Monetarist Theory

What Is Monetarist Theory?

The monetarist theory is an economic concept that contends that changes in money supply are the most significant determinants of the rate of economic growth and the behavior of the business cycle. When monetarist theory works in practice, central banks, which control the levers of monetary policy, can exert much power over economic growth rates.

The competing theory to the monetarist theory is Keynesian economics.

Understanding Monetarist Theory

According to monetarist theory, if a nation's supply of money increases, economic activity will increase — and vice versa.

Monetarist theory is governed by a simple formula: MV = PQ, where M is the money supply, V is the velocity (number of times per year the average dollar is spent), P is the price of goods and services and Q is the quantity of goods and services. Assuming constant V, when M is increased, either P, Q, or both P and Q rise.

General price levels tend to rise more than the production of goods and services when the economy is closer to full employment. When there is slack in the economy, Q will increase at a faster rate than P under monetarist theory.

In the U.S., the Federal Reserve (Fed) sets monetary policy without government interference. The Fed operates on a monetarist theory that focuses on maintaining stable prices (low inflation), promoting full employment, and achieving steady gross domestic product (GDP) growth.

Controlling Money Supply

In the U.S., it is the job of the Fed to control the money supply. The Fed has three main levers:

Example of Monetarist Theory

Former Federal Reserve Chair Alan Greenspan was a proponent of monetarist theory. During his initial years at the Fed in 1988, he increased interest rates, decreasing growth and raising inflation rates, which almost touched five percent.

The U.S. economy tipped into recession during the early 1990s. In response, Chair Greenspan boosted economic prospects by commencing on a rate-cutting spree that resulted in the longest period of economic expansion in the history of the U.S. economy. A loose monetary policy of low interest rates made the U.S. economy prone to bubbles, culminating in the 2008 financial crisis and the Great Recession.