Monetarism gave a model for inflation where 'money does matter 1. for inflation in the long-run and 2 business cycle swings in the short-run'


  • Monetarism vs Keynesian is at its heart free market vs interventionist
  • Friedman's Restatement
    • M_t'=P_t*y_t/V & M_t'=M_t
    • where M_t' is the demand for money, M_t is the supply, P_t and y_t are constant so increases in the supply of money require an increase in P_t so that there is equilibrium in the money market.
  • Assets - wealth can be held in four different forms
    • Money
    • Bonds
    • Equities
    • Physical capital
    • Tastes
  • Demand function - given the following assumption we can derive the usual quantity theory of money.
    • Bond and equity yields are stable over time
    • Equity response to price level can be modelled sufficiently with capital response.
    • If return on bonds and return on equities are an adequate measure of total return
    • Homogeneity postulate the demand function can be assumed to be independent of nominal units.
    • Thus velocity is assumed to be a constant function but not a constant number - thus velocity varies systematically and predictably. 
  • Natural rate of unemployment
  • Rational expectations
  • Inflationary expectations -
    • IS curve depends upon the real rate of interest whilst the LM curve on the nominal rate of interest where i_t=r_t+expectedp_t - i.e. the Fisher effect 
    • M-dot_t=0, P-dot_t=0, i_t=r_t=5% equilibrium


Four key aspects of monetarism

  1. Absence of a fundamental flaw in the price mechanism and a tendency to a long-run equilibrium position characterized by full employment of resources
  2. Quantity theory of money, in all its versions, rests on a distinction between the nominal quantity of money and real quantity of money
  3. Monetary changes exert an only transitory effect upon the real rate of interest. The interest rate is not the price of money but the price of credit. Although there is a short-term liquidity effect, interest rates will return to where they started
  4. Substantial changes in prices are almost always caused by changes in the nominal supply of money. Thus government deficits are expansionary primarily if they serve as a means of increasing the stock of money.

Key equations

  • S(y_t, r_t) = I(r_t)
  • L(y_t, r_t) = M_t/P_t
  • Two equations and three unknowns require a missing equation - typically solve by fixing y_t=y_0

Inflationary expectations model

  • Equilibrium is disturbed by a sustainable (and initially unanticipated) increase in the money stock of 10%, real initial interest rates are negative (liquidity effect) but then in response spending increase, driving up prices and expectations adjust and the new nominal interest rate is 15% 


  • Change in monetary growth rate only feeds through to change in the rate of growth of nominal income 6/9 months later. With the change in output before prices. Prices only change another 9 to 15 months after that. 
  • Short-run (5-10 years) monetary changes affect primarily output and only in the long run affects prices. 
  • Fiscal policy is not important for inflation - it's how it's financed (e.g. printing money or tax payer consumption substitution).
  • Using the IS-LM model with the assumption of y_t=y_0 an increase in the money supply shifts the LM curve out lowering interest rates in the S-R only to have prices respond and have the LM curve return to its original level. Similarly changes in the interest rate to changes in money demand are also temporary (shifting the LM curve left temporarily).
  • The expectation of inflation shifts the IS curve outwards but not the LM curve which raises nominal interest rates - leaving real rate of interest and real income unchanged in equilibrium. However, inflation expectations does not lead to continuous price rises (i.e. inflation) only a one-off adjustment.
  • Re: inflation expectations Friedman suggested the liquidity effect might take 6 months and the income effect 12 months - so the whole process takes 18 months. Price expectations effect might take 10 to 20 years!
  • Monetarist superneutrality is the idea that variations in monetary growth find reflection predominately in inflation and only in the short-run in interest rates, output and unemployment etc.


  • Usurped Keynesian orthodoxy only to itself eventually peter out. 
  • Inflationary expectations is why interest rates around the world are highest where monetary growth and prices increases are the highest. 


  • Monetarism's undoing is when under the influence of rational expectations monetary changes needed to distinguish unanticipated from anticipated. Ultimately real business cycle explanation of economic fluctuations supplanted monetarism.
  • Fisher and the quantity theorists treated 1/V as a constant, Keynes made the ratio depend upon the interest rate and state of expectations, Friedman recast Keynesian liquidity preference into a theory of choice amongst various assets based on known/anticipated returns. Downplaying role of imperfect info and the specific nature of the services provided by money.
  • Hyperinflation
    • Definition: generally and arbitrarily defined as price increases > 50%/month
    • 3 sources 1. depreciation of the foreign currency value of the currency 2. Upward adjustments in wages, for example, under trade union pressures 3. inflation may stem from a budget deficit and money creation.
    • 3 puzzles 1. Behaviour of velocity and apparent flight from money where price increases far outstrip money supply increases 2. Shortage of money (isn't inflation caused by too much money chasing too few goods?) 3. Why the money creation? 
    • Kagan used a demand for money function which includes expectations of future prices changes. This model explains puzzle
      • 1. making hyperflation endogenous to the model
      • 2. Two forces act on real balances from prices first adaptive inflation expectations and second in order to maintain constant real balances the public has to accumulate nominal money balances at a rate equal to the rate of inflation.
      • 3. Two answers first printing money is a convenient way to provide the government with real resources second the effectiveness of this method declined over time requiring larger issues
  • Inflation Tax 
    • Inflation is a tax on holding real balances and a revenue available for government expenditure. 
    • In the face of an inflation tax the demand for real money balances falls and so the government, in an effort to maintain same revenues, has to further increase the level of inflation tax.