Keynes, who theorized economic panic to stem from an insufficient national money supply leading the nation toward an alternate currency followed by eventual economic collapse, his theories focus on the value of currency stability to maintain national economic health. Milton Friedman, in contrast, focused on price stability to ensure economic health and looking for stable equilibrium between the supply of and the demand for money to bring about such well-being.
Friedman argued that “inflation is always and everywhere a monetary phenomenonââ‚¬ and advocated a central bank policy aimed at keeping the supply and demand for money at an economic equilibrium, as measured by a balanced growth in productivity and demand. Friedman originally proposed a fixed “monetary rule,” where the money supply would be calculated by known macroeconomic and financial factors and would target a specific level or range of inflation. There will be no flexibility for central bank reserves, and businesses can expect all monetary policy decisions.
Friedman restated the quantity theory of money, and argued that the demand for money depended predictably on several major economic variables. He claimed that if the money supply were to be expanded, consumers would not seek to hold the extra money in idle money balances. This argument follows that consumers, assumed to be in equilibrium before the money supply increase, already held money balances that suited their requirements. With the increase, consumers would have a surplus of money balances that exceeded their requirements. These excess money balances would therefore be spent and cause an increase in aggregate demand levels. Similarly, if the money supply experienced a reduction, consumers would aim to replenish their holdings of money by reducing their spending levels. In this argument, Friedman challenged the claim that Keynesian money supply is not effective in analyzing the level of aggregate consumption. Instead, Friedman argued that indeed the money supply affect total spending in the economy, in doing so the term “monetarist” was coined.
The popularity of monetarism increased as Keynesian economics seemed unable to explain or cure the problems that seem to contradict rising unemployment and price inflation which erupted after the collapse of the Bretton Woods system gold standard in 1972 and the 1973 oil crisis shock. Although higher levels of unemployment seemed to call for Keynesian policies on inflation, the rising level of inflation seemed to call for Keynesian deflation. The result is a significant disappointment with Keynesian demand management. In response, the Volcker sought as main objective to reduce inflation, and consequently restricted the money supply to tame inflation the economy. The result was the worst recession of the post-war period, but also the accomplishment of the desired price stability.
Milton Friedman and Anna Schwartz argued that the Great Depression of the 1930 was caused by the large contraction of the money supply and not by a lack of investment as argued by Keynes. They also maintained that post-war inflation caused by an over-expansion of the money supply. For many the perception that the economy has been shaped by the ideas of Keynes, it seemed that the Keynesian-Monetarism debate was merely about whether fiscal or monetary policy was the more effective tool of demand management. By the mid-1970s, however, the debate had moved on to things more deeply, as monetarists presented a more fundamental challenged to Keynesian orthodoxy in looking to recover the pre-Keynesian idea that the economy was of an inherently self-regulating nature.
Many Monetarists raised former view that the market economies prove stable in the absence of major not expected fluctuations in the money supply. This belief in the stability of free market economies also asserted that active demand management, especially fiscal policy, it is not necessary and in fact tend to be dangerous economy. The basis of this argument centered around an equilibrium was established between “stimulus” fiscal spending and future interest rates. In fact, Friedman argues that the model of fiscal spending creats as much of a drag on the economy by raising interest rates as it does to create consumption. According to monetarists, fiscal policy was shown to have no real effect on total demand, but merely shifted demand from the investment sector to the consumer sector.
Monetarism became less credible when once-stable velocity of money defied monetarist prediction and began to move erratically in the United States the early 1980s. Monetarist methods of a single-equation model and non-statistical analysis of plotted data also lost out to the simultaneous-equation modeling favored by Keynesian. Policies and analysis of monetarism lost influence among academics and central bankers, but its core tenets of long-run neutrality of money (increase in money supply can not have long-term effects on real variables, such as output) and use of monetary policy for stabilization to be part of the macroeconomic mainstream even among Keynes.