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Monetarism is a theory that explains inflation as the inevitable consequence of an increase in the money supply and prescribes control of the money supply as the only means of controlling inflation.

Overview

A simplistic version of monetarism, offers an easily understood explanation of inflation and a straightforward prescription for its cure. It seems intuitively obvious that if pound notes were dropped by helicopter to the extent necessary to double the amount in circulation, then prices would double. It is a small step from that "thought experiment" to the conclusion that inflation is caused by an increase in the money supply, and it is an obvious further step to prescribe control of the money supply as the cure for inflation. However, the economists of the Chicago School did not take so simple a view, but accepted that, although such an explanation would hold in a primitive society , in which a single financial asset provided the only means of payment, it could not be assumed to hold in a modern society that has fractional-reserve banking and a variety of different financial assets.

The monetary equation

Monetarism is conventionally explained in terms of the "quantity theory of money" which derives from the equation

MV   =   PT

The right hand side of that equation consists of some measure of total physical output in a given period (denoted by T) multiplied by some measure of the price per unit of that output (denoted by P). The left hand side consists of the total amount of money in circulation multiplied by the number of times it is spent during that period (termed the "velocity of circulation" and denoted by V). The equation shows that if the velocity of circulation can be taken to be constant, and if it can be assumed not to be affected, then an increase in the quantity of money must lead to a proportional increase in prices.

As it stands, however, that equation is empty of content, being no more than the consequence of the assumptions that make it up. It acquires content only if the "if" statements in the above sentence can be shown to hold in practice. The substance of monetarism depends upon the empirical verification of those statements.

The behaviour of the velocity of circulation

An analysis of United States statistics , indicated that price increases had, in fact, followed money supply increases, but with time-lags that were long and variable. Critics argued that this was not conclusive proof, and further statistical tests were attempted to test it against the Keynesian theory that increases in the money supply would not affect the prices of goods because they would be spent on financial assets. The results did not give conclusive support to that alternative explanation, nor to the contention that it could safely be ignored.