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Monetarism

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Definition: Monetarism is an economic theory that says monetary policy is more effective than fiscal policy in regulating the economy. It emphasizes the role of the Federal Reserve and other central banks because they control the money supply.

One of monetarism founders, Milton Friedman, argued that increasing the money supply can only provide a temporary boost to economic growth and job creation. Long term, it will just create inflation. Therefore, he said, the money supply would need to be always gradually increased to offset a return to higher unemployment rates. He also argued that, properly managed, an economy can have low unemployment with an acceptable level of inflation.

The Fed manages the money supply with the Fed funds rate. This is a targeted rate the Fed sets for banks to charge each other to store their excess cash overnight and it impacts all other interest rates. The Fed uses other monetary tools, such as the reserve requirement, which tells banks how much of their money they must have on reserve each night.

The Fed reduces inflation by raising the Fed funds rate or decreasing the money supply. This is known as contractionary monetary policy. However, the Fed must be careful not to tip the economy into recession. To avoid recession, and the resultant unemployment, the Fed must lower the Fed funds rate and increase the money supply. This is known as expansionary monetary policy.

Monetarists also argue that economy watchers need to pay attention to the difference between nominal and real interest rates. Most of the rates you see today are nominal rates. Real interest rates take out the effects of inflation. These points are generally accepted by most economists. (Source: Econlib, Monetarism; Milton Friedman)

Today, money supply is a less useful measure of liquidity than in the past. Liquidity is the total amount of money, including cash, credit and money market mutual funds. The important part of liquidity is credit, which includes loans, bonds, mortgages, and other agreements to repay. That's because the money supply does not measure other assets, such as stocks, commodities and home equity. These assets created booms that the Fed largely ignored, which led to the subsequent recessions of 2001 and 2009.

Examples:
Before the Great Recession, the Fed had to use contractionary monetary policy to offset the Federal Government's expansionary fiscal policy.
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