25 years ago Milton Friedman was an economic Yoda teaching that money supply was an ever present “Force” controlling the economy. With a new financial Death Star threatening, Friedman is remembered by the Federal Reserve’ Jedi Knights of money supply.
Before his death, Master Friedman was the “monetarists” leader. He taught that money supply determines economic activity and changes in the amount of money directly affects inflation, GDP and employment.
Like Jedi Knights in hiding, Friedman’s disciples are quietly emerging and using money supply as a light saber to avoid an economic catastrophe created by the banking crisis and defeat inflation caused by soaring commodity prices.
The Quantity Theory of Money
Monetarists’ unifying theory is called the “quantity theory of money” which states that GDP and inflation are directly affected by changes in the level of money supply. The quantity theory of money holds that GDP is equal to the amount of money available multiplied by the velocity of money. The velocity of money is the speed that money turns over or is spent and respent.
As an example, if a consumer has $100 that is used to buy dinner at a restaurant, $100 of GDP is created. When the restaurant respends the $100 to pay for food and electricity, GDP is $200 (the original $100 purchase and the respending of the $100) and the velocity is 2x. If the restaurant’s food suppliers and electric company respend the $100, GDP increases by another $100 and velocity is 3x. Every time the $100 is respent, GDP increases by $100 and the number of times it is respent is the velocity of money. As such, monetarists believe that GDP must equal the amount of money multiplied by the number of times it is respent.
Also, monetarists believe that there is a maximum velocity that money can be respent based upon practical and real world limits on how fast people can spend money. Monetarists teach that velocity will accelerate to the theoretical maximum rate and therefore is more or less constant. As a result, if the Federal Reserve sets the amount of money and the velocity is constant, then the Federal Reserve can determine GDP through monetary policy.
Monetarists believe that increasing money supply is the only way to have growing GDP (so if the consumer has $125 to spend rather than $100, GDP will be greater). Monetarists also believe that if money supply grows faster than the growth rate in GDP, then inflation will result. Similarly, if money supply grows slower than GPD growth, monetarists believe that deflation will be the consequence.
The Limits of Monetarism
While monetarism is a powerful economic force, in the 1970s and 1980s Friedman’s Jedi Knights at the Federal Reserve used money supply growth as their primary policy tool with poor results.
There were two principal problems with the Fed’s over reliance on monetarism. First, the amount of money in “money supply” is uncertain and changes for reasons beyond the Federal Reserve’s control. Second, the velocity of money is variable and also outside the Federal Reserve’s control. Since GDP is a combination of two factors beyond the Federal Reserve’s control, targeting money supply growth didn’t work well.
Monetarism and the Federal Reserve Today
Master Friedman wrote in Two Lucky People about a cause of the Great Depression:
“The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933…Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government.”
The Federal Reserve Jedi Knights know that without intervention, the current credit crisis will destroy money supply just like in the Depression. With aggressive action the Federal Reserve has preserved money supply and avoided disaster. The measurement problems of the 1970s and 1980s are irrelevant when money supply is being destroyed in an uncontrolled meltdown.
Also, Friedman warned that controlling money supply is the only way to control inflation. In A Monetary History of the United States 1867 – 1960, Friedman wrote
“Inflation is always and everywhere a monetary phenomenon.”
Since March, the money supply (as measured by M2) has been essentially unchanged and has shrunk in real terms. While holding short term interest rates low, the Federal Reserve used tight money supply to control inflation, promote a strong dollar and prick the commodity bubble. The Fed seems to have adopted a “new way” of applying the old principals of the monetarists with good results to date.
Just Luke Skywalker blowing up the Death Star, the money supply Jedi Knights have shown creativity as they honor their own personal Yoda, Master Milton Friedman.