Monetarist Theory

What Is Monetarist Theory?

The monetarist theory is an economic concept that battles that changes in money supply are the main determinants of the rate of economic growth and the behavior of the business cycle. At the point when monetarist theory works in practice, central banks, which control the switches of monetary policy, can apply a lot of power over economic growth rates.

The contending theory to the monetarist theory is Keynesian economics.

Grasping Monetarist Theory

As indicated by monetarist theory, in the event that a country's supply of money increases, economic activity will increase — and vice versa.

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

General price levels will generally rise more than the production of goods and services when the economy is nearer to full employment. At the point when there is slack in the economy, Q will increase at a quicker rate than P under monetarist theory.

In the U.S., the Federal Reserve (Fed) sets monetary policy without government obstruction. The Fed operates on a monetarist theory that spotlights on keeping up with stable prices (low inflation), advancing full employment, and achieving consistent gross domestic product (GDP) growth.

Controlling Money Supply

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

• The reserve ratio: The percentage of reserves a bank is required to hold against deposits. A lessening in the ratio empowers banks to loan more, in this way expanding the supply of money.
• The discount rate: The interest rate the Fed charges commercial banks that need to borrow extra reserves. A drop in the discount rate will urge a bank to borrow more from the Fed and consequently loan more to its customers.
• Open market operations: Open market operations comprise of buying and selling government securities. Buying securities from large banks increases the supply of money, while selling securities contracts diminishes the money supply in the economy.

Illustration of Monetarist Theory

Previous Federal Reserve Chair Alan Greenspan was a defender of monetarist theory. During his initial a very long time at the Fed in 1988, he increased interest rates, decreasing growth and raising inflation rates, which nearly contacted five percent.

The U.S. economy tipped into recession during the mid 1990s. In response, Chair Greenspan helped economic possibilities by beginning on a rate-trimming binge that brought about 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 inclined to bubbles, coming full circle in the 2008 financial crisis and the Great Recession.

Features

• As per monetarist theory, money supply is the main determinant of the rate of economic growth.
• It is administered by the MV = PQ formula, in which M = money supply, V = velocity of money, P = price of goods, and Q = quantity of goods and services.
• The Federal Reserve controls money in the United States and uses three primary switches — the reserve ratio, discount rate, and open market operations — to increase or diminish money supply in the economy.