Monetarism

This school argues that disturbances within the monetary sector are the principal causes of instability in the economy. According to monetarists, the money supply is the principal determinant of the levels of output and employment in the short run and the price level in the long run. It is based upon the monetarist formulations of the demand for money function and the transmission mechanism.

Friedman's Demand for Money Function

The demand for money is viewed as being stably related to a few key variables. Monetarists argue that the demand for money is no longer a function solely of the interest rate and income, but that the rate of return on a much wider spectrum of physical and financial assets will influence an individual's demand for money.According to Milton Friedman, money is only one way of holding wealth. Wealth can be held in other forms such as bonds, equities, physical goods and human capital. Individuals act in such a way as to ensure that the rate of return at the margin is equal across the complete range of physical and financial assets that they could purchase. If wealth increases more money is demanded. If either the bond or equity interest rate increases, individuals demand less money since bonds or equities are now relatively more attractive to hold than money. Similarly, if rate of inflation rises, it becomes relatively more expensive to hold money as it depreciates in value during inflation. As a result, if the expected inflation rate rises, the amount of money demanded will be reduced. The ratio of physical capital to human capital and the variables which affect tastes and preferences are assumed to be constant in the short run. Thus, money is seen as being substitute for all other assets and the demand for money is therefore a function of the rates of return on all the other assets.

In contrast, of course, money was seen as a substitute for financial assets only in the Keynesian economics and thus, it was the rate of return i.e. the interest rate, that influenced the demand for money. However, in practice if the rate of return across all physical and financial assets moves to equality then the interest rate will clearly serve as a proxy for these. Thus the modern quantity theory of the demand for money can be represented in similar fashion to that of Keynes as follows:

Though both the schools use this functional form in empirical work, the underlying theories, however, are very different. Monetarists maintain that the demand for money function is better determined statistically than either the consumption or investment demand function and this shows their preference for monetary policy rather than fiscal policy.

Friedman's formulation of demand for money function is significant, because with an increase in the money supply various portfolio adjustments occur. These adjustments are very crucial to the monetarist view of the transmission mechanism.

In most versions of the IS-LM model, the money supply is assumed to affect income through the interest rate and investment. According to monetarists adjustment takes place over a broad range of assets and that the IS-LM framework is too narrow to capture the essence of the adjustment process. As a result they offer an alternative view of the adjustment or transmission mechanism.

For example, if the country's central bank increases the money supply through open market purchases of Treasury securities, according to Friedman and others, the effects are two-fold: the price of the securities increases, thereby reducing the yield, and the composition of the public's portfolio (collection of assets) is altered. The public now holds more money and fewer securities. Since the public does not want to hold this much money, individuals try to rearrange their portfolios so as to reduce their money holdings. For example, suppose they first attempt to purchase marketable securities. As the purchases take place, security prices increase and yields decrease. As a result, the demand for other assets, including equities and real assets such as houses and land, increases. With the increase in demand, the prices of these assets increase. The increase in the price of real assets has, according to Friedman, some additional effects. With higher prices, the production of real assets is stimulated and the demand for resources used in their production increases. Moreover, increase in the price of these assets means that the price is higher relative to the prices of services. For example, it is now relatively less costly to rent an automobile than to buy one. Thus, the demand for services increases correspondingly.

To summarize, an increase in the money supply results in increased expenditures for financial and real assets and for services. The increases in expenditures include rise in both investment and consumption spending.

Thus, the monetarists, led by Friedman conclude that an increase in the money supply leads to a significant increase in aggregate demand. In the short run, an increase in the money supply results in increase in both output and the price level. In the long run, increase in the money supply affects mainly the price level. Friedman believes that the long run growth rate of output is determined by real factors, such as the saving rate and the structure of industry. Thus, in the long run, more rapid increases in the money supply result in higher rates of inflation, but not higher growth in real output and employment.