Friedman’s “The Role of Monetary Policy”
Like many other people in the class, I chose to read Friedman’s (apparently) influential 1967 presidential address before the Eightieth Annual Meeting of the American Economic Association. I have also perused a couple of the other articles from the reader, so if some of their content seeps into this review, that is why.
Friedman’s goal is as the title states; he desires to outline what the goals of monetary policy should and should not be, and much of this is based on his work in resurrecting the quantity theory of money over the previous decade. After an introduction that relates a brief history of the valuation of monetary policy in the decades preceding and following Keyne’s General Theory, Friedman divides his talk into three sections: What monetary policy cannot do, what monetary policy can do, and how monetary policy should be conducted.
As for what monetary policy can not do, Friedman claims that it can peg neither a specific interest rate nor a particular unemployment rate for the long run. Here Friedman is explicitly referring to his natural rate hypothesis. When interest rates are raised or lowered above the natural level (as through open market operations), individuals will begin to see an unexpectedly larger quantity of money in their pockets. They will feel their income has increased, and as that money moves through the economy, the price level may rise. Additionally, greater income means a greater demand for loans and the like, bidding up interest rates. The only way to prevent this is to increase the rate of money growth at an increasing rate, and this is even more true as expectations adapt, requiring even greater acceleration. Even when the rate of money growth is slowed to previous levels, interest rates will probably continue to rise and overshoot the natural rate, below which the money infusions were meant to keep interest rates in the first place. Thus, monetary policy can not peg interest rates in the long run.
It is not hard to see how this same reasoning may be applied to the unemployment rate, and here we see Friedman’s proposition of the vertical long-run Phillips Curve. More money means greater income means greater demand for goods and services. This leads to an increase in the value of the marginal product of labor, increasing labor demand. But here aggregate demand/supply analysis tells us that the price level will increase, increasing real wages and reducing labor demand. The only way to keep unemployment below its natural level for more than a short period is, as with the interest rate, to increase the acceleration of money growth, and this leads to inflation and its various and sundry dire effects.
Friedman’s ideas of what monetary policy can do is very much reflective of Friedman’s position on the role the government should play in the economy (not much). First, monetary authorities shouldn’t screw up. Monetary policy can have powerful effects on the economy whether it is done well or not, as the Great Depression attests. Second, monetary policy should be conducted conservatively as often as possible so that, when its powers truly are needed, it can achieve maximum effect. Essentially, people should not expect the Fed to act except in dire circumstances so that it remains a potent tool. Finally, monetary policy can indeed act to great effect in times of serious economic disturbance, but should not engage itself in fine-tuning the economy. This is not so much a third point as it is a necessary conclusion from the first two points.
Finally, Friedman concludes with a note on the conduct of monetary policy, in which he prefers that a rate of monetary growth be the goal rather than an interest rate. Here, at least, history has not born out Friedman’s thought. With deregulation of the financial markets and the volatility of the 1970’s and 1980’s, sudden and drastic changes in the money supply became the norm, and it became inadvisable to trust any one measure of money (M1, M2, etc.). Now, as I understand it, the Fed controls money demand through interest rates, letting the chips of money supply fall where they may. Edit: The previous sentence is incorrect. The Fed lets money demand fluctuate and targets interest rates by adjusting money supply.
If this article truly is one of the most influential of all works in economics, I think I can see why. It is clear and concise and represents a powerful rejection of the standing thinking of the time. One thing bugs me, however, and my guess is that more current theory would bear this out.
Specifically, I simply don’t buy the position that changes in the money supply are neutral in their effect on the economy in the long run. It strikes me, and Mayer discusses this only in analytical detail in his article “The structure of monetarism,” that the aggregate effects of monetary policy changes depend a great deal on 1) transmission mechanisms and 2) the state of individual sectors of the economy at the time of the change. I would argue (against a very strict rational expectations assumption) that nominal changes in money supply are registered in the near-term as real changes. If investment and consumption decisions are based on perceived real changes, this can have long-lasting effects on the structure of the economy. Investment may be undertaken that has no basis in “real”-ity so that excess money is filtered into the hot sectors of the day. But if such investments are long-term in nature, such as in real-estate or expensive equipment, a nominal change in the money supply may nonetheless bring about long-run real changes in the economy. Empirically, I suspect this hypothesis is incredibly difficult to prove. As Mayer also discusses, monetarists and the schools into which it evolved rely on reduced form equations that perceive the process by which interest rates are changed as black box. On the other hand, large structural models preferred by Keynsians and those of a similar vein are bound to be criticized, and rightly so, for failing to account for certain vital factors or for violating ceteris paribus constraints.
Yet my instinct remains - monetary policy can give impetus to actions that bring about economic restructuring, possibly by reinforcing network effects and leading to path dependence. A neutral monetary policy, it seems to me, would require policy-makers to judge the amount of money needed in each sector (a seemingly impossible task bound to be erroneous in its conclusions) and find ways to bring money into each of those sectors, accordingly.
A complete theory of monetary policy effects would have to account for this possibility. Anyway, that’s my two cents. Thoughts?
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February 5th, 2008 at 10:54 pm
Hi Isaac!
I must admit, you did a more thorough job than I did explaining what monetary policy actually can do. I have one nit-picky detail that I think you probably just chose to omit. In Friedman’s discussion of how monetary policy cannot peg an unemployment rate, you say that aggregate supply/demand analysis indicates that there should be a rise in real wages as a result of an increase in prices. I’m not entirely sure this is the case, as an increase in prices would decrease real wages, but nominal wages would eventually adjust so real wages would be more or less at the same place they were before the Fed decided to play with unemployment. Perhaps I’m overcomplicating it, but that’s how I understood the process.
One of the things I read previously (Phillips Curve, I think?) suggested that firms actually do assume that nominal changes in price are real for a period of time, and then cut back on their spending once they realize that real prices haven’t changed at all. You do a good job of ruining the beautiful simplicity of that statement for me by slathering it with the messy details of reality. Indeed, it would be careless for a firm to abandon a long term investment upon realizing that they misread the price level. Instead of these markets continuing to expand despite the stagnation of real prices, perhaps they operate on a lag and tend to invest when nominal prices increase for a period of time (or maybe they figured out how cycles work). Instead of cutting back on spending as the Phillips Curve statement suggested, perhaps they accumulate a considerable debt during the downward slope of the business cycle which they then have to account for when conditions start to improve later. Regardless, I think you’re on to something!
Thanks also for the recommendations on books to learn about monetary policy! I do have trouble with this one, and ANY additional things I can read would be excellent. I’m still waiting for the day when I actually get through a monetarist theory book and realize that business cycles are caused by unicorns or some nonsense like that. That absurd belief alone is enough reason to never finish a book.
Well done, sir!
Sierra