User:Nick Gardner /Sandbox

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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

in which M is money stock, V the velocity with which money circulates, P the average price level and T the number of transactions.  An implication of that equation is  that if  V and  T can be assumed constant,  an increase in the  money supply (will produce a corresponding increase in the general level of prices. 

Monetarism is founded upon the contention that for practical purposes, V and T can be assumed constant.  Its validity  thus  depends upon the empirical confirmation of that assumption. 

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.