a major fall in output in one quarter followed by a major jump in the next, due primarily to the imposition, and then removal, of credit controls. Finally, in 1981 and into the middle of 1982, a sustained period of monetary stringency brought about the deepest recession since the Great Depression of the 1930s and began to bring inflation down, more rapidly than many economists anticipated, toward acceptable values.

While some disagreement remains, certain things are clear. Interestingly, most of the changes to Keynesian thinking that early monetarists proposed are accepted today as part of standard macro/monetary analysis. After all, the main proposed changes were to distinguish carefully between real and nominal variables, to distinguish between real and nominal interest rates, and to deny the existence of a long-run trade-off between inflation and unemployment. Also, most research economists today accept, at least tacitly, the proposition that monetary policy is more potent and useful than fiscal policy for stabilizing the economy. There is some academic support, and a bit in central bank circles, for the real-business-cycle suggestion that monetary policy has no important effect on real variables, but this idea probably has marginal significance. It is hard to believe that the major recession of 1981–1983 in the United States was not caused largely by the Fed’s deliberate tightening of 1981—a tightening that shows up in ex-post real interest rates and in M1B growth rates as adjusted by the Fed at the time