Monetarism is a main theoretical and policy alternative to Keynesian macro economics. The principal elements and tenets of monetarism are summarized as follows: 3Monetarism is a modern, upgraded version of the Classical system (or the Full-Employment model). 3The economic system naturally tends to full-employment of resources--there is no systemic insufficiency of aggregate demand as claimed by Keynes and his followers. 3Fluctuations of real GDP and employment can be explained by: (a) the failure of money wages and prices to quickly adjust to changing market conditions; and/or (b) erratic or unforeseen changes in the money supply (MS). Monetarists say: “It ain’t broke, so don’t fix it.” Monetarism
Monetarism begins with the equation of exchange: MV PY [1] where: M is the nominal money supply; V is the income velocity of money, that is, the average number of times per year a unit of the money supply circulates in exchange for newly-produced goods and services; P is a price index measuring the average prices of goods and services that make up GDP; and Y is real output (or GDP) measured in units.
MV = spending for newly-produced goods and services in a year. PY = the market value of of new goods and services produced in a year, or nominal GDP (also equal to nominal income). The equation of exchange is an identity. That is, it is true by definition
M is autonomous--that is, determined by the FED. The evidence shows that V fluctuates in a narrow range (or at least this is what the monetarists claim) so that if we treat V as a constant, we are not far from the truth. Y is determined by the equilibrium in the labor market in conjunction with the short-run aggregate production function. That is, Y= Y f. Thus we can write: MV = PY f [2] Hence: Money is neutral “Inflation is always and everywhere a monetary phenomenon.”
Long run aggregate supply (LRAS) Price level Real GDP AD 1 AD 2 YfYf 0 11 22 Money is neutral The increase in the money supply stimulates AD—but real GDP and employment are unaffected