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What is Monetarism and How Does it Work?


This article analyzes the economic philosophy of monetarism developed by Milton Friedman and followed by the Chicago School of Economics.



Monetarism is an economic theory that focuses on the macroeconomic effects of changes in the money supply.

This theory traces its roots back to the 1950s, when Friedman challenged the dominant Keynesian economics principles in favour of an alternative theory.

The key proponents of Monetarism advocated for government control over the money supply in order to prevent inflation from getting out of control.

Friedman’s ideology would have him oppose the creation of the Federal Reserve in the U.S. (as well as any central bank), however Friedman had stated that given its existence, the central bank should regulate the money supply.

Similarly, Friedman also had various differing views on the causes of the great depression.

He argued that the great depression had not started by people spontaneously hoarding money but rather, these slumps were caused when nations would withdraw money from their money supply.

Recall that, prior to World War II, the world operated under a unified gold standard, and international trade had been transacted in gold. At this time, whenever a nation would run up a huge trade deficit, it would pay its bill out of its gold reserves, thus causing a reduction in its domestic money supply.

This in turn facilitated the depression that wrecked so many national economies.

Friedman also argued that if the money supply were simply held constant, nations would not suffer from depressions in the first place, and thus would have no need to rely on deflation or Keynesian policies in order to correct them.


Monetarism vs. Keynesian Economics

There are two main arguments Friedman has proposed against Keynesian economics and both centre on the following macro economic policies:

  1. Inflation and Unemployment
  2. Role of Government intervention in the Economy


1. Inflation and Unemployment

Instead of the full employment policies followed by Keynesians, Monetarists focused on targeting inflation, arguing that there was a natural rate of unemployment and that if employment was higher than this rate, then inflation would become a major issue.

In other words, Friedman argued that full employment would increase the risk of rising inflation.

Monetarists attributed the sole cause of inflation in the economy, to the increase in the money supply, arguing that the additional money would be used by businesses to employ more workers.

Friedman advocated for a strict monetary policy employed by the government, in order to control the rate of growth of the money supply.

Friedman articulated his views in his book titled The Counter-Revolution in Monetary Theory, where he wrote,

Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. … A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society.

Due to their shared views, Monetarists agree with Austrian school economists in that inflation would be caused by the growth in the money supply.

In addition, Monetarists also share the Austrians economist’s view on the neoclassical axiom of neutral money, which postulates the rejection on the notion of ‘neutral money’ since increasing the money supply, does indeed cause inflation.

The dangerous implications of inflation has led monetarists to propose an absolute minimal amount of government intervention in the economy, thus creating another point of conflict between them and the Keynesians.

2. Government Intervention in the Economy

Monetarists differ from Keynesians on the role of government in the economy. As noted in Article 9 of this series, Keynesians advocated for more government intervention as a check in order to prevent a depression. Keynesians also argued that stimulus spending during depression was necessary for faster recovery and for increasing the employment rate.

In contrast, Monetarists generally disagreed with large government intervention in the economy because they argued for free market policies.

Friedman’s writings went on to achieve great recognition particularly during the late 1960s and 70s, when they greatly influenced an another school of thought, at the Chicago School of Economics.


Chicago School of Economics

The Chicago school had strongly been influenced by the work of Friedman, and held the same stance on many vital issues concerning economic liberalism and free markets.

Free markets were among the basic principles advocated by Friedman and other Chicago school economists such as Frank Knight.

The emphasis on free markets and economic liberty led many Chicago economists to vehemently oppose government intervention on the grounds that it would only destabilize and hinder the market.

Friedman captured the sentiments of monetarism in his book titled There’s no such thing as a free lunch, where he wrote,

I think the government solution to a problem is usually as bad as the problem and very often makes the problem worse.

Here, Friedman argued that government intervention in the free market would often exacerbate the problem and produce negative consequences for everyone.

Despite his views, Friedman also believed the government was necessary in order to regulate and ensure the free market remained “free”.

In another book titled Capitalism and Freedom, Friedman wrote

The existence of a free market does not of course eliminate the need for government. On the contrary, government is essential both as a forum for determining the “rule of the game” and as an umpire to interpret and enforce the rules decided on.

Thus in essence, Friedman and other Chicago school economists believed that the government was necessary to enforce rules on businesses so that the free market would not morph into a monopolistic market.

Another prominent Chicago economist, Robert Lucas Jr., had also argued for less government intervention in the economy.

Friedman, along with other Chicago school economists, believed that the government had an inherent social responsibility in five main areas;

  1. Protecting the public from internal/external enemies (military and police force)
  2. Administration of justice to achieve peaceful reconciliation of conflict (courts)
  3. Provision of Public Goods (defense)
  4. Protection of children and mentally handicapped
  5. Control of the money supply to regulate inflation

Aside from these responsibilities, he argued that the government would only hinder and negatively impact the economy.

Friedman’s views on government intervention had put him at odds with the majority of economists at the time, since many of them had been following a Keynesian approach, which advocated for an increase in government intervention.

Rise of Monetarism

Monetarism gained popularity during the 1970s as a method of explaining the onset of stagflation, something that the Keynesians had failed to address.

The effects of stagflation were previously unknown to many economists, since many countries were experiencing rising prices while at the same time, wages were stagnating.

Thus workers were earning less and were not able to purchase as much as they could before, resulting in high inflation.

As explained above, Monetarist’s argued that the cause of the stagflation had been due to the rapid growth in the money supply, which exceeded the growth of production.

Canadian economists also adopted a policy of monetarism starting in the mid-1970s.


Monetarism in Canada

At this time, inflation rose from 5% up to 17%, creating the most severe case of inflation in Canada’s history, and forcing many Canadian officials such as Finance Minister Bob Johnson and Bank of Canada Governor Gerald Bouey to address the issue.

