Milton Friedman and the Road to Monetarism: A Review Essay

This paper examines the influence of Irving Fisher's writings on Milton Friedman's work in monetary economics. We focus first on Fisher's influences in monetary theory (the quantity theory of money, the Fisher effect, Gibson's Paradox, the monetary theory of business cycles, and the Phillips Curve, and empirics, e.g. distributed lags.). Then we discuss Fisher and Friedman's views on monetary policy and various schemes for monetary reform (the k% rule, freezing the monetary base, the compensated dollar, a mandate for price stability, 100% reserve money, and stamped money.) Assessing the influence of an earlier economist's writings on that of later scholars is a challenge. As a science progresses the views of its earlier pioneers are absorbed in the weltanschauung. Fisher's Purchasing Power of Money as well as the work of Pigou and Marshall were the basic building blocks for later students of monetary economics. Thus, the Chicago School of the 1930s absorbed Fisher's approach, and Friedman learned from them. However, in some salient aspects of Friedman's work we can clearly detect a major direct influence of Fisher's writings on Friedman's. Thus, for example with the buildup of inflation in the 1960s Friedman adopted the Fisher effect and Fisher's empirical approach to inflationary expectations into his analysis. Thus, Fisher's influence on Friedman was both indirect through the Chicago School and direct. Regardless of the weight attached to the two influences, Fisher' impact on Friedman was profound.

In this article, I examine what I call Milton Friedman's Monetary Instability Hypothesis. Drawing on Friedman's work, I argue that there are two main components to this view. The first component is the idea that deviations between the public's demand for money and the supply of money are an important source of economic fluctuations. The second component of this view is that these deviations are primarily caused by fluctuations in the supply of money rather than the demand for money. Each of these components can be tested independently. To do so, I estimate an otherwise standard New Keynesian model, amended to include a money demand function consistent with Friedman's work and a money growth rule, for a period from 1875 to 1963. This structural model allows me to separately identify shocks to the money supply and shocks to money demand. I then use variance decompositions to assess the relative importance of shocks to the supply and demand for money. I find that shocks to the monetary base can account for up to 28% of the fluctuations in output whereas money demand shocks can account for less than 1% of such fluctuations. This provides support for Friedman's view.

In this paper, I examine what I call Milton Friedman's Monetary Instability Hypothesis. Drawing on Friedman's work, I argue that there are two main components to this view. The first component is the idea that deviations between the public's demand for money and the supply of money are an important source of economic fluctuations. The second component of this view is that these deviations are primarily caused by fluctuations in the supply of money rather than the demand for money. Each of these components can be tested independently. To do so, I estimate an otherwise standard New Keynesian model, amended to include a money demand function consistent with Friedman's work and a money growth rule, for a period from 1875-1963. This structural model allows me to separately identify shocks to the money supply and shocks to money demand. I then use variance decompositions to assess the relative importance of shocks to the supply and demand for money. I find that shocks to the monetary base can account for up to 28% of the fluctuations in output whereas money demand shocks can account for less than 1% of such fluctuations. This provides support for Friedman's view.

Friedman's monetary economics in practice

This paper views the policy response to the recent financial crisis from the perspective of Milton Friedman's monetary economics. Five major aspects of the policy response were: 1) discount window lending was provided broadly to the financial system, at rates that were low in relation to the market rates prevailing before the crisis; 2) the Federal Reserve's holdings of government securities were adjusted with the aim of putting downward pressure on the path of several important interest rates for a given path of short-term rates; 3) deposit insurance was extended, helping to insulate the money stock from credit market disruption; 4) the commercial banking system received assistance via a recapitalization program, while existing equity holders bore losses; and 5) an interest-on-reserves system was introduced. These five elements of the policy response were in keeping with those that would arise from Friedman's framework, while a number of the five departed appreciably from other prominent benchmarks (such as the Bagehot prescription for discount rate policy, and New Keynesian approaches to stabilization policy). One notable part of the policy response, the TALF initiative, drew largely on frameworks other than Friedman's. But, in important respects, the overall monetary and financial policy response to the crisis can be viewed as Friedman's monetary economics in practice.

