Monetarist Model - Online Tutor, Practice Problems & Exam Prep

The Monetarist Model, developed by Milton Friedman, emphasizes the importance of the money supply in economic stability, contrasting with Keynesian Economics, which advocates for government intervention. The model is grounded in the Quantity Theory of Money, expressed as $M^{1}V=P^{1}Y$, where M is money supply, V is velocity, P is price level, and Y is real GDP. Monetarists believe that a stable velocity allows for controlled increases in money supply to foster economic growth, although this approach faced criticism during the inflationary period of the 1970s and 1980s.

Monetarist Model

Throughout this course, we're focused mainly on Keynesian Economics. Let's quickly discuss another model called the Monetarist Model. So the Monetarist Model argues that Keynesian Economics overstated the instability in the economy. Remember that Keynesian Economics focused on government intervention. Government intervention to fight inflation and to fight recessions as well. Right? Government intervention was always necessary, and they also thought that there were sticky wages and prices. However, the Monetarist models had a few different opinions. It was developed by Milton Friedman, who was a Nobel Prize-winning economist. He won a Nobel Prize around the 1970s, but he developed this theory in the 1940s. So the basis of monetarism is the primary focus on the money supply. Okay? They spend a lot of time thinking about the money supply. And remember, when we studied the money supply, this is controlled by the Fed, right? The Federal Reserve is the central bank in the United States and they control the money supply in the United States, okay? So, they didn't believe in this instability in the economy. They did believe that competitive markets led to a high degree of stability. So we didn't need so much intervention to keep the economy in check.

So the main thing with the monetarist model is the quantity theory of money. Okay? And we have a whole other video where we go a lot deeper into the quantity theory of money, and we'll talk about this in a lot more detail. So the quantity theory of money; it's a theory that connects the money supply with the level of prices. It basically holds the whole quantity theory of money as based on this formula right here:

M∙V=P∙T

Where:

• M = money supply,
• V = velocity of money,
• P = price level,
• T = real GDP.

The velocity of money, think about when you have a dollar and you spend that dollar. That same dollar gets spent again. You go to the store and you buy a soda with that dollar. The store takes it and puts it in the bank. The bank loans it to someone else. That same dollar goes through the system several times in a year, right? So that's the velocity of money. It's how often $1 gets spent; it changes hands over and over throughout the course of the year. Whereas the money supply is the number of dollars there are. So the number of dollars times how many times those dollars are spent, that's going to equal the price level, how much things cost times real GDP, what's being produced. Okay? So that's the whole theory, the quantity theory of money, that the monetarist model follows.

The monetarist model believes that the velocity of money is stable. So the velocity of money is thought to be pretty much always the same every year. They thought that the velocity of money was stable; each dollar gets spent the same amount of times year over year. So what they thought is by steadily increasing the money supply, they'll be able to increase real GDP. So real GDP will consistently grow with the increases in the money supply, it'll increase growth in spending and GDP. However, the monetarist model got a lot of hype and was used in the early 1980s and it influenced monetary policy quite a lot in that era. But during this era, inflation soared, and it led people to think that monetarism was flawed. So that's the main thing about the monetarist model, this quantity theory of money. We'll have another video where we discuss that. But for now, that's basically all we need to know about monetarism in this class. Alright? Let's go ahead and pause and we'll move on to the next video.

Here’s what students ask on this topic:

What is the Monetarist Model in economics?

The Monetarist Model, developed by Milton Friedman, emphasizes the importance of the money supply in maintaining economic stability. Unlike Keynesian Economics, which advocates for government intervention to manage economic fluctuations, the Monetarist Model focuses on controlling the money supply. The core of this model is the Quantity Theory of Money, expressed as $MV=PY$, where $M$ is the money supply, $V$ is the velocity of money, $P$ is the price level, and $Y$ is real GDP. Monetarists believe that the velocity of money is stable, allowing for controlled increases in the money supply to foster economic growth.

Who developed the Monetarist Model and when?

The Monetarist Model was developed by Milton Friedman, a Nobel Prize-winning economist. He formulated this theory in the 1940s, although it gained significant attention and influence in the 1970s and early 1980s. Friedman's work emphasized the critical role of the money supply in economic stability and growth, contrasting with the Keynesian focus on government intervention.

What is the Quantity Theory of Money?

The Quantity Theory of Money is a fundamental concept in the Monetarist Model. It connects the money supply with the level of prices and real GDP. The theory is expressed by the equation $MV=PY$, where $M$ is the money supply, $V$ is the velocity of money, $P$ is the price level, and $Y$ is real GDP. Monetarists believe that the velocity of money is stable, meaning that changes in the money supply directly affect the price level and real GDP.

How does the Monetarist Model differ from Keynesian Economics?

The Monetarist Model and Keynesian Economics differ primarily in their approach to economic stability and growth. Keynesian Economics advocates for active government intervention to manage economic fluctuations, focusing on fiscal policies to combat inflation and recessions. In contrast, the Monetarist Model, developed by Milton Friedman, emphasizes the importance of controlling the money supply. Monetarists believe that a stable velocity of money allows for controlled increases in the money supply to foster economic growth, reducing the need for government intervention.

Why did the Monetarist Model face criticism during the 1970s and 1980s?

The Monetarist Model faced criticism during the 1970s and 1980s due to the high inflation rates experienced during this period. Despite the model's emphasis on controlling the money supply to maintain economic stability, inflation soared, leading many to question the effectiveness of monetarist policies. Critics argued that the model's assumptions, such as the stable velocity of money, did not hold true in practice, and that other factors, such as supply shocks and external economic conditions, also played significant roles in influencing inflation and economic stability.