This led the Governor of the Bank of Canada, Gerald Bouey, to welcome the economic framework of monetarism proposed by Friedman in 1975.

He expressed his desire to implement monetarist policies in a speech given at the Saskatoon Manifesto in 1975 when he said,

The maintenance of an average rate of growth of the money supply no higher than the long-term average rate of growth of the production of goods and services in Canada …is required if the inflation is to be brought under control.

Thus starting in 1975, Canada began to follow the monetarist principles proposed by Friedman, and the Bank of Canada began to control the rate of growth of the money supply in order to reduce inflation.

In order to control the growth of the money supply, the Bank of Canada refused to extend loans to the Canadian government under Trudeau.

Since the Trudeau government could not borrow from the Bank Canada, due to the restriction of monetarist policies, Trudeau began to borrow money from the private banks at interest to fund various social and infrastructure programs.

To understand the effect of monetarist policy in Canada, one must examine the rate of inflation in Canada from 1970 to 1975. This is because 1970 is when inflation began to mount, and 1975 is when monetarist policies were officially adopted in Canada.

Professors from the University of Manitoba and Simon Fraser, Clarence Barber and John Mccallum respectively, addressed the role of monetarist policies in Canada in their paper titled The Failure of Monetarism in Theory and Policy.

The authors argued that monetarism in Canada had been ”a failure as a theory and policy” because it did not explain the fluctuations in price nor did it decrease inflation.

Included in their paper, is a graph depicting the inflation rates as measured by consumer prices of the world, and of all industrial countries, and of Canada from 1950 to 1980.

As one can see, the levels of inflation in Canada did not decrease even after the implementation of monetarist principles in Canada in 1975.

Professor Andrew C. Drainville of Laval University in Quebec reached a similar conclusion about the failure of monetarist policy in Canada.

In his paper titled Monetarism Canada and the World Economy, Drainville wrote,

As a technical exercise in controlling money growth, Canadian monetarism was a failure. From the start, the narrowness of M1 made it quite meaningless for the purpose of monetary regulation, and financial deregulation made increasingly difficult any attempts at targeting.

M1 is a monetary aggregate which is used as a measure of the money supply and it refers to the amount of notes and coins (currency) in circulation, and includes traveler’s checks, demand deposits, and other checkable deposits (OCDs).

According to Drainville, M1 was too narrow for the purposes of monetary regulation because it did not include currency in bank vaults, savings deposits, money market funds, and other large liquid assets.

The regulation of the M1 aggregate had clearly been insufficient to decrease the inflation in Canada which remained high during the late 1970s and early 80s when Canada ultimately had drifted away from monetarist policies.

After the fall of monetarism in Canada, the central bank decided to pursue a policy of price stability otherwise known as zero inflation, which continues to this day.

Monetarist policy had failed many other countries besides Canada. This policy had been implemented by the U.K. government in order to reduce the high inflation in the 1970s.

monetarism caused the British economy to sink into a deep recession.

Although inflation had been reduced from 10% to 4.3%, it came at the cost of doubling the unemployment figure from 1.5 million to over 3 million.

The rise in unemployment largely stemmed from the foreclosure of factories,

In other words, the government let the businesses foreclose instead of subsidizing them or intervening in the free market.

The failure of monetarist as a policy and theory has sparked significant criticism against Monetarism, Friedman and the Chicago school of thought associated with it.



The Chicago school, which advocates for unfettered free markets and little government intervention came under attack in the wake of the financial crisis of 2007–2010.

New Keynesian economists Joseph Stiglitz blamed the free market philosophy of the Chicago school for the cause of the financial crisis.

Stiglitz’s criticism was noted in a book titled: The Financial Crisis – Who is to Blame, where he wrote,

The Chicago School bears the blame for providing a seeming intellectual foundation for the idea that markets are self- adjusting and the best role for government is to do nothing.

Another New Keynesian, Paul Krugman, similarly criticized Milton Friedman in his article titled: Who Was Milton Friedman, where he wrote

He [Friedman] slipped all too easily into claiming both that markets always work and that only markets work. It’s extremely hard to find cases in which Friedman acknowledged the possibility that markets could go wrong, or that government intervention could serve a useful purpose.

Post Keynesians such as Steve Keen also criticize Milton Friedman and the free market principles of monetarism.

Keen expresses his stance against Friedman and monetarism, in an article titled Krugman on (or maybe off) Keen, where he writes,

…I and my Post-Keynesian colleagues and forebears take money seriously while simultaneously being trenchant critics of Friedman’s simplistic Monetarism.

Another Post Keynesian economist Nicholas Kandor, strongly opposed the monetarism principles put forth by Friedman and expresses anti-monetarist sentiments in his book The Scourge of Monetarism, where he writes,

I regard “monetarism” as a terrible curse, a visitation of evil spirits, with particularly unfortunate, one could almost say devastating, effects on our own country, Britain.

Here, Kandor is referring to the recession of the 1980s, when the U.K. government employed monetarism in order to reduce inflation, yet instead sank into a recession.


Austrian economists such as Murray Rothbard also criticize Friedman on the government control over the money supply.

Rothbard’s criticisms are outlined in his article titled Milton Friedman Unraveled, where he has written,

One of Friedman’s crucial errors in his plan of turning all monetary power over to the State is that he fails to understand that this scheme would be inherently inflationary. For the State would then have in its complete power the issuance of as great a supply of money as it desired. Friedman’s advice to restrict this power to an expansion of 3–4% per year ignores the crucial fact that any group, coming into the possession of the absolute power to “print money,” will tend to . . . print it!

Other schools of thought such as MMT theory and Circuitism reject Monetarism, as well as mainstream New Keynesian principles, arguing for a completely different approach to macroeconomics and monetary theory.

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