Belief: As the economy grows, the money supply should grow in order to keep prices general stable (or allow them to rise slightly) otherwise falling prices will encourage consumers to stop spending now in the hope of spending in the future when goods are cheaper.
Policy recommendation: The government must use monetary policy to control inflation.
Monetarism is a school of thought that focuses on the macro effects of the money supply. Its main proposition is that inflation is caused by an excessive growth in the money supply and that monetary policy must be used to control inflation. Monetarists argue that the central bank must set targets for the growth of the money supply in order to maintain price stability otherwise uncontrollable inflation (or deflation) will cause agents to postpone spending, negatively affecting national output.
Monetarism rose to fame in the 1970s when Keynesian economics failed to explain the rising levels of inflation and unemployment across the Western economies. Monetarists redefined the Phillips curve to contend that stagflation (rising inflation and unemployment) was caused by loose monetary policy. The founder of Monetarism, Milton Friedman, contended that, to cure stagflation, the government use a tight monetary policy to raise interest rates and lower the price level. The Western world put Friedman’s policy into practise and got inflation under control.
Monetarists, like Keynesians, agree that government intervention is crucial to stabilise the business cycle and manage unemployment but, whereas Keynesians argue that government intervention can affect long-run output, Monetarists assert that the government can only affect the short-run level of output and employment.
However, ever since the 1990s, Monetarism took a big hit because it became increasingly evident that the relationship between money supply growth and inflation was becoming disconnected. Moreover, the 2007 global financial crisis put another dent into Monetarist policies as the the developed economies came into a liquidity trap. Interest rates had fallen to such low levels that monetary policy could not be used to boost the economy, governments had to crawl back to Keynesianism and fiscal policy.