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Monetarist prescription: target money supply to control inflation

Monetarist prescription: target money supply to control inflation
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First Published: Sun, Jul 27 2008. 10 05 PM IST

Updated: Sun, Jul 27 2008. 10 05 PM IST
If there is ever a graffiti competition among economists, then we think that Milton Friedman’s present day champions of what came to be known as “monetarism” would carry the day. While most other economists would be busy trying to figure out how to put their complex theories into simple and short graffiti, monetarists everywhere would be smearing the wall. They have so many handy messages—“Inflation is always and everywhere a monetary phenomenon”, “MV=PT”, “Long live the quantity theory of money”, “Always focus on money supply”, and so on.
Jinny: Whenever we face high inflation, monetarists start writing unsolicited messages. Recently, I read a message of one anonymous monetarist foretelling the doom of the world economy amid uncontrolled money supply.
I think the time has come to take the writings on the wall more seriously.
Johnny: Monetarists? Are they the new rowdy boys in town?
Jinny: Well, monetarists owe their existence to the old Quantity Theory of Money, or QTM.
The early 1980s were the heyday of monetarism, when reining in money supply was the latest fad in town.
In monetarisms such as QTM, the belief is that the level of prices in an economy depends on the volume of money. In other words, inflation depends on how much money is chasing goods and services.
Milton Friedman was a most ardent supporter of monetarism who argued all his life that governments should keep money supply under control. The money supply should be expanded only moderately each year for accommodating the actual growth of the economy.
To understand the concept behind monetarism, we first need to understand QTM in detail.
Johnny: What is QTM all about?
Jinny: QTM originated in the 16th century. QTM believes that prices of goods and services are determined by the quantity of money available for transactions.
If the entire economy only has Rs100 for buying goods and services, then the prices of all goods and services produced in the economy cannot exceed Rs100.
In case the quantity of money available for transactions is doubled, then prices would also double, thus causing inflation.
Irving Fisher(1867-1947) explained this whole wisdom through what is known as the Fisher equation: MV=PT, where M is money supply, V is velocity of circulation, that is, the number of times money changes hand, P is the average price level and T is the volume of transactions of goods and services.
This formula presumes that the velocity of circulation and the number of transactions remain constant at least in the short run.
So, what can we conclude from this equation? For a given velocity of circulation and number of transactions, any increase in money supply would lead to an increase in the price level.
Monetarists use this wisdom to emphasize that monetary policy should always focus on money supply. Monetarists have come out with their own operating principles for conducting monetary policy.
Johnny: What are the main operating principles of monetarists?
Jinny: Monetarists believe that central banks should firmly target growth in money supply and the same willautomatically take care ofinflation.
For controlling money supply, monetarists prescribe the use of direct instrument such as changes in cash reserve instead of changes in short-term interest rates.
Many central banks may not be comfortable with this prescription. They have always used short-term interest rates as their primary instrument for controlling credit growth and aggregate demand in the economy.
Make the pizza costlier and demand for it will automatically decline, leading to a decrease in supply. By the same logic, if we raise the interest rate then the demand for new loans would automatically decline, leading to a decrease in money supply.
Making pizza costlier or raising short-term interest rates requires market intervention. The monetarists follow a different line of argument.
Don’t worry about fixing the price of pizza; if you restrict the quantity of ingredients used, the supply of pizza will automatically decline.
So, the prescription of monetarists is, increase the cash reserve so that banks have less money for lending, which would lead to a decrease in money supply.
This prescription was widely tested during the 1980s by different countries, most notably the US under Ronald Reagan and the UK under Margaret Thatcher, but there are many points on which critics don’t agree with the monetarists’ prescription.
Johnny: What are the main points of criticism against monetarism?
Jinny: The critics say that the relationship between money supply and inflation is not as straight as presumed by monetarists. They argue that a decrease in money supply may lead to an increase in the velocity of circulation and thus may not affect the price level.
In an economy, how many times money changes hands depends on the impulses of the people holding money. Simply restricting money supply may not in itself control inflation.
However, we have many central banks that specifically target monetary aggregates. So, monetarism still has many supporters.
Jinny: That’s true, Jinny. I hope monetarists will keep guiding the world economy with their short and simple messages.
What:Monetarists believe that the level of prices in an economy is related directly to money supply.
How: Monetarists prescribe that the central banks should always target money supply to control inflation.When: Money supply should be expanded only moderately each year to accommodate the actual growthof the economy.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Jul 27 2008. 10 05 PM IST