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.

Natural-Rate-of-Unemployment | Macro Paper Warehouse

The Role of Monetary Policy