In this section we consider briefly the main principles of the monetarist theory of inflation and the role that monetary policy can play in stabilising prices and output in an economy.

The basics of monetarism

The key features of monetarist theory are as follows:

• The main cause of inflation is an excess supply of money leading to in the words of Monetarist Economist Milton Friedman, “too much money chasing too few goods”. We will see graphically how this can lead to a build up of inflationary pressure in an economy.
• Tight control of money and credit is required to maintain price stability
• Attempts by the government to use fiscal and monetary policy to “fine-tune” the rate of growth of aggregate demand are often costly and ineffective. Fiscal policy has a role to play in stabilising the economy providing that the government is successfully able to control its own borrowing.
• The key is for monetary policy to be credible – perhaps in the hands of an independent central bank – so that people’s expectations of inflation are controlled.

A simple way of explaining how a surge in the amount of money in circulation can feed through to higher inflation is shown in the next flow chart.

Excess money balances held by households and businesses can affect demand and output in several directions. Consumers will often increase their own demand for goods and services adding directly to aggregate demand (although a high proportion of this extra spending may go on imports).

Secondly some of the excess balances will be saved in bonds and other financial assets, or invested in the housing market. An increase in the demand for bonds causes a downward movement in bond interest rates (there is an inverse relationship between the two) and this can then stimulate an increase in investment.

Similarly money that flows into housing will push house prices higher, and we know understand quite well how a booming housing market stimulates consumer wealth, borrowing and an increase in spending.

The Quantity Theory of Money

The Quantity Theory was first developed by Irving Fisher in the inter-war years as is a basic theoretical explanation for the link between money and the general price level. The quantity theory rests on what is sometimes known as the Fisher identity or the equation of exchange.  This is an identity which relates total aggregate demand to the total value of output (GDP).

M x V = P x Y
Where

1. M is the money supply
2. V is the velocity of circulation of money
3. P is the general price level
4. Y is the real value of national output (i.e. real GDP)

The velocity of circulation represents the number of times that a unit of currency (for example a £10 note) is used in a given period of time when used as a medium of exchange to buy goods and services. The velocity of circulation can be calculated by dividing the money value of national output by the money supply.

In the basic theory of monetarism expressed using the equation of exchange, we assume that the velocity of circulation of money is predictable and therefore treated as a constant. We also make a working assumption that the real value of GDP is not influenced by monetary variables. For example the growth of a country’s productive capacity might be determined by the rate of productivity growth or an increase in the capital stock. We might therefore treat Y (real GDP) as a constant too.

If V and Y are treated as constants, then changes in the rate of growth of the money supply will equate to changes in the general price level. Monetarists believe that the direction of causation is from money to prices (as we saw in the flow chart on the previous page).

The experience of targeting the growth of the money supply as part of the monetarist experiment during the 1980s and early 1990s is that the velocity of circulation is not predictable – indeed it can suddenly change, partly as a result of changes to people’s behaviour in their handling of money. During the 1980s it was found that direct and predictable links between the growth of the money supply and the rate of inflation broke down. This eventually caused central banks in different countries to place less importance on the money supply as a target of monetary policy. Instead they switched to having exchange rate targets, and latterly they have become devotees of inflation targets as an anchor for the direction of monetary policy.

Measuring the money supply

There is no unique measure of the money supply because it is used in such a wide variety of ways:
 
M0 (Narrow money) - comprises notes and coins in circulation banks' operational balances at the Bank of England. Over 99% of M0 is made up of notes and coins as cash is used mainly as a medium of exchange for buying goods and services. Most economists believe that changes in the amount of cash in circulation have little significant effect on total national output and inflation. At best M0 is seen as a co-incident indicator of consumer spending and retail sales. If people increase their cash balances, it is mainly a sign that they are building up these balances to fund short term increases in spending. M0 reflects changes in the economic cycle, but does not cause them.

M4 (Broad money) is a wider definition of what constitutes money. M4 includes deposits saved with banks and building societies and also money created by lending in the form of loans and overdrafts.

M4 = M0 plus sight (current accounts) and time deposits (savings accounts).

When a bank or another lender grants a loan to a customer, bank liabilities and assets raise by the same amount and so does the money supply. Again M4 is a useful background indicator to the strength of demand for credit. The Bank takes M4 growth into account when assessing overall monetary conditions, but it is not used as an intermediate target of monetary policy. Its main value is as a signpost of the strength of demand which can then filter through the economy and eventually affect inflationary pressure.