Business Economics · Main economic schools and their key features

Monetarism and the Chicago School: Key Features and Friedman's Ideas

Updated 11 October 2026 · Fact-checked

Monetarism says that money supply growth is the main driver of inflation in the long run. Friedman used the quantity theory, MV = PT, argued for fixed rules rather than discretion, and said unemployment returns to its natural rate. To answer exam questions, state the idea, then contrast it with Keynesian views.

Understand Monetarism and the Chicago School

Monetarism is a school of thought led by Milton Friedman and the Chicago School. Its core claim is that changes in the money supply drive nominal spending and, in the long run, the price level. Inflation is, in Friedman's words, always and everywhere a monetary phenomenon.

The starting point is the quantity theory of money, written MV = PT. M is the money supply, V is the velocity of circulation, P is the price level and T is the volume of transactions. Monetarists assume V is stable or predictable, and that T (or real output) is set by real factors in the long run. If so, faster growth in M feeds through into higher P.

Monetarists also reject a permanent trade-off between inflation and unemployment. Each economy has a natural rate of unemployment, set by supply-side factors such as job search, skills and labour market rules. Policy can push unemployment below this rate only briefly. Workers come to expect higher inflation, wages adjust, and unemployment returns to the natural rate, but with higher inflation. This is the expectations-augmented Phillips curve.

This leads to criticism of Keynesian demand management. Monetarists say fiscal fine-tuning suffers from time lags, poor forecasts and crowding out. They prefer rules over discretion: for example a fixed, steady growth rate of the money supply, in line with long-run output growth. This gives predictability and removes the temptation for policymakers to inflate before elections.

Keynesians disagree on several points. They see velocity as unstable, prices and wages as sticky, and demand shortfalls as able to persist, so active fiscal policy has a role. Monetarists favour free markets and a limited government role, which links the school to the supply-side and neoliberal shift from the 1970s.

Key rules to remember

Equation of exchange: MV = PT; M = money supply, V = velocity, P = price level, T = volume of transactions. It is an identity; it becomes a theory when V and T are assumed stable.
Growth-rate form: %ΔM + %ΔV ≈ %ΔP + %ΔT; An approximation for small changes. If V is constant, inflation ≈ money growth − output growth.
Monetarist inflation rule: Inflation ≈ money supply growth − real output growth (with V constant); Holds only if velocity is constant.
Expectations-augmented Phillips curve: Actual inflation = expected inflation + f(unemployment gap from natural rate); At the natural rate, actual inflation equals expected inflation. There is no long-run trade-off.
Money growth rule: Money supply growth = target growth in real output (steady rate); Friedman's rule to give stable prices and predictability.

How to solve Monetarism and the Chicago School questions

Use this method for both calculation and essay questions on monetarism.

1Identify what is asked: a calculation with MV = PT, a definition, a comparison with Keynesians, or an evaluation of policy.
2For calculations, write the equation first and list which variables are given and which is unknown.
3State the assumption you use, usually that V is constant and T (or real output) is at its long-run level.
4Solve step by step. For growth rates, use %ΔM + %ΔV ≈ %ΔP + %ΔT and rearrange for the unknown.
5For theory questions, give the monetarist claim, then the reasoning behind it (expectations, natural rate, lags).
6Contrast with the Keynesian view on velocity, price stickiness and the role of government.
7Evaluate: say when the monetarist view works (long run, stable velocity) and when it is weaker (unstable velocity, deep recessions).
8Finish with a one-line conclusion that answers the question asked.

Quickest way: Three-line monetarist answer

When to use it: For MCQs and short written parts where time is limited.

Money supply growth leads to inflation in the long run, if V and output are stable.
Unemployment returns to the natural rate; no long-run Phillips trade-off.
Use rules, not discretion; Keynesian fine-tuning is mistimed and inflationary.

Common mistakes in Monetarism and the Chicago School

Saying MV = PT is a theory that is always proven true.
Students forget it is an accounting identity.
Fix: Say it is an identity. It becomes the quantity theory only when V and T are assumed stable.
Claiming monetarists say money supply affects output permanently.
Confusing short-run and long-run effects.
Fix: State that money may affect output in the short run, but in the long run it affects mainly prices.
Saying the natural rate of unemployment means zero unemployment.
The word natural is misread.
Fix: Define it as the rate that remains when the labour market is in balance, including frictional and structural unemployment.
Forgetting to mention expectations when explaining the Phillips curve.
Students recall only the old inverse relationship.
Fix: Explain that workers adjust their expectations, which shifts the short-run curve upward and leaves no long-run trade-off.
Giving a one-sided answer in evaluation questions.
Students describe monetarism but do not weigh it.
Fix: Add a point on unstable velocity or sticky prices, and compare with the Keynesian view.

Worked examples

Example 1

In an economy, the money supply grows by 8% a year, velocity is constant, and real output grows by 3% a year. Using the quantity theory, estimate the rate of inflation.

Show the solution

Write the growth form: %ΔM + %ΔV ≈ %ΔP + %ΔT.
Substitute: 8% + 0% ≈ %ΔP + 3%.
Rearrange: %ΔP ≈ 8% − 3% = 5%.

Answer: Inflation is approximately 5% a year.

Example 2

Explain why a monetarist would argue that a government policy to keep unemployment below the natural rate will fail in the long run.

Show the solution

Define the natural rate: the unemployment rate at which the labour market is in balance, set by supply-side factors.
Explain the short-run effect: extra demand raises prices faster than wages, so real wages fall, jobs are created and unemployment falls below the natural rate.
Explain the adjustment: workers revise their inflation expectations and demand higher wages, so real wages recover.
Result: firms cut jobs, unemployment returns to the natural rate, but inflation stays higher.
Conclude: to hold unemployment down, the government would need ever-accelerating inflation, so the policy fails.

Answer: Policy can lower unemployment only temporarily. In the long run unemployment returns to the natural rate and the economy is left with higher inflation.

Exam tips

Always state the assumption that velocity is constant before using MV = PT in a calculation.
Link each monetarist idea to its policy implication: money growth rule, central bank independence, smaller government.
In compare questions, use a short list of contrasts: velocity, price flexibility, role of fiscal policy, view of the Phillips curve.
Mention the 1970s stagflation as the event that gave monetarism its influence, but do not give dates or figures you are unsure of.
In MCQs, watch for options saying money affects only output in the long run, or that unemployment can be permanently lowered below the natural rate; both are not monetarist.

Practice questions from Main economic schools and their key features

Monetarism and the Chicago School: frequently asked questions

What are the key features of monetarism?

Money supply growth drives inflation in the long run. There is a natural rate of unemployment, and no lasting Phillips trade-off. Monetarists prefer rules to discretion and are sceptical of fiscal fine-tuning.

How do Keynesians and monetarists differ?

Keynesians see demand shortfalls persisting because prices and wages are sticky, so they support active fiscal policy. Monetarists see markets as self-correcting and focus on controlling money growth. They also differ on how stable velocity is.

Is MV = PT true by definition?

Yes, as an identity it holds by definition because total spending equals total value of transactions. It becomes the quantity theory when you assume V and T are stable, so M determines P.

Why do monetarists prefer rules over discretion?

Rules give predictability and reduce policy errors caused by lags and poor forecasts. They also limit the temptation to create inflation for short-term gain, such as before elections.