Monetarist Revolution: Meaning, Features and Criticisms

In this article we will discuss about:- 1. Meaning of Monetarist Revolution 2. Features of Monetarist Revolution 3. Criticisms.

Meaning of Monetarist Revolution:

The “monetarist revolution” refers to the new and important contributions made to monetary theory and policy by Prof. Friedman and his colleagues at the University of Chicago. It was a sort of revolution against the views of Keynesians who held the view that “money does not matter.”

The Keynesians regarded the money supply as a passive factor in the economic system whose economic effects were highly unpredictable. On the other hand, in the monetarist revolution “only money matters” for three reasons: one, because the quantity of money is capable of being controlled fairly accurately by deliberate policy; two, because changes in the quantity of money can produce substantial changes in the flow of income, prices and other important variables; and three, because the” relationships between stock of money and other assets are relatively stable and dependable.”

Features of Monetarist Revolution:

The monetarist revolution possesses the following characteristics:

1. The money supply is the crucial determinant of economic activity in the short-run.

It is the money supply that determines total spending, and therefore, output, employment and the price level. Thus there is a direct link between the money supply and the national income. That link is the constant velocity of money. The constant velocity is expressed as Y/M.

As a result of the stability of monetary velocity, a change in the money supply will change total spending and national income by a predictable amount. The demand for money is a stable function of income.

The demand for money is the transactions demand for money which is determined by the level of income. If the central bank increases the money supply by purchasing securities, people who sell securities find that their holdings of money have increased. They will, therefore, spend their excess holding of money partly on assets and partly on consumer goods and services.

This spending will reduce their money balances and at the same time raise the national income. On the contrary, a reduction in the money supply by selling securities on the part of the central bank will reduce money holdings of the buyers of securities.

They will, therefore, increase their money holdings partly by selling their assets and partly by reducing their consumption expenditure on goods and services. This will reduce the national income. Thus, on both counts, the demand for money remains stable.

According to Friedman, a change in the money supply causes a proportionate change in the price level or income or both. Given the demand for money, if the economy is operating at less than full employment level, an increase in the money supply will raise output and employment with a rise in total expenditure in the short-run. An increase in the money supply causes national income to rise because with excess money supply, people start spending more until the demand and supply of money are equal.

Thus an increase in the money supply in the short run raises output, employment and income. But a rise in the money supply in the long-run, with further increase in demand, prices and wages will increase. In the expectation of inflation, price-wage spiral will rise further. Thus there will be inflation due to inappropriate increase in money supply. That is why the monetarists regard inflation as a purely monetary phenomenon.

The monetarists regard their viewpoint as revolutionary as against the Keynesians because the rate of interest plays no part in influencing either the demand for money or the supply of money. Moreover, changes in the money supply influence economic activity directly and not indirectly through changes in the interest rate like the Keynesians.

2. The transmission mechanism of monetary influences on economic activity involves reshuffling of both financial and real assets in the portfolios of economic units:

Keynes considered only two types of assets, bonds and speculative cash balances, in his transmission mechanism. According to the monetarists, when the central bank increases the money supply by purchasing securities in the open market, their prices rise but yields fall due to a fall in the market rate of interest.

People will, therefore, sell securities, and their holdings of money will increase. This raises the demand for financial and real assets. This will lead to the substitution of excess money balances for financial assets and durable consumer goods. The increase in aggregate expenditure on assets and goods will tend to raise the national income. This is the substitution effect of the portfolio adjustment process.

Further, when money is converted into securities with their purchase in the open market, the nominal wealth of the community increases. This is the direct wealth effect. Again, with the fall in the market rate of interest, the market value of current capital stock increases which also raises the nominal wealth of the society.

This is the interest induced effect of wealth effect. But these effects increase the net wealth. Consequently, people buy financial and real assets which lead to the production of new producer and consumer durables goods and encourage the purchase of consumer non-durable products.

In the monetarist system, a central bank cannot influence interest rates through changes in the supply of money. If it tries to reduce the interest rate by releasing large quantity of money, this will only cause inflation since the economy is already at near-full employment level. In fact, this will reduce the real money supply and increase interest rates.

3. In the long-run the level of real national income is determined by the forces of demand and supply:

This is based on the assumptions that prices and wages in all markets are inherently flexible. They rise in response to excess demand and fall in response to excess supply. If some prices are inflexible, the burden of their adjustments would fall on other products.

Thus the economy is usually at or near the full employment level where there is no involuntary unemployment. Friedman refers to this as the natural rate of unemployment. This view is in marked contrast to the Keynesian view that there is always underemployment equilibrium in the economy and unemployment is involuntary.

4. The monetarists hold that the economy is stable:

They do not believe like the Keynesians that it is subject to wide or sudden fluctuations due to changes in the propensities to consume and invest. According to them, instability exists in the economy on account of monetary and fiscal policies adopted by the government.