AN INTERVIEW WITH ANNA J. SCHWARTZ

Comment

The Monetary Theory and Policy of Henry Simons

In order to comprehend how monetary elements and Kenya's financial environment interact, this research investigates the application of monetarism theory to liquidity decisions for enterprises in Kenya. Milton Friedman's monetary theory places a strong emphasis on how the amount of money in circulation affects how the economy performs. Understanding the use of monetarism theory becomes essential in the Kenyan context, as the Central Bank of Kenya plays a key role in enacting monetary policy. The study assesses the effect of monetary policy instruments, including interest rate changes and open market operations, on liquidity decisions and looks at the relationship between changes in the money supply and firm-level liquidity positions. In the context of monetarism theory, it also looks at how macroeconomic variables like inflation rates, currency fluctuations, and economic growth affect firm-level liquidity decisions. This study attempts to add to the body of knowledge on the connection between monetary conditions and firm-level liquidity decisions by applying monetarism theory to the Kenyan setting. The results can help Kenyan policymakers make decisions that are supported by facts and that will promote financial stability, effective liquidity management, and long-term economic growth.

A Keynesian View of Friedman's Theoretical Framework for Monetary Analysis

This paper compares Keynes’ and Friedman's views on monetary policy in the light of contemporary views on this issue. First, it is demonstrated that what are today called ‘rules’ do not fit into a Friedmanite tradition, basically because of Friedman's refusal to allow any discretion to monetary authorities and his model-uncertainty argument. Second, it is shown that Keynes’ monetary guidelines are also in fact ‘rules’, although his conception of a ‘discretionary rule’ is in sharp contrast with contemporary conceptions. What is ultimately at stake here is the capacity of collective bodies to behave efficiently, and the role played by uncertainty in the economy.

Editors’ Introduction

Monetary Policy in Developing Countries

Last week, we witnessed one of the most exciting developments in monetary policymaking since the 1930s. The Japanese central bank staged an honest-to-goodness regime shift. The Bank of Japan went beyond vague promises and cheap talk. As I will describe in more detail later, it took dramatic actions and pledged convincingly to do whatever it takes to end deflation in Japan. The theoretical reasons why this regime shift may be important are well understood by economists. Persistent deflation and anemic growth suggest that Japan continues to suffer from a shortfall of demand. But their policy interest rate is already at the zero lower bound. Furthermore, riskier, long-term rates are also very low— suggesting that unconventional policies such as large-scale asset purchases are unlikely to do much to further reduce nominal rates. As discussed by Paul Krugman, Gauti Eggertsson and Michael Woodford, and others, if unconventional monetary policy can raise expected inflation, this can push down real interest rates even though nominal rates cannot fall. 1 This, in turn, can raise aggregate demand by stimulating interest

Some, though far from total, agreement has begun to emerge as to the role and effects of monetary policy in a closed economy. At least major issues have been delineated and the battle joined in terms of fairly well-defined analytical frameworks. The impact of changes in the stock of money (or its rate of change) on prices, output and interest rates has been discussed at the theoretical level and investigated empirically. Much dispute remains as to the lag-structure of response to monetary disturbances, as to the division into output and price effects, and as to proper monetary targets and policy indicators. Nevertheless, most economists would agree that monetary policy can be used as a countercyclical device, and that the stock of money (or its rate of growth) can, in some average sense over the medium run, be controlled, however difficult it may be to exercise such control in the very short run and however poorly monetary authorities have actually performed in this respect. Discussion of monetary policy in the open economy, on the other hand, has proceeded at a higher level of abstraction (or over-simplification) and empirical work has remained scarce. The reason is close at hand: with some notable exceptions, recent developments in monetary theory and policy analysis have been, largely, the work of economists based or trained in the United States; and, from an American vantage point (especially a Middle-Western one and before the so-called dollar crises), what more natural simplifying assumption than that of the closed economy? Yet, in recent years, under the pressure of events and following the rediscovery of Hume and Ricardo and the work of, among others, Meade, Alexander, Polak, Prais, Tsiang, Johnson and Mundell, the analysis of monetary policy in the open economy has made much progress, at least on a theoretical plane. The focus and conclusions of that work, especially that of Mundell, have been rather different from those of analyses dealing with the closed economy: the monetary balance-of-payments adjustment mechanism and the role of capital mobility and of the size of countries are emphasized; severe ' Preliminary versions of this paper were presented at the Second Konstanz Seminar on Monetary Theory and Policy (June, 1971) and at the February 1972 Money Study Group Conference held at Bournemouth. I am indebted to Leonall Anderson and Karl Brunner for their incisive discussion at Konstanz and to Harry G. Johnson for helpful comments. 136