Monetarism is one of the economic schools of thought, which states that the money supply (the total amount of money in an economy) is the chief determinant on the demand-side of short-run economic activity. Monetarism was largely spread by the leading monetarism exponent, Milton Friedman who had created a macroeconomic theory that money supply should remain steady in order for the economy to grow. Monetarism is largely different from Keynesian economic school of thought in which they state that the government is the chief determinant. Although both schools of thoughts have their strength and weaknesses, this paper will focus largely on monetarism. Is monetarism a valid economic theory? In other words, how well does Monetarism predict the economic movements particularly by the money supply? But before finding and plotting out answers, the monetary theory must be well defined.
The origin of monetarism dates back to 1945 when an American economist Clark Warburton was first credited for making the first solid monetarist interpretation of the business cycle. During this period however, monetarism was not well-known throughout the economy largely because economies did not severely experienced any major inflations as they remained stable and Keynesian economics were working up until the 1960s. However in the 1970s, economies around the world experienced high inflation and hyperinflations due to economic crises, oil shocks, slow growth, and high unemployment. Governments all over the world experienced high debt and stagflation, which is a state of high inflation and high unemployment. The Keynesian theory, which advocated increase in government spending, did not seem to have any effect during this period since spending more simply increased inflation. Thus key political leaders such as Margaret Thatcher from the UK and Ronald Reagan from the US changed their economy to monetarism. The theory found favor among other central banks and the Federal Reserve in the US. In theory, the monetary policy looked reasonable.
However, there is a great problem with monetarism, which is the extreme difficulty to measure the total amount of money circulating the economy. This is because of the countless amounts of money transactions occurring in the economy every single moment. For example in Australia alone, there are about 16.1 million credit card transactions every day making the total amount of transactions even greater. Likewise, the underground economies prevent the economy to count the accurate amount of money in circulation.
The Reserve Bank of Australia, like many other banks, measures the money circulation using a range of definitions and aggregates:
• M1: currency bank and the currency deposits of the private non-bank sector
• M3: M1 + all other bank deposits of the private non-bank sector