Monetary
theory is a set of idea or ideas on how monetary policy should be conducted
within an economy. Monetary theory suggests that different monetary polices can
benefit nations depending on their unique set of resources and limitations. There are three main schools of thought
which have made major contributions to the development of monetary theory. They
are classical, Keynesian and Monetarist theories. However, a brief review will
be made on these schools of thought with respect to economic growth.
The Classical Economists
The
classical economist view of monetary policy is based on the quantity theory of
money. According to this theory an increase (decrease) in the quantity of money
leads to a proportionate increase (decrease) in the price level. The quantity
theory of money is usually discussed in terms of the equation of exchange which
is given by the expression.
MV
= PT
Where
M
= stocks of money
V
= velocity of circulation
P
= price level
T
= volume of transaction
The
equation states that the money supply MV equals the total value of output PT in
the economy. The classical interpretation of the equation is however
interesting. They view the equation as an explanation of the behaviour of the
price in response to a change in money supply since they believe in the
operation of market forces, they held the view that only deviation from full
employment equilibrium is abnormal and would be taken care of in the long run.
They assumed a constant (T) in the sense that if output is not at full
employment level, price adjustment would automatically restore equilibrium,
regarding (V) as relatively stable. The classicist obtained a direct
relationship between the money supply and the general price level. (Expo and
Osakwe 1997:93).
The Keynesian Economists
Keynesian
economist do not believe in the direct link between the supply of money and the
price level that emerges from the classical quantity theory of money. They
reject the notion that the economy is always at or near the natural level of
real GDP so that the level of current real GDP can be regarded as fixed. They
also reject the proposition that the velocity of circulation of money is
constant and can cite evidence to support their case. Keynesian do believe in
an indirect link between the money supply and real GDP. They believe that
expansionary monetary policy increases the supply of loanable fund available
through the banking system, causing interest rates to fall. With lower interest
rates, aggregate expenditure on investment and interest. Sensitive consumption
goods usually increase causing real GDP to rise. Hence, monetary policy can
affect real GDP indirectly. Keynesians, however remain skeptical about the
effectiveness of monetary policy they point out that expansionary monetary
policies that increases the reserves of the banking system need not lead to a
multiple expansion of the money supply because banks can simple refuse to lend
out their excess reserves. Furthermore, the lower interest rate that results
from an expansionary monetary policy
need not induce an increase in aggregate investment and consumption
expenditure because firms and households demands for investment and consumption
goods may not be sensitive to the lower interest rates. For these reasons,
Keynesian tend to place less emphasis on the effectiveness of monetary policy
and more emphasis on the effectiveness of fiscal policy which they regard as
having a more direct effect on GDP. (Transmission mechanism of monetary policy:
Journal of Economic studies volume 31 issue 5:2004)
Monetary View of Monetary Theory
During and after World War II, inflation replaced
depletion as a major economic problem facing many western industrial countries.
Keynesian economics failed to explain the emergency of high and sustained level
of inflation and unemployment; this lead to the rebirth of the old notion that
monetary management was the key to economic stability. The intellectual
leadership of the monetarist was provided by Milton Friedman of the University
of Chicago through his seminal contribution to the quantity theory of money – a
restatement in M. Friedman studies in the quantity theory of money and a
monetary history of the US 1867-1960 with A. J. Schwarz. Monetarist argued that
disturbances within the monetary sector are the principal cause of instability
in the economy. Monetarist argued that the economy is basically or inherently
stable and government principal economic role in stabilization should consist
in providing for orderly and systematic expansion of money supply according to
fixed policy rates. Such fixed policy rules in the view of the monetarist, are
necessary to insulate the economy against ill conserved and badly timed
government actions which leads to instability. (Friedman, Milton quotes,
Wikiquote)
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