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Evaluate the Monetarist's Explanation?

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Introduction

Evaluate the Monetarist's Explanation? The quantity theory of money is one of the oldest theories of inflation. The quantity theory of money states that the price level is directly related to the amount of money in the economy. The Fisher equation comes into play here. At its simplest form the quantity theory of money can be described as 'too much money chasing too few goods'. The fisher equation sums this up: MV ? PT This states that the money supply time the number of times money changes hands (the velocity if circulation) equal the price level times the total number of transactions. In order for this equation to be true and valid we have to make three assumptions. These assumptions are the view taken by monetarists. 1. The price level is determined by the money supply. 2. V may be constant because the rate at which money is spent may not change very much over time. 3. T may be constant if the economy is near full employment which would mean that output and therefore number of transactions in the economy could not change much. ...read more.

Middle

Moreover, money supply can only rise in line with real growth in the economy with no rise in prices. However, if money supply is expanded over the real rate of growth then inflation will occur. Only in this situation does the real growth of the economy matter when determining the price level. The Fisher equation though becomes controversial and inconsistent when we see the Keynesian viewpoint. Keynesians firmly believe that the velocity of circulation (V) can change as when people have more money they may hold on to it instead of spending it. Monetarists believe that money is only held for transactional reasons. This highlights a serious flaw in their viewpoint. Furthermore, Keynesians think that an increase money supply leads to more output rather than higher prices. Increased interest rates lead to large changes in the demand for money and therefore V is volatile in the short run. Monetary accommodation related to the quantity theory of money also the highlights the disagreement between monetarists and Keynesians over the demand and supply side shocks. ...read more.

Conclusion

Monetarists believe that instead of government intervention to increase money supply and AD leading to inflation in the long run, the economy will return to full employment through the process of real wage cuts. So monetarists clearly argue that demand and supply side shocks cannot cause inflation. It is only if the money supply is allowed to increases that inflation will occur. To further evaluate, the Fisher equation is correct if we take the Monetarist view that consumer will always spend their money and therefore transactions are constant and so is the velocity of money. Keynesians though believe consumers don't adjust so easily and may save money therefore making transaction unstable and the equation doesn't apply. When looking at the monetary explanation Keynesians believe in demand management to influence in the money supply to adjust AD in times of a supply side shock. Inflation occurs though when we reach equilibrium but Monetarists argue that wages will adjust in the long run and leave a non-inflationary equilibrium. Clearly both views have negatives and positives but it seems that in the UK economy today where new Keynesian views and some monetarist ideas interconnect the Fisher equation doesn't seem to apply. 1 ...read more.

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