Question

Which of the following is a basic proposition of monetarism? (LO5) a) The key to stable economic growth is a constant rate of increase in the money supply. b) Expansionary monetary policy will permanently depress the interest rates. c) Expansionary monetary policy will permanently reduce the unemployment rate. d) Expansionary fiscal policy will permanently raise output and employment.

Short answer

The basic proposition of monetarism is: a) The key to stable economic growth is a constant rate of increase in the money supply.

Step-by-step solution

Option a: The key to stable economic growth is a constant rate of increase in the money supply.

This statement is consistent with the core beliefs of monetarists who argue that a steady increase in the money supply results in stable economic growth. Monetarists oppose excessive monetary expansion, as it may lead to inflation and economic instability. Thus, option a could be the basic proposition of monetarism.

Option b: Expansionary monetary policy will permanently depress the interest rates.

This statement is partially true concerning the short-term effects of expansionary monetary policy. However, monetarists believe that such policy can only provide temporary relief, and eventually, interest rates will return to their natural levels. Hence, option b is not the basic proposition of monetarism.

Option c: Expansionary monetary policy will permanently reduce the unemployment rate.

Monetarists argue that such policy may temporarily lower the unemployment rate, but it cannot provide a long-term solution. In the long run, monetary policy has little to no influence on the unemployment rate, according to monetarism. Therefore, option c is not the basic proposition of monetarism.

Option d: Expansionary fiscal policy will permanently raise output and employment.

Monetarism primarily focuses on the importance of the money supply in determining economic growth and stability, rather than concentrating on fiscal policy measures. Therefore, option d is not in line with the central tenets of monetarism. Based on the analysis, we can conclude that: The basic proposition of monetarism is: a) The key to stable economic growth is a constant rate of increase in the money supply.

Key concepts

Stable Economic Growth

When discussing monetarism, stable economic growth is a fundamental goal. Monetarists, like Milton Friedman, believe that the economy's health is deeply connected to the stability of its growth rate, which can be steered by controlling the money supply. The belief is that erratic changes in the amount of money circulating in the economy can lead to unpredictable fluctuations in consumption, investment, and ultimately, the overall economic activity.

For monetarists, the ideal scenario is a predictable and steady increase in the money supply, matching the natural growth of the economy, usually in line with the long-term rate of growth in productivity and population. Such steady growth helps businesses plan for the future, make investment decisions and aids consumers in managing their finances, all of which contribute to a stable and growing economy.

Money Supply

The money supply is the total amount of monetary assets available in an economy at a specific time. Monetarists emphasize the crucial role of the central bank in managing this supply, asserting that its effective control is the linchpin for economic stability. By manipulating the money supply, the central bank influences the rate of inflation, purchasing power, and indirectly, employment and production levels.

From the perspective of monetarism, for a healthy economy, the growth rate of the money supply should be kept constant and not be too reactive to short-term economic conditions. This approach is in contrast to some economic theories that advocate for more aggressive changes to the money supply in response to economic indicators.

Expansionary Monetary Policy

Expansionary monetary policy refers to the actions taken by a central bank to increase the money supply and lower interest rates, making money more accessible to consumers and businesses. This policy is often used to stimulate economic activity during a downturn. Monetarists caution against the overuse of such policies, as they can lead to inflation if the increase in the money supply outpaces economic growth.

While short-term benefits can be realized, such as a temporary boost in economic activity or employment, monetarists argue that over the long term, natural market forces will reassert themselves. In this view, any attempt to permanently reduce the unemployment rate through expansionary monetary policy is ultimately futile.

Interest Rates

Interest rates are the cost of borrowing money. They are a crucial monetary policy tool and hold significant sway over the economy's direction. For monetarists, the central bank's role in setting interest rates is to strike a balance between inflation and economic growth, not necessarily to directly control long-term employment levels.

In the monetarist framework, short-term interest rate manipulation can indeed influence economic activity; however, long-term interest rates are seen as being determined by market forces, including the expectations of inflation and the natural rate of interest —the rate at which the economy operates without creating inflation.

Unemployment Rate

The unemployment rate is the percentage of the labor force that is jobless and actively seeking employment. Monetarism posits that there exists a natural rate of unemployment, driven by market factors such as the skills of the workforce and technological changes, which cannot be permanently altered by monetary policy.

While expansionary monetary policy might temporarily decrease unemployment, monetarists argue that once prices adjust to the increased money supply, the unemployment rate will return to the natural rate. This concept is central to the monetarist critique of using monetary policy as a tool to sustain long-term employment levels.

Fiscal Policy

Fiscal policy involves government spending and taxation decisions and is a separate but related set of tools for managing the economy. While monetarism tends to focus on monetary policy and the money supply, it does not completely dismiss the role of fiscal policy. Monetarists acknowledge that fiscal measures can affect aggregate demand in the short term, but they caution against relying on fiscal policy to permanently enhance employment or output.

According to monetarist principles, consistent and sustainable economic growth is more effectively achieved through the careful control of the money supply rather than through large-scale fiscal interventions, which can lead to budget deficits and higher long-term interest rates.