“The Role of Monetary Policy” - Milton Friedman
Friedman describes the origin of monetary policy and its strengths and weaknesses in “The Role of Monetary Policy”. Monetarism gained momentum in reaction to Keynes’ assessment of the Great Depression (referred to as the “Great Contraction” by Friedman), as Keynes’ followers believed that monetary policy had a minimal effect on monetary policy. This led to inefficient policies that adopted low interest rates regardless of the cost and thereby allowed for rampant inflation; this in turn stimulated the rise of monetarism. Monetarists reassessed major economic activity of the previous years in terms of flow variables, such as rates of inflation and unemployment, as opposed to stock variables, such as aggregate demand and price levels that assume a specific point in time.
Friedman clearly states misconceptions about monetary policy and explains the realities that give rise to these concepts. Specifically, monetary policy cannot “peg” interest rates or unemployment rates. The economy’s reaction to a change in the money supply as induced by a change in the interest rate is often lagged. First the change will impact spending, then income and prices, then the demand for funds. Ultimately these changes will force the interest rate to be driven in the opposite direction to regulate the money supply. The response of the economy to variation in the money supply results in the cyclical behavior of monetary policy.
Monetary policy’s behavior in relation to unemployment is a bit more tricky. Friedman uses the Phillips Curve as a starting point for his analysis, stating that the general idea is accurate but the implications are oversimplified. Indeed, there does appear to be a relationship between inflation and unemployment, but the trade off is not that simple and does not refer to clear-cut stock variables. An expansionary policy would lead to both an increase in aggregate demand and therefore an increase in employment at the same nominal wages. However, this policy would also cause prices to rise and therefore real wages would fall. Once the workers catch on to the fact that their real wages have fallen, the will either refuse to work at their current wage rate or will be laid off as a result of the fall in consumption, driving unemployment upward. Like the previous issue with pegging the interest rate, any alteration targeted toward moving unemployment in one direction will eventually lead to a reaction in the opposite direction. The major difference between this argument and the Phillips Curve argument is their treatment of inflation and unemployment. Monetarist theory treats these items as flow items, stating that a general increase in the rate of inflation will cause the unemployment rate to decrease.
While monetary policy is often assaulted by individuals with these misconceptions, its tools can be useful in minimizing the shocks to the economy. Borrowing an analogy from Mill, Friedman describes money as a machine, or the means to exchange. The purpose of monetary policy is to make sure that the money machine is working properly and smoothly. Therefore, its task should be to address external shocks and internal cycles by carefully adjusting the money supply. These changes should not be dramatic, as a substantial change of direction in policy would cause more harm than good : basically it would be an internal shock. Historically, changes such as these have made the economy unstable because consumers and firms become unsure of their expectations in regard to prices and real wages.
I’ll probably either come back to make this more reader-friendly later or just try to read something else. I read Greenlaw’s post about not choosing the same one as other people too late, unfortunately. In my defense, I start reading two of the other articles in the Reader, but realized that I have too limited a background in monetarist theory to fully absorb the content of those articles. I’ll do my best to get through one that no one else wants to read later. Promise.
Friedman, Milton. 1968. The role of monetary policy. American Economic Review 58 (March): 1-17.
