The Role of Monetary Policy

Friedman traces a swing from overconfidence in monetary “fine tuning” in the 1920s, through Keynesian near-dismissal of monetary policy from the Depression through the 1940s, to a postwar “revival of belief in the potency of monetary policy” (pp. 1-5). He documents the trough of that dismissal with quotations from economists in the mid-1940s who barely mention interest rates or monetary control at all (pp. 3-4), then attributes the revival to three developments: Pigou/Haberler wealth effects undermining Keynes’s claim that involuntary unemployment could be a full equilibrium (pp. 2-3); a reinterpretation of 1929-1933 showing the Federal Reserve pursued “highly deflationary policies” rather than doing its ineffective best, with the money stock falling by one-third (p. 3); and disillusionment with the practical, politically-constrained feasibility of fiscal fine-tuning (p. 4). His concern in 1967 is that “the pendulum may well have swung too far” in the opposite direction, risking assigning monetary policy “a larger role than it can perform” (p. 5).

"(1) It cannot peg interest rates for more than very limited periods; (2) It cannot peg the rate of unemployment for more than very limited periods" (Part I, p. 5), selected because “essentially the same theoretical analysis covers both” (p. 5). Both failures stem from the gap between the immediate impact of a monetary change (via unanticipated shifts in real balances) and the delayed adjustment of expectations and the resulting “natural” benchmark (the natural interest rate in one case, the natural unemployment rate in the other) that eventually reasserts itself.

Buying securities to lower rates also raises bank reserves and the money supply; the resulting spending stimulates income (raising the demand for loans and the liquidity preference schedule) and, if it raises prices, reduces real money balances – effects that “reverse the initial downward pressure on interest rates fairly promptly, say, in something less than a year” and return rates toward their prior path over “a year or two,” often overshooting (pp. 6-7). A further “price expectation effect” – Irving Fisher’s insight that anticipated inflation raises nominal interest rates – means sustained attempts to hold rates down instead require ever-faster monetary growth, so that historically “high and rising nominal interest rates have been associated with rapid growth in the quantity of money” and low rates with slow monetary growth – the opposite of the conventional wisdom Friedman opens the address by describing (p. 7).

It is “the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on” (p. 8), and it need not correspond to equality between the number unemployed and the number of vacancies (p. 8, fn. 3). Friedman is explicit that it is not immutable: “many of the market characteristics that determine its level are man-made and policy-made,” with minimum wage laws, the Walsh-Healy and Davis-Bacon Acts, and union strength cited as raising it in the U.S., and better information about job vacancies as capable of lowering it (p. 9).

Friedman argues Phillips’s analysis “contains a basic defect – the failure to distinguish between nominal wages and real wages,” implicitly written for “a world in which everyone anticipated that nominal prices would be stable and in which that anticipation remained unshaken and immutable whatever happened to actual prices and wages” (p. 8). Using Brazil’s experience as an example – wages there had to rise at over 75 per cent a year just to hold real wages constant, and disinflating to 45 per cent a year still caused a sharp rise in unemployment because wage-setters were still catching down from higher anticipated inflation – he concludes that “restate Phillips’ analysis in terms of the rate of change of real wages – and even more precisely, anticipated real wages – and it all falls into place” (p. 9), which is also why empirical Phillips curves shift level with the average rate of price change and become poorly defined when that rate is unstable (p. 9, fn. 5).

“There is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off. The temporary trade-off comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation… A rising rate of inflation may reduce unemployment, a high rate will not” (p. 10). Friedman offers this only as “a personal judgment, based on some examination of the historical evidence”: the initial employment effects of an unanticipated inflation “last for something like two to five years,” beginning to reverse thereafter, with “a full adjustment to the new rate of inflation” taking “about as long for employment as for interest rates, say, a couple of decades” – estimates he explicitly ties to the moderate magnitude of U.S. inflation experience, noting the whole process is “greatly speeded up” for larger changes such as those in South America (p. 10).

