Quantity theory of money and Monetarism

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Key features of Monetarism

Key features of monetarism

  • Main cause of inflation is excess supply of money in an economy leading to 'too much money chasing too few goods'.
  • Tight control of money and credit is required to maintain price stability. 
  • Attempts by the govt. and central bank to 'fine-tune' AD with fiscal and monetary policy are ineffective. Fiscal policy can stabilise the economy provided the govt. can control their level of borrowing. 
  • The key is for monetary policy to be in control by an independent central bank so that people's expectations of inflation are controlled.
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How excess supply of money becomes inflation

  • Excess money balances held by households and firms affect demand (D) and output (O). Consumers will increase D for g/s and this increases AD. A large proportion of this increase in AD could be imports (M).
  • Some excess balances will be saved in the form of bonds or other FA's. Increased D for bonds causes bond r/i to go downwards which can stimulate an increase in investment (I).
  • Money that flows into housing will push house prices upwards which stimulates consumer wealth, borrowing and spending (similar to credit crunch).
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Quantity theory of money

  • Fisher's equation is MV=PY (basic explanation for link between price and money supply.
  • M is money supply, P is price, V is the velocity at which money is cicrulated and Y is the level of output (GDP).
  • Treat V and Y as constants because GDP not affected by monetary variables and V thought to remain constant because 'predictable'. This means M directly influences P.
  • Monetarist experiment of 80's and 90's shows that V is not predictable and direct link between money supply and inflation broke down. Not very relevant now.
  • Central banks don't have money supply targets but rather exchange rate and later inflation targets as part of monetary policy.
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Measuring money supply

  • M0 - Narrow money. Comprises of notes and coins. Changes in M0 supply thought to have little effect on real GDP or inflation. At best co-incident indicator of short term spending because any increase in M0 is thought to be solely for spending. Changes in M0 reflect but don't cause changes in economic cycle.
  • M4 - Broad money. Time and sight deposits (bank and building security) as well as money created by lending in the form of overdrafts and loans.
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