Question

State and explain the basic equation of monetarism. What is the major cause of macroeconomic instability, as viewed by monetarists?

Short answer

The basic equation of monetarism is MV = PQ.

Here, M is money supply, V is the velocity of money, P is price level, and Q is output level.

The major cause of macroeconomic stability, as viewed by monetarists, is government interference and inappropriate monetary policy.

Step-by-step solution

Monetarist equation

The left side of the equation of exchange, MV, represents the total amount spent by purchasers of output, while the right side, PQ, represents the total amount received by sellers of that output. The nation’s money supply (M) multiplied by the number of times it is spent each year (V) must equal the nation’s nominal GDP (= P × Q). The dollar value of total spending must equal the dollar value of total output.

Macroeconomic instability according to monetarism 

The monetarists view government interference by setting minimum wage laws, pro-union legislation, guaranteed prices for certain farm products, and pro-business monopoly legislation cause macroeconomic instability. In a monetary policy, the inappropriate increase in the money supply leads to inflation, the instability of real output and employment, and the inappropriate decline in the money supply leads to deflation and the instability of real GDP and employment.