“The monetary authority controls nominal quantities… In principle, it can use this control to peg a nominal quantity… or to peg the rate of change in a nominal quantity… It cannot use its control over nominal quantities to peg a real quantity” – not the real interest rate, the unemployment rate, real national income, or the real quantity of money, nor their real growth rates (p. 10). This is the organizing claim of Part I and the basis for the positive prescriptions of Parts II and III.

Three things (Part II, pp. 11-14). First, and most important, “monetary policy can prevent money itself from being a major source of economic disturbance” – illustrated by the Great Contraction, which Friedman calls “tragic testimony to the power of monetary policy – not… evidence of its impotence,” since the money stock fell by a third because the Federal Reserve “failed to exercise the responsibilities assigned to it” (pp. 12-13). Second, monetary policy “can provide a stable background for the economy,” conserving the economy’s inherently limited price-wage flexibility for adjusting relative prices rather than wasting it correcting for monetary mismanagement, a role once played imperfectly by the gold standard (pp. 13-14). Third, monetary policy “can contribute to offsetting major disturbances in the economic system arising from other sources,” such as an independent secular boom or an explosive fiscal deficit (p. 14).

Because, in his words, “we simply do not know enough to be able to recognize minor disturbances when they occur or to be able to predict either what their effects will be with any precision or what monetary policy is required to offset their effects,” so that fine-grained countercyclical mixing of monetary and fiscal policy is beyond present knowledge; “in this area particularly the best is likely to be the enemy of the good,” and Friedman recommends using monetary policy this way “only when [disturbances] offer a ‘clear and present danger’” (p. 14) – explicitly the most limited and qualified of the three roles he grants monetary policy.

First, “the monetary authority should guide itself by magnitudes that it can control, not by ones that it cannot control” – rejecting interest rates or the current unemployment rate as immediate policy targets (“it will be like a space vehicle that has taken a fix on the wrong star”), and, for the United States, also rejecting the exchange rate and, more reluctantly, the price level itself as guides, on the grounds that the link from policy action to the price level is comparatively indirect and variably lagged, leaving a monetary total as “the best currently available immediate guide or criterion” (Part III, pp. 14-15). Second, “the monetary authority [should] avoid sharp swings in policy,” since historically the Federal Reserve has typically moved in the right direction but “too late and too much,” a pattern Friedman attributes to policymakers reacting to today’s conditions when their actions will affect the economy only “six or nine or twelve or fifteen months later” (pp. 15-16), citing 1919-20, 1937-38, 1953-54, 1959-60, and the “sharpest change in the rate of monetary growth of the postwar era” in 1966 as recurring examples.

His preferred prescription is that the monetary authority “go all the way in avoiding such swings by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total,” which he estimates, based on his own past work, at “something like a 3 to 5 per cent per year rate of growth in currency plus all commercial bank deposits” to achieve rough average price stability (p. 16, citing unpublished work suggesting a still-lower 2 per cent rate might be preferable on optimum-quantity-of-money grounds, fn. 6). He is explicit that the specific total and the specific rate matter less than simply having a publicly known, steadily followed rule: “it would be better to have a fixed rate that would on the average produce moderate inflation or moderate deflation, provided it was steady, than to suffer the wide and erratic perturbations we have experienced” (p. 16); short of full commitment to a rule, he says it “would constitute a major improvement” merely to avoid wide swings (p. 16).

Friedman uses the Depression as the pivot of his entire historical narrative: he first notes that contemporaries (Keynes included) believed the U.S. monetary authorities had “done their best” and failed, but “recent studies have demonstrated that the facts are precisely the reverse” – the quantity of money fell by a third because the Federal Reserve “forced or permitted a sharp reduction in the monetary base” rather than because willing borrowers vanished (p. 3). This reinterpretation does double duty in the address: it is offered as the key piece of evidence for monetary policy’s genuine potency (used to justify the postwar revival of interest in monetary policy, pp. 2-3), and it later reappears in Part II as the leading illustration that the single most important thing monetary policy can do is avoid being, itself, “a major source of economic disturbance” (pp. 12-13) – linking the paper’s diagnosis of past over- and under-confidence in monetary policy directly to its closing policy prescription.