The Lag in Effect of Monetary Policy

This 1961 Journal of Political Economy paper is Milton Friedman’s reply to J. M. Culbertson’s criticism of an earlier finding, developed jointly with Anna J. Schwartz, that monetary actions affect economic conditions “only after a lag that is both long and variable,” and it defends three separable parts of that claim: that changes in the behavior of the money stock exert an important independent influence on subsequent events, that the average lag is large relative to the length of the business cycle, and that the lag varies substantially across episodes. Friedman’s evidence is not a formal econometric identification but a set of timing comparisons: matching turning points in the percentage rate of change of the money stock against National Bureau of Economic Research reference-cycle peaks and troughs over eighteen non-war cycles since 1870, and, separately, cross-correlations between money-stock changes and income/consumption drawn from the Meiselman-Friedman investment-multiplier study. On the average of the eighteen cycles, money’s rate-of-change peaks lead reference-cycle peaks by sixteen months and rate-of-change troughs lead reference troughs by twelve months (five and four months respectively using step-dates, an alternative dating method); the quarterly 1948-1958 cross-correlation exercise finds money leading consumption and income by three to four quarters, with peak correlations of .52 and .58 (both significant at the .001 level), implying a nine-to-twelve-month lead that Friedman treats as consistent with the longer-sample estimate given ordinary sampling variation. The standard deviation of these timing intervals is about six or seven months, which Friedman argues overstates the “true” variability of the lag because measurement error inflates the variance without similarly biasing the mean; on this basis he rejects Culbertson’s implicit claim that the lag’s standard deviation is under 0.9 months. Friedman explains the length of the lag through a balance-sheet transmission mechanism in which an open-market purchase leaves the non-bank public holding temporarily excess cash that is spent down gradually across a widening set of assets and expenditures, with interest rates and asset prices possibly serving only as a conduit rather than a necessary channel. He concludes that because the lag is long and variable, discretionary countercyclical monetary policy is likely to act as an additional, highly serially correlated disturbance rather than an offsetting one, strengthening the case for policy rules over discretion — while noting the fuller evidentiary presentation was still forthcoming in the Friedman-Schwartz Monetary History.

The Role of Monetary Policy

Delivered as Friedman’s presidential address to the American Economic Association in December 1967, this paper argues that two decades of professional opinion had swung too far toward assigning monetary policy tasks it cannot actually perform – pegging interest rates and pegging the unemployment rate, each for more than a limited transitional period. Reworking Wicksell’s distinction between the “natural” and “market” rate of interest, and adding Irving Fisher’s nominal/real interest rate distinction, Friedman argues that a monetary authority can hold the market interest rate below its natural level, or unemployment below what he calls the “natural rate of unemployment” – the rate that would be produced by the actual, imperfection-laden structure of labor and commodity markets working through a Walrasian general-equilibrium system – only by continuously accelerating inflation, and can hold either above its natural level only by continuously accelerating deflation; trying to hold either fixed indefinitely therefore fails and instead sets off an unstable adjustment process. He reinterprets Phillips’s empirical unemployment-wage relationship as valid only because it implicitly assumed a stable, unshaken anticipated rate of price change, and argues that once inflation itself becomes anticipated the trade-off shifts, so that “there is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off” – a rising rate of inflation can temporarily lower unemployment, but a high, steady rate cannot. Because monetary policy directly controls only nominal magnitudes (a nominal quantity of money, a nominal exchange rate, a price level) and not real magnitudes (the real interest rate, real unemployment, real national income), Friedman concludes it can nonetheless make three genuinely available contributions – keeping money itself from becoming a source of disturbance, providing a stable monetary background so the economy’s limited price-wage flexibility is not wasted correcting monetary mistakes, and cautiously offsetting only “major” disturbances arising from other sources – and he prescribes that policy be guided by a magnitude the authority can actually control, ideally a steady, publicly announced rate of growth in a monetary total, rather than by interest rates or the current unemployment rate.

Milton Friedman | Macro Paper Warehouse

The Lag in Effect of Monetary Policy

The Role of Monetary Policy