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The basic propositions of monetarism (Part I)

(1) The Key to Stable Economic Growth Is a Constant Rate of Increase in the Money Supply. Has our economic history been one of stable growth? No inflation? No recessions? Since World War II alone, we've had at least four waves of inflation and 10 recessions.

The monetarists place almost the entire blame on the Federal Reserve Board of Governors. If only they had been increasing the money supply by a steady 3 percent a year, we could have avoided most of this instability.

Let's trace the monetarist reasoning by analyzing the Fed's actions over the course of a business cycle. As a recession sets in, the Fed increases the rate of growth of the money supply. This stimulates output in the short run, helping to pull the economy out of the recession. In the long run, however, this expanded money supply causes inflation. So what does the Fed do? It slams on the monetary brakes, slowing the rate of growth in the money supply. This brings on a recession. And what does the Fed do in response? It increases the rate of monetary growth.

"Is this stop-go, stop-go monetary policy any way to run an economy?" ask the monetarists. This type of policy inspires about as much confidence as the student driver approaching a red light.

In the first half of the 1940s, the Fed helped finance the huge increase in the national debt (incurred by World War II) by pumping up the money supply by tens of billions of dollars. The 1950s, however, were a time of tight money, marked, incidentally, by three recessions.

In the late 1960s, an accelerating rate of monetary growth was accompanied by a rising rate of inflation, which, in the early 1970s, reached double-digit proportions. In 1973 the Federal Reserve Board put on the brakes, and we went into the worst recession we had suffered since World War II. In 1975 the Fed eased up and we recovered. Then, in late 1979, the brakes were applied. The prime rate of interest soared to more than 20 percent, and in January 1980 we went into a sharp six-month recession. What happened next? You guessed it. The Fed eased up again. Interest rates came down, and economic recovery set in. But in 1981 the Fed, alarmed at the rising inflation rate, stepped on the monetary brakes, and we entered still another recession in August 1981. The prime once again soared to more than 20 percent. This recession proved even deeper than that of 1973-75. In summer 1982 the Fed saw no course but to ease up on the brakes; sure enough, by November of that year the recession had ended.

(2) Expansionary Monetary Policy Will Only Temporarily Depress Interest Rates. In the short run, when the Fed increases the rate of monetary growth, interest rates decline. If the interest rate is the price of money, it follows that if the money supply is increased and there is no change in the demand for money, then its price (the interest rate) will decline.

The monetarists tell us that in the long run an increase in monetary growth will not lower interest rates; the increased money supply causes inflation. Lenders will demand higher interest rates to compensate them for being repaid in inflated dollars.

Let's say, for example, there's no inflation and the interest rate is 5 percent. This is the real rate of interest. The rate of inflation then rises to 8 percent; that means if it cost you $10,000 to live last year, your cost of living is now $10,800. If lenders can anticipate the rate of inflation, they will insist that they be paid not just for the real interest rate of 5 percent but also for the anticipated inflation of 8 percent. This raises the interest rate from 5 percent to a nominal rate of 13 percent.

When the Federal Reserve allows the money supply to grow quickly, interest rates are kept down for a while until lenders realize the rate of inflation (caused by faster monetary growth) is rising. They will then demand higher interest rates. Thus, a higher rate of monetary growth in the short run will keep interest rates low, but in the long run it will lead to higher interest rates.

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