Overview and Examples of the Economic Theory

What Is Monetary Theory?

Monetary theory is based on the idea that a change in money supply is a key driver of economic activity. It argues that central banks, which control the levers of monetary policy, can exert much power over economic growth rates by tinkering with the amount of currency and other liquid instruments circulating in a country’s economy. 

Understanding Monetary Theory

According to monetary theory, if a nation’s supply of money increases, economic activity will rise, too, and vice versa. A simple formula governs monetary theory: MV = PQ.

M represents the money supply, V is the velocity (number of times per year the average dollar is spent), P is the price of goods and services, and Q is the number of goods and services. Assuming constant V, when M is increased, either P, Q, or both P and Q rise.

General price levels tend to rise more than the production of goods and services when the economy is closer to full employment. When there is slack in the economy, Q will increase at a faster rate than P under monetary theory.

In many developing economies, monetary theory is controlled by the central government, which may also be conducting most of the monetary policy decisions. In the U.S., the Federal Reserve Board (FRB) sets monetary policy without government intervention.

The FRB operates on a monetary theory that focuses on maintaining stable prices (low inflation), promoting full employment, and moderating long-term interest rates so the country can achieve steady growth in gross domestic product (GDP).

The idea is that markets function best when the economy follows a smooth course, with stable prices and adequate access to capital for corporations and individuals.

Types of Monetary Theories

In the U.S., it is the job of the FRB to control the money supply. The Federal Reserve (Fed) has three main levers:

• Reserve ratio: The percentage of reserves a bank is required to hold against deposits. A decrease in the ratio enables banks to lend more, thereby increasing the supply of money.
• Discount rate: The interest rate the Fed charges commercial banks that need to borrow additional reserves. A drop in the discount rate will encourage banks to borrow more from the Fed and therefore lend more to its customers.
• Open market operations (OMO): OMO consists of buying and selling government securities. Buying securities from large banks increases the supply of money while selling securities contracts the money supply in the economy.

Phillips Curve and Monetary Theory

The Phillips curve is an economic concept that illustrates the inverse relationship between unemployment and inflation. Introduced by economist A.W. Phillips in 1958, the curve shows that as unemployment decreases, inflation tends to increase, and vice versa.

The theory behind the Phillips curve is that lower unemployment leads to higher demand for labor, which drives up wages. As wages rise, businesses pass these increased labor costs on to consumers in the form of higher prices, thereby causing inflation. Conversely, when unemployment is high, wage growth slows, and inflation tends to decrease as demand for goods and services weakens.

In the context of monetary theory, the Phillips curve provides the most important insight for central banks and policymakers regarding the trade-offs between inflation and unemployment. It’s an oversimplification, but central banks are usually most interested in those two competing issues. Most often, to address one, the other is more likely to be negatively impacted.

Note that central banks must often navigate uncertain or unique situations. For instance, in the 1970s, the phenomenon of stagflation—where high inflation and high unemployment occurred simultaneously—challenged the simplicity of the original Phillips curve model. This led to the concept of the “natural rate of unemployment,” where inflation is stable regardless of the unemployment rate.

Monetary Theory vs. Modern Monetary Theory (MMT)

Monetary theory, in its traditional form, refers to the study of how money functions in an economy. Classical and neoclassical monetary theories typically emphasize the importance of controlling the money supply to maintain price stability.

More recently, modern monetary theory (MMT) represents a more recent and unconventional approach to monetary economics. MMT challenges the mainstream view by arguing that a government that issues its own currency cannot run out of money in the same way households or businesses can. According to MMT proponents, such a government can always print more money to finance deficits without necessarily triggering inflation, as long as the economy has unused capacity, such as unemployed labor and underutilized resources.

One of the major differences between traditional monetary theory and MMT is how they view government debt. In traditional monetary theory, accumulating large amounts of government debt is seen as potentially harmful because it could lead to higher interest rates, crowding out private investment, and increasing the risk of inflation. MMT, by contrast, asserts that government debt is less of a concern, especially in countries with sovereign currencies, like the United States, because these countries can always create more money to pay off their debt. Instead of focusing on reducing deficits, MMT argues that the government should focus on spending to achieve full employment and economic stability.

One prominent modern example of a politician who has expressed support for MMT is Alexandria Ocasio-Cortez. The Democratic representative from New York has advocated for incorporating MMT principles into discussions about economic policy and government spending. In January 2019, Ocasio-Cortez stated that MMT should be “a larger part of our conversation” when it comes to funding ambitious policies such as her proposed “Green New Deal.”

Criticisms of Monetary Theory

Not everyone agrees that boosting the amount of money in circulation is wise. Some economists warn that such behavior can lead to a lack of discipline and, if not managed properly, cause inflation to spike, eroding the value of savings, triggering uncertainty, and discouraging firms from investing, among other things.

The premise that taxation can fix these problems has also come under fire. Taking more money from paychecks is a deeply unpopular policy, particularly when prices are rising, meaning that many politicians are hesitant to pursue such measures.

Critics also point out that higher taxation will end up triggering a further increase in unemployment, destroying the economy even more.

Japan is often cited as an example. The country has run fiscal deficits for decades now, with mixed results. Critics regularly point out that continual deficit spending there has forced more people out of work and done little to boost GDP growth.

Monetary Theory vs. Fiscal Policies

Monetary theory primarily focuses on the management of the money supply, interest rates, and inflation through the actions of central banks. Its main goal is to ensure price stability and manage economic cycles. A different approach involves fiscal policies. Fiscal policy involves government decisions regarding taxation and public spending which aim to influence overall demand, employment, and economic growth.

The relationship between monetary theory and fiscal policy becomes especially important in times of economic downturns or periods of high inflation. For instance, when the government uses fiscal policy to increase spending or cut taxes to stimulate demand, it can lead to higher deficits. If these actions push up demand too much, the central bank may need to intervene by tightening monetary policy (by doing things like raising interest rates or reducing money supply). Therefore, the two policies must often work in coordination to achieve economic stability.

However, markets can suffer if monetary and fiscal policies are not aligned. For example, if the government is pursuing an aggressive fiscal policy with high levels of spending while the central bank is attempting to control inflation through contractionary monetary measures, the conflicting approaches can make both approaches ineffective. Fiscal stimulus might increase aggregate demand, while tight monetary policy could simultaneously suppress spending by making borrowing more expensive.

The Bottom Line

Monetary theory works on the principle that changes in the money supply can impact economic activity. Central banks, such as the Federal Reserve, can use tools to control inflation and either promote growth or slow down the economy, depending on what is needed.

Critics call for caution when utilizing the money supply to impact the economy, stating that it causes inflation spikes, which would devalue savings, creating uncertainty in the economy.