These policies destabilise rather than stabilise the economy. Friedman does not favour even contra cyclical monetary policy. According to him, monetary policy might do more harm than good because of the operation lag. On average, it takes a long time for a change in the money supply to affect national income.

The time lag involved is so large that contra cyclical monetary policy might actually have a destabilising effect on the economy. Fiscal policy has no place in the monetarist system. It does not affect the economy unless it is accompanied by changes in the money supply. So there is no need for fiscal policy as the same results can be achieved by monetary policy.

However, to stabilise the economy and avoid inflation, Friedman advocates a steady and inflexible growth in the rate of money supply. When the money supply increases at the same rate as output, the national income grows without inflation.

5. Expectations play an important role in the monetarist’s view:

Every person whether he is a businessman, consumer or worker is capable of correctly anticipating the effects of his own and other persons’ actions. The monetarists hold that expectations are rational. “Decisions taken on the basis of such expectations will cause the anticipated future results to occur even more quickly, if not at once. Thus intelligent expectations are self- reinforcing and stabilising, so long as the government does not create false signals by erratic and irrational intervention.”

They have revolutionised economic thinking through the rational expectations hypothesis, e.g., the rational expectationists deny the possibility of any inflation-unemployment trade-off even in the short run. Economists regard the above views of the monetarists as revolutionary.

Criticisms of Monetarist Revolution:

Prof. Kaldor does not regard the above views of the monetarists as revolutionary. He characterizes them as a “counter-reformation—the reaction against the new economics of the 1930s and return to 19th century orthodoxies.”

He and many Keynesians have criticised the monetarist tenets on the following grounds:

1. Money Supply Endogenous:

The supply of money is varied by the monetary authorities in an exogenous manner in Friedman’s system. But the fact is that in the United States the money supply consists of bank deposits created by changes in bank lending.

Bank lending in turn, is based upon bank reserves which expand and contract with:

(a) Deposits and withdrawals of currency by non-bank financial intermediaries;

(b) Borrowings by commercial banks from the Federal Reserve System;

(c) Inflows and outflows of money from and to abroad; and

(d) Purchase and sale of securities by the Federal Reserve System.

The first three items definitely impart an endogenous element to the money supply. Thus the money supply is not exclusively exogenous, as assumed by Friedman. It is mostly endogenous.

2. Demand for Money not Stable:

Regarding the stability of the demand for money, Prof. Kaldor found that the demand for money as a proportion of income is neither stable between countries nor stable over time except in some countries.

3. Money Supply and GNP not positively correlated:

Money supply and money GNP have been found to be positively correlated in Friedman’s findings. But Kaldor found his evidence to be largely irrelevant. For example, he found that in Switzerland, Italy and Japan, the money supply on the broad definition, M₃ had been rising for over twenty years in relation to incomes, while it had been falling in the US and the UK. Even on the narrow definition, M,, the money supply in Switzerland was nearly three times as great as in the UK or the US as a proportion of the GNP. From this, he concludes that “yet no one would regard Switzerland as an ‘inflation prone’ country (let alone more inflation prone) than the US cr the UK.”

4. Neglects the Role of NBFIs:

The transmission mechanism explained by the monetarists has also been questioned. The Radcliffe Committee and Gurley and Shaw criticize the monetarist transmission mechanism for neglecting the role played by the non-bank financial intermediaries and their effects on real and financial assets.

5. Real World does not approximate to a General Equilibrium System:

The monetarist view that prices in all markets are completely flexible, is based on the Walrasian general equilibrium model of the economy. This implies that the economy is at the full employment level. Critics point out that wages and prices do not adjust themselves simultaneously in the Walrasian sense.

In fact, trade unions are engaged in wage bargains with the rise in prices in the past. Similarly, entrepreneurs try to adjust their reduced profit margins which have been eroded by inflation. This further increases inflation. As pointed out by Kaldor, the monetarists failed to recognise the all-important difference between a demand inflation and cost-inflation. Thus the real world does not approximate to a general equilibrium system.

6. Economy not inherently stable:

The monetarists contend that the economy is inherently stable and it is interference in the form of monetary policy that brings instability. This view has not been accepted by the Keynesians who argue that there are frequent wild and erratic shocks in the economy due to variations in investment and consumption spendings that produce business cycle. This necessitates appropriate contra cyclical monetary and fiscal policies.

7. Money Supply fails to grow at a Smooth and Steady Rate:

Further, to stabilise the economy and avoid Inflation, the monetarists favour a steady growth in the rate of money supply, and the rate of intent no place in their policy-frame. But the experience of both the US and the UK tells a different story where the monetarist monetary policy was put into operation in 1979-80.

“The money supply failed to grow at a smooth and steady rate; its behaviour exhibited a series of wriggles. The rate of interest and the rate of inflation, though both were very high at the start, soared to unprecedented heights in a very short time.” Thus on the basis of above criticisms, it can be concluded that the monetarist viewpoint was not a revolution but a sort of reformation of the Keynesian economics and the revival of the orthodox monetarism.