Monetarist Theory of Inflation

What is the monetarist theory of inflation?

Milton Friedman’s and other monetarist economists views on the economy are known as the monetarist theory of inflation. Although the monetarist theory of inflation is in line with the demand-pull inflation theory, it places more emphasis on the belief that excess money supply causes excess aggregate demand. A major influence on this theory comes from the oldest inflation theory: the Quantity Theory of Money.

What is the quantity theory of money?

There are three important points to consider in regard to this theory:

1. The quantity theory of money states that inflation is caused by a continuous increase in the money supply.
2. The quantity theory of money describes a situation where the government supplies too much money in relation to national output. This leads to people having excess money, which increases the prices of goods and services.
3. The quantity theory of money was developed by economist Irving Fisher in the twentieth century. He developed the theory using a concept he called an equation of exchange.

The quantity theory equation of exchange

The quantity theory equation of exchange explains the process of how inflation happens in the economy. Let’s study it in detail.

Money supply (stock of money) X the velocity of circulation of money = price level X quantity of output

Alternatively, it can be written as follows: MV = PQ

Let’s say the stock of money (M) in the economy for a year is multiplied by the velocity of circulation (V), which corresponds to the speed at which money is circulated around the economy when people make purchases. This first part of the equation is equal to the price level (P) times by the quantity of real output (Q). In the monetarist view, V is unstable, so when M increases, there is an increase in purchases of goods and services. Nevertheless, if there is no increase in real output, this will cause prices to rise, causing inflation.

Criticism of the quantity theory of money

The quantity theory has been criticised by Keynesian economists, as they argue that when M increases, it is controlled by the slowdown in V. This means that the extra money is not spent on either goods or services, but on investments on capital assets. This is likely to stimulate aggregate demand and economic growth, therefore increasing Q rather than P.

Reflection

Overall, PQ can increase because of two reasons:

• Increase in real output.

• Increase in price levels of goods and services.

Difference between Keynesians and the monetarist theory of inflation

The following are the important economic problems and solutions identified by monetarists and Keynesians.

Table 1. Differences between Keynesian theory and Monetarist theory of inflation - StudySmarter.

Expectations and changes in the price level

Despite the complexity of expectation theories, the fundamental idea is that people’s expectations affect their behaviour, which in turn affects inflation and deflation in economics. People predicting inflation might behave in an inflationary way. For example, trade unions and employees engaging in wage bargaining has the effect of increasing production costs, which in turn raises the prices of products and services. Moreover, inflation can be hard to control due to ‘inflation psychology’. This is a phenomenon that happens when people continue to bargain due to their expectations of inflation.

Inflation remained stable between 1997 and 2007 through government influence. Because of this stability, people’s behaviour was easier to control, so bargaining for higher wages was reduced, but inflation revived during the financial crisis from 2007 and remained unstable until 2011, which once again affected people's expectations.

Consequences of expectations

It is possible for people’s expectations, such as behaving in an inflationary or deflationary way, to negatively impact both the economy and themselves. Let’s analyse the consequences of inflation and deflation expectations and the negative effects that they may have on the economy.

Inflation

Unequal distribution of money

Inflation can cause unequal distribution of wealth/money. In such a scenario, individuals receiving fixed wages/salaries will have the same income regardless of the increase in prices of goods and services, thereby reducing their wealth.

On the other hand, employees who have bargaining power will often see their wages increase along with inflation, making them even richer than fixed wage employees. Moreover, inflation works in favour of borrowers but not lenders, as despite the inflation borrowers are paying the same interest.

The function of money decreases

In extreme cases where inflation becomes hyperinflation, this can result in catastrophic effects on the economy as cash becomes worthless. Therefore, citizens may start using other less efficient methods of exchange to replace cash.

Disturbance of normal consumer behaviour

Inflation expectations drive consumers’ behaviour, as they are likely to make large purchases and store them as they anticipate the price of the products will be higher in the future. This can also affect firms’ behaviour as instead of making effective investments due to the high demand firms will invest in the mass production of commodities.

Time is wasted comparing prices

Inflation may result in consumers spending more time shopping, especially in regards to goods made from leather or other good quality materials. Consumers may spend their time comparing prices in regards to different producers and seeing by how much the prices have increased.

Loss of competitiveness in international trade

There can be two scenarios: if the exchange rate is fixed and if the country has a higher exchange rate than its competitors, it will cause the price of exports to increase. This will influence lower demand for exports contributing to lower economic growth and increased unemployment. On the other hand, in the floating exchange rate system, the exchange rate will decrease. However, imports may be at higher prices, which influences further inflation.

Deflation

As well as inflation, deflation can cause disruptions in the economy.

Let’s have a look at one example of how deflation can have negative effects on the economy.

We must keep in mind that deflation can be separated into two categories, one good and one bad. By looking at the graphs below we can identify these two types of deflation.

Fig. 1 - A 'good' deflation

Figure 1 illustrates an example of a good deflation. The deflation has been caused by the reduction in business costs of production due to improvements in the supply side of the economy. If the AD curve is stable even when the SRAS and LRAS shift to the right, the prices of businesses’ goods and services will fall, whereas output and employment will increase.

Fig. 2 - A 'bad' deflation

Figure 2 illustrates the example of a bad deflation also known as ‘malign’ deflation. A bad deflation can be detected during a recessionary period, as was the case in the UK between 2008 and 2009. Figure 2 illustrates this situation, showing how a reduction in aggregate demand with the AD curve shifting from AD1 to AD2 resulted in bad deflation (a drop in price from P1 to P2). In addition to extreme declines in aggregate demand, a credit crunch or negative multiplier effects can also trigger bad deflation. Malign deflation can cause negative effects on the economy such as increased unemployment and business failures.

Sources

1. Milton Friedman, Counter-Revolution in Monetary Theory, 1997.