All this, however, changed following the publication of Keynes’ General Theory which advocated a positive role for the fiscal policy as a major economic policy instrument for stabilisation.
Monetary policy was completely emasculated and disfigured by the Keynesians. Keynes argued that due to liquidity trap, an expansionary monetary policy could not act as an effective remedy for depression and unemployment.
The success of Keynes was so completely sweeping that the slogan ‘money does not matter’ became the catch phrase among the economists.
The fisacal policy dominated approach which gathered strength under the protection of the Keynesian umbrella dominated the scene for about two decades.
It was only in the mid-1950s that a reaction against the fiscalist approach set in with the economists challenging the very existence of the Keynesian liquidity trap.
Milton Friedman of Chicago University a large number of economists asserted that “money does matter” in the economy. In fact, the ‘hard core’ within the group asserted that ‘money alone matters’.
These economists who were labelled as monetarists have staged a grand comeback for the monetary policy and have advocated the view that periods of hyper-inflation and deep recession are exclusively the consequence of the disturbances originating in the monetary sector of the economy resulting from an outright expansion and contraction in the money supply.
The central thesis of the monetarists is that money matters and consequently monetary policy has a crucial role to play in any programme of economic stabilisation. The extreme monetarists have asserted that money alone matters.
Their assertion is based on the validity of the particular assumptions regarding the demand for and supply of money. According to these economists, the demand function for money and the supply of money functions are perfectly interest inelastic.
The Chicago economists are the vehement supporters of the free market system and are wedded to the belief that almost all economic problems have their solution in the free operation of the market forces of supply and demand.
However, even the staunchest champion of the market system feels that there is justification for some governmental intervention and according to Friedman, regulation of the money supply is one such area where governmental control is called for.
He is, however, of the firm belief that government intervention must be regulated by certain specified rules so that the scope for discretion is minimal. Rules and not discretionary powers, should govern the actions of the regulator.
Apart from believing in the efficacy of the market system the Chicago economists adhere to the quantity theory of money as the basic framework for monetary analysis.
Furthermore, the supply of money is determined exogenously by the monetary authority quite independently of the demand for money.
According to the monetarists the central bank controls the money supply and the factors affecting the supply of money do not affect the demand for money.
The monetarists also believe in the ‘realness’ of the rate of interest being determined by the forces of thrift and productivity.
They criticise the Keynesian approach which treats the rate of interest as a purely monetary phenomenon. It is asserted that had the interest rate been a purely monetary phenomenon, the monetary authority could push it to any chosen level.
The basic monetarist theory, as developed by Friedman, asserts that money plays a crucial role in determining the level of aggregate economic activity.
Monetarism is based on a revised version of the quantity theory of money and stresses the need to control the level of money supply for achieving the economic stability.
According to Friedman, the rate of growth of the money supply should be kept stable and to achieve this monetary authority should use open market operations.
Speaking about the U.S. economy, Friedman asserts that the Federal Reserve System should ensure that the money supply grows at some predetermined constant annual rate which should be consistent with the long run growth of the economy at stable prices.
At the centre of monetarism is the key relationship between changes in the money supply and changes in the level of money income. The line of causation runs from changes in the money stock to changes in money income so that money changes cause income changes.