Business Cycles Explained: Monetarist Theory

Moving to the world of Monetarism, Tyler Cowen introduces Milton Friedman and evaluates the case for creating monetary stability.

Monetarism claims that money supply fluctuations drive the rate of inflation and deflation. Notable monetarist Milton Friedman proposed that stabilizing monetary supply would prevent excessive highs and lows that lead to inflation on one hand and economic downturn on the other.

The monetarist theory wins points for historical support; we can find plenty of evidence that deflationary pressures lead to economic downturns. Cowen takes us to the period of stagflation in the 1970s to show the monetarist theory at work. During this period, interest and inflation rates ramped up. When the Federal Reserve decreased the money supply, deflation and unemployment followed, just as the monetarists would have predicted.

But monetarism falls behind when it comes to practical ideas about how to control the growth of the money supply. How do you go about measuring money supply? Perhaps more importantly, how do you convince central banks to follow general rules limiting money-​supply growth?

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