Figure 2
Imagine that we are first at point A. This level of unemployment is deemed unacceptable to the government, therefore, policies to stimulate aggregate demand are put in place, which leads to more demand for labour and more employment. As a consequence, this drives up nominal wages, or wages that haven’t been adjusted for inflation, and, as explained above, causes inflation to rise. This is shown by a movement from point A to point B in Figure 2. Monetarists argue that workers will then take account of the higher inflation and realise that the purchasing power of real wages, or wages adjusted for inflation, has decreased. Thus workers will reduce the amount of labour they want to supply at this wage point and, unless real wages are increased, the curve will shift from SRPC1 to SRPC2. We have now gone from point B to point C; unemployment has shifted back to its original level but now with higher inflation.
The monetary position on unemployment lays out the case for a ‘natural rate of unemployment’, which is where the actual rate of inflation and the expected rate of inflation are equal. This is the vertical long run Phillips curve in Figure 2 above. On this curve, the economy is at the natural rate of unemployment, where expectations are in line with the current rate of inflation. This again feeds the monetarist argument that governments should not attempt to micromanage the economy, rather the economy will self-regulate and return to the long-run state.
The rise and fall of the monetarists
“The rapid inflation of the 1970s and early 1980s turned the nation’s attention away from the main concern of Keynesianism – unemployment – to the concern of Fisher and Friedman – inflation.” According to Brue and Grant in their book, The Evolution of Economic Thought [2012], this moment in history led to a major break with Keynesianism as monetarism rose to the fore. To many policy makers it seemed that monetarists had the answers to the problems of inflation and slow economic growth. Leaders in both the US and the UK, namely the new Chairman of the Federal Reserve, Paul Volcker, and the then British Prime Minister Margaret Thatcher, put in place policies to reduce the money supply through setting targets around the money growth rate. The aim was also to reduce expectations around inflation in an attempt to reduce demands for higher wages. Interventions included raising interest rates, as well as cutting spending.
While the policies were successful in cutting inflation, they also led to deep recessions in both the US and the UK, characterised by soaring unemployment. Strict monetarist policies were ultimately abandoned by both governments. The predictability of the velocity of money, which Friedman and Schwartz had charted across nearly a century, started to fail. A breakdown in the relationship between money supply, prices, and economic growth followed. The authorities at the time cited possible reasons, including changes to financial regulations and new financial innovations. However, they also argued that monetarist theories were incredibly difficult to put into practice.
So, what became of monetarism?
As our understanding of economics has evolved, the dividing lines between different schools of economic thought have become less distinct. Despite the apparent failure of monetarist policies in the 1980s, monetarist ideas have had a profound effect on the development of economic theory and policy. For example, monetary policy remains an important tool for maintaining economic stability today. Although central banks abandoned targeting the money growth rate, inflation targeting, or setting an explicit target for inflation, has become the main policy of many central banks. The monetarist inclusion of expectations in economic theory and modelling has also been subsumed into mainstream thinking, along with other key ideas, such as the natural rate of unemployment and the long run vertical Phillips curve. Of course, the debates over the necessity and extent of government intervention still rage on.
Of course, as Brue and Grant put it, given the constant evolution of economic thought, “a final assessment of these contributions must await the scrutiny of our children and grandchildren.”
Further Monetarism reading on Perlego
Keynesianism vs. Monetarism
Whatever Happened to Monetarism?
Keynes, the Keynesians and Monetarism
The History of Economic Thought
Recharting the History of Economic Thought
Bibliography
Brue, S and Grant, R. (2012) The Evolution of Economic Thought. Cengage Learning EMEA. https://www.perlego.com/book/801895/the-evolution-of-economic-thought-with-economic-applications-and-infotrac-2semester-printed-access-card-pdf
DeLong, J. (2000) ‘The Triumph of Monetarism?’ Journal of Economic Perspectives.https://pubs.aeaweb.org/doi/pdf/10.1257/jep.14.1.83
Friedman, M and Schwartz, A. (2008) A Monetary History of the United States, 1867-1960. Princeton University Press. https://www.perlego.com/book/733854/a-monetary-history-of-the-united-states-18671960-pdf
Galbraith, J. (2008) ‘The Collapse Of Monetarism and the Irrelevance of the New Monetary Consensus.’ The Levy Economics Institute of Bard College. https://www.levyinstitute.org/pubs/pn_08_1.pdf
Greenlaw, S, Taylor, T and Shapiro, D. (2017) Principles of Macroeconomics for AP® Courses 2e. OpenStax. https://www.perlego.com/book/695164/principles-of-macroeconomics-for-ap-courses-2e-pdf
Kurz, H and Riemer, J. (2016) Economic Thought: A Brief History. Columbia University Press. https://www.perlego.com/book/773903/economic-thought-a-brief-history-pdf
Jahan, S and Papageorgiou, C. (2014) ‘What is Monetarism?’ IMF. https://www.imf.org/external/pubs/ft/fandd/2014/03/pdf/basics.pdf
Rivot, S. (2013) Keynes and Friedman on Laissez-Faire and Planning. Routledge. https://www.perlego.com/book/715468/keynes-and-friedman-on-laissezfaire-and-planning-pdf
Vaggi, G and Groenewegen, P. (2016) A Concise History of Economic Thought. Palgrave Macmillan. https://www.perlego.com/book/3499940/a-concise-history-of-economic-thought-from-mercantilism-to-monetarism-pdf