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According to the monetarists the most serious threat to economic stability is inflation. In their view, inflation is a monetary phenomenon resulting when rate of growth of they money supply exceeds the rate of economic growth ( or rate of growth of real GDP ). Their model of the economy, simplified by the Equation of Exchange, is as follows:
M * V = P * Q
Where
M = Money Supply
V = Velocity of money ( number of times it changes hands during 1 year)
P = Price Index
Q = Level of production of Real GDP
Example:
Let's assume that for the year 2000 the money supply is $600 billion, the price index is 120% (1.2) and Real GDP is $1200 billion. From this we can calculate the velocity of M.
600*V = 1200*1.2
600V = 1440
V = 2.4
In the Monetarist model, velocity is assumed to remain constant. Now suppose that in the year 2001, the money supply increases by 10%, real GDP increased by 3%, and velocity remains constant. From this new information and using the equation of exchange, we can calculate the new price index and, consequently, the new rate of inflation in this second year.
New money supply = 600 + 600 * .10 660 billion
New Real GDP = 1200 + 1200 * .03 = 1236 billion
Substituting these new values into the equation of exchange:
660 * 2.4 = P * 1236
1584 = P * 1236
1584 / 1236 = P
1.2816 = P
This new value for P represents the price index for the latter year. To calculate the rate of inflation, we need to computer the percentage change in the price index from year 1 to year 2 as follows:
Inflation Rate = (Price Index Year 2 - Price Index Year 1) / ( Price Index Year 1 )
In our example the inflation rate for the year 2001 = ( 1.2816 - 1.2 ) / 1.2 = .68 or 6.8%
Monetary Policy under the monetarist view
The monetarists disagree with the Keynesians' counter-cyclical monetary policy of faster money supply growth to combat recessions and slower money supply growth to combat inflation. Rather, the monetarists' economic policy prescription, referred to as the Monetarists' Rule calls for a constant rate of growth of the money supply equal to the long-term average annual rate of growth of real GDP. If for a given country over the long term real GDP has grown at an average annual rate of 3%, in order to prevent inflation, that country's central bank must make sure that year in and year out, the money supply increases at the same 3% annual rate.
Monetarists' View of Interest Rates
Recall that in the Keynesians' view, expansionary monetary policy to combat a recession leads to faster money supply growth and to lower interest rates which might then lead to increase in aggregate demand. In contrast, the monetarists argue that the increase in the money supply fuels the threat of inflation and such expectations of higher inflation rates include induce lenders into increasing interest rates before inflation actually takes hold. They argue, therefore, that the expansionary monetary policy will not work to promote an economic recovery because it leads to higher rather than lower interest rates, and consequently the anticipated increase in aggregate demand does not materialize. The economy, monetarists argue, will in the long run restore itself back to full employment via their monetarist rule policy.
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