Monetarism and the Quantity Theory of Money

Monetarist school of thought gained a reputation during the 1970's when the US was battling high inflation and slow economic growth period to which the Keynesian's had no answer. According to this school of thought, the money supply is the chief determinant of nominal GDP in the short run and price levels in the long run. Money supply plays a central role in the Monetarist theory. So during the 1970s when the inflation rates in the US soared to as high as 20%, the Fed decided to shift from Keynesian to Monetary theory and constricted the money supply. This helped them control inflation, although at the cost of a recession. However, the ability of this school to help curb inflation and explain the reasoning that Keynesian's had failed brought them in the limelight. 

The Monetarist theory is based on the works of Nobel Laureate Milton Friedman and founds its basis in the Quantity Theory of Money. Monetarists further believe that the economy is inherently stable and settles at long-run equilibrium at full employment. They believe in laissez-faire economy i.e. minimalist governmental intervention and consider government and the fiscal policy as a source of destabilization. Extending the sources of destabilization they suggest that the Fed should be bounded by certain rules in conducting monetary policy because according to them markets correct themselves without the need of external stimulus and un-necessary intrusions would only lead to destabilization. Keynesian's disagree since they do not believe in auto-correction of the markets and suggest that government and Fed should have proper powers to conduct fiscal and monetary policy in order to stabilize the economy. However, they suggest that the Fed should focus on controlling the money supply, mainly increasing it at the same rate as the real GDP so as to keep inflation under check. 

So, as per the Quantity Theory of Money, MV = PQ where M is the money supply, V is the money velocity, P is the price and Q is the number of goods and services produced (GDP). The equation relates to no controversy amongst economists. According to the theory, prices and wages are sticky and do not adjust quickly in the short run and so fluctuations in the money supply may lead to fluctuations in the real GDP i.e. short-run non-neutrality of money. On the other hand prices and wages adjust to maintain equilibrium by themselves and so in the long run money supply will only affect nominal GDP and not the real GDP i.e. long run non-neutrality of money. The assumption that the theory made while arriving at this conclusion is that the velocity of money is stable or predictable, which is the main point of controversy.​

Until the early 1980's we observe that the velocity was quite predictable but then catering to the reforms in the banking and financial industry, money velocity became highly unstable and unpredictable. Thus, the relation between money supply and nominal GDP would not remain the same which raised questions on the theory and the monetarist view.

Well when I think about the monetarist view of controlling the money supply however, it does make sense to me. Generally in the past decade or so the defendants of Keynesian's claim the use of extreme monetary and fiscal policies during the 2008 crisis helped us pull ourselves out of the depression. On the other hand, I would like to ask that firstly why did the depression happen? One of the main reason was sub-prime loans i.e. a lot of money was created out of thin air and distributed amongst the people. The result was the global depression. Now to overcome this, the fed used quantitative easing and conducted extreme monetary moves, which I do agree did help. But to what extent. We observe that now as again the interest rates are beginning to come to the pre-crisis level, its creating problems in the emerging markets. So, isn't it correct that too much discretionary powers to conduct monetary and fiscal policies from decades have resulted in this convoluted environment? What if the money supply was allowed to grow within certain bounds. If I think of that scenario it feels that the crisis that we have witnessed would not have been, thus there would have been no requirements to take extreme QE by Fed and no emerging market crisis of today. Somehow it makes me feel that Friedman's view of keeping money supply and policy conduct under check holds some ground and should be looked upon.