During the early years of the twentieth century, the American economy focused on the study of economic growth through a framework provided by a famous thinker named Ludwig von Mises. His basic assumption was that business cycles are caused by changes in consumer demand, which he called exogenous factors. His model of economic growth assumes that these changes affect the supply of money and the level of production, both of which determine the level of economic activity.
The model assumes that there is a constant relation between supply and demand: what supply of money will enable economic activity to take place. If the demand for money rises, then prices of goods and services also rise. Thus, to keep equilibrium, the level of overall economic activity should be equalized by the increase in the supply of money.
The strength of this theoretical foundation allowed Mises to build upon it to develop his own methodology of economic development. However, his efforts did not satisfy those who were searching for a more parsimonious explanation of economic growth. Many felt that the theory should offer an alternative way to economic calculation and problem solving. They preferred a more abstract and idealistic description of how economic activity is carried out by the forces of demand and supply on the market.
To provide this alternative, monetographers, including John Maynard Keynes and Frank Polkitt, developed a different approach to the problem. Rather than address the effects of supply on demand, they focused on the role of monetary instruments in determining the level of investment. With this new approach, they argued, the theory of economic growth could tell us about how the supply of money and the level of total economic activity relate to each other. Theirs was a more refined and theoretically adequate view of how the theoretical model worked.
While monetarists continue to dispute some aspects of the validity of these newer approaches, it is generally accepted that many aspects of the theory are still valid. In addition, monetarists have added important elements of observation and experiment to the methodology. More recent additions include information about the relationships between investment and growth in aggregate economic units. More research is also needed to provide a stronger foundation for studying the theory of value, wealth and prosperity.
With the exception of the United States, growth in the economy occurs through increasing prices rather than increasing production. The models therefore treat changes in the rate of inflation as random, exogenous, and inefficient. The ability of the model to provide a comprehensive description of the process of economic activity and the role of prices in . . . . . . predicting output levels is therefore limited. A focus on price level changes instead of overall economic activity leads to some limitations of models that attempt to generalize about economic growth.
One type of model that does attempt to overcome the limitations of monetarist theory is the demand-side theory. The demand-side theory postulates that increases in the demand for specific goods and services, or increases in the relative demand for money (as in the case of central banks printing paper currency) will automatically lead to increases in the level of prices. Some modern versions of this theory include both the factor analysis approach and the business cycle approach.
The main drawback of Monetarist economic theories is that they are static in nature, with no ability to be altered. They cannot be used to describe fluctuations in the growth of the economy. The major exception to this is the Phillips curve, which depicts the change in output across time by considering long term trends in price level changes. Although these models provide a convenient description of the general characteristics of economic activity, they are unable to explain the specifics.