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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.


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" [1] 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

The first question - whether the velocity of circulation is in fact constant - cannot be tested directly because it is not a directly measurable quantity. It can be tested indirectly, however, by examining the relationship between the monetary value of national income (PT) and the money supply (M). Casual examination of the published statistics indicated that if such a relationship exists, it could not be a simple one: national income does not rise and fall with the money supply on a month-by-month basis. But that is not the end of the matter - it would not be reasonably to expect the national income of a complex economy to respond instantaneously to a change in its money supply. Econometric techniques were used to test for relationships that incorporate time-lags, and they revealed a strong association between the money supply and national income, with the money supply changes preceding the associated income changes. An analysis of United States statistics [2], indicated that price increases had, in fact, followed money supply increases, but with time-lags that were long and variable. Other results, using both British an American data, confirmed that finding, although they generally showed shorter time-lags. It was also found that the velocity of circulation implied by their findings had not been constant, but that it was concluded that its variation does not matter in practice because it had been slow and steady [3].

Those findings were not universally accepted as conclusive, however, because the possibility remained that it had been the changes in national income had caused the change in the money supply. Work done by economists at the Bank of England suggested that it may, in fact be a two-way relationship with causation running both ways[4]. In that possibility, and of possible shortcomings of the econometric techniques that had been used, some economists considered that more evidence would be needed before the monetarist thesis could be accepted as conclusively proved, and further tests were set up to examine the "transmission mechanism" by which changes in the money supply could create changes in national income.

The transmission mechanism

In the "helicopter money" version, the transmission mechanism was obvious: those who picked up the money would spend it on goods, and since the supply of goods would not be affected, that would bid up their price. That explanation would hold provided that the money could only be spent on goods, but it need not hold if the money could also be spent on financial assets. Keynesian theory implies that it would all be spent on financial assets so that there would be no tendency to bid up the price of goods. Monetarists do not accept that people draw such a distinction between goods and financial assets, but see both as yielding a return, with physical assets such as houses and cars yielding returns that are no less real for veing unmeasurable, and that, in response to a change in the money supply they adjust their entire portfolio in such a way that at least part of it the money is spent on goods. The difference between Keynesian and monetarist theory in this respect thus turns upon the proportion of the additional money that is spent on goods. If people treat interest-bearing financial assets such as building society deposits as close substitutes for money, then the bulk of the adjustment might take the form of purely financial assets, with relatively little being spent on goods, but such a purchase might be a mainly temporary arrangement so that the bulk of the money is eventually spent on goods. [5]


Employment effects

Exchange rate effects

Technical problems

Practical experience

Current practice


  1. Quantity Theory of Money (CEPA)
  2. Friedman and Meiselman The relative stability of monetary velocity and the Investment Multiplier in the United States 1897-1958 in Stabilisation Policies, CMC Research Papers p165 Prentice-Hall 1964
  3. Charles Goodhart: Monetary Theory and Practice, page 44, Macmillan, 1984
  4. Charles Goodhart: Monetary Theory and Practice, page 87, Macmillan, 1984
  5. Mathias Zurlinden:Credit in the Monetary Transmission Mechanism: An overview of some recent research using Swiss data, Swiss National Bank, November 2003
  6. Peter N. Ireland The Monetary Transmission Mechanism, Prepared for The New Palgrave Dictionary of Economics, 2005