The Federal Reserve and Monetarism

Once the basic institutional facts about the Federal Reserve System have been presented, any discussion of the Fed should begin with a discussion of monetarism. After all, the Fed’s primary reason for being is to control the nation’s money supply, and monetarism is the economic discipline that studies central banks and the effects of monetary policy on the economy. The founder of monetarism, Milton Friedman, was a Keynesian as a graduate student who later became disenchanted with Keynes’ ideas. Instead, he became a champion for a free market with minimal government intrusion. To introduce his ideas to the general public, he produced and hosted a famous public television series “Free to Choose” together with a companion book with the same title. You can still view the TV series (as well as a number of other conservative oriented shows) on the internet at a website bearing the “Free to Choose” moniker. The book is also still available from a number of distributors including Amazon.com (see reference[E10]).

One of the most important results from monetarism is the connection between the money supply and inflation or deflation. In Friedman’s words, “inflation is always and everywhere a monetary phenomenon.” In particular, we can derive that the fractional inflation (or deflation) rate  is related to the fractional change in the supply of money the fractional change in the velocity of money and the fractional change in the GDP according to the equation

The Delta operators give the change in a quantity, and are defined in such a way that they are positive if the quantity increases. The velocity of money is defined as the average number of times that a dollar changes hands in a transaction each year. (Usually the money supply M is defined to be M2, currency plus demand deposits, plus so-called “near-money”: savings deposits, money market mutual funds and other time deposits.) Let us suppose that both the money supply and the velocity of money are constant, but that there is a positive growth of the GDP. In that situation the equation above says the fractional change in the price index is negative and therefore is a deflation rate. This makes sense because we then would have the same number of dollars traveling with the same velocity chasing a larger number of goods On the other hand, if the money growth and the change of velocity are positive and the change in the GDP is negligible or falling, the nation is in an inflationary environment: more dollars being exchanged faster are chasing the same or fewer number of goods.

An observed fact is that if the economic environment is inflationary, the growth in the money supply that is usually the fundamental cause of inflation is almost always reinforced in its inflationary effect by an increase in the velocity of money. As soon as people realize that the value of their money is being inflated away, they will try to get rid of their money as fast as possible by buying something of real worth.

Given these facts, how should the Federal Reserve craft their monetary policy? One would think that the Fed would choose a policy that would have the best chance of preserving the several functions of money in the economy. These functions are:

1. To be a medium of exchange. This allows people who produce different things in the economy to procure what they do not produce themselves without bartering. Because they can do this, they can specialize in their economic activity. This allows for the division of labor that is a source of productivity.
2. To be a store of value. Possessing money, an individual can retain the value of his income without having to immediately consume it. This allows investment or savings that is redirected by banks to investment.
3. To be a unit of account, i.e. a common measure for measuring the relative worth of goods and services. This statement can be recast in the following form: To be a conduit of signals to producers and consumers alike of what should be produced and bought. (See the post on Adam Smith’s “invisible hand”.)

Remember that money itself is not wealth; rather it is a claim-check for wealth. Real wealth is what you can buy with your dollars. So long as the value of money does not change, it will be a reliable medium of exchange and store of value. The values of items of wealth will then only change under the law of marginal utility, if technology or new discoveries of raw materials make possible cheaper goods or new kinds of goods. Prices then provide reliable information to producers as to what and how much should be produced, and to consumers as to how much of what they want they can buy. Either inflation or deflation wreaks havoc on all three of these functions by changing the value of the dollar.

Given all these considerations, one would think that the optimal course of the Federal Reserve would be to choose  a rate of growth or contraction of the money supply to exactly cancel the effects of any changes in the velocity of money and the growth (or contraction) of the economy. If the Fed could achieve that, there would be neither inflation nor deflation, and stable money value would allow money to fulfill all three of its functions. Unfortunately, a peculiar development has affected monetarism since its introduction by Milton Friedman. It has been captured by Keynesians as yet another tool to juice up the economy. We will tell this tale when we discuss recent economic effects of the Federal Reserve in the next post of this series.

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