Milton Friedman’s ” The Role of Monetary Policy” – 50 Years Later

By Silvia Merler, an Affiliate Fellow at Bruegel in August 2013. Prior to that, she worked as Economic Analyst in DG Economic and Financial Affairs of the European Commission. Originally published at

In March 1968, Milton Friedman’s “The Role of Monetary Policy” – after his famous presidential address to the American Economic Association – was published in the American Economic Review. 50 years later, economists reflect on this famous work.

 stress that expectations, the long run, the Phillips curve, and the potential and limits of monetary policy all continue to be actively researched. In the near future, the meagre economic growth since the 2008–2009 recession may lead to a reexamination of Friedman’s natural-rate hypothesis. At this point, the simplest explanation is that this stagnation is due to a slowdown in productivity unrelated to the business cycle. Alternatively, however, it might contradict Friedman’s classical view of the long run, either through hysteresis effects or through chronic shortage of aggregate demand. Future work might do well to re-embrace Friedman’s vision and turn to modelling expectations for a better understanding of the Phillips curve, aiming for a better benchmark model of that can replace both adaptive and rational expectations. Mankiw and Reis argue that the role of monetary policy is in flux today and has drifted quite far from the topics that Friedman emphasised in his presidential address. The road ahead will likely lead to progress in four areas: the interaction between fiscal and monetary policy, the role of bank reserves, near-zero interest rates, and financial stability.

wonders whether we should reject the natural rate hypothesis. While the hypothesis was controversial at the time, it quickly became widely accepted, and has been the dominant paradigm in macroeconomics ever since. It is embodied in the thinking and the models used by central banks, and it is the basis of the inflation-targeting framework used by most central banks today. Recently, grumblings about the extent to which this hypothesis fully characterises the world have increased for two reasons, both linked to the Great Financial Crisis and the accompanying recession. First, the level of output appears to have permanently been affected by the crisis and its associated recession. Second, in contrast to the accelerationist hypothesis, very high unemployment did not lead to lower and lower inflation, but rather just to ongoing low inflation. Blanchard sees macroeconomic and the microeconomic evidence as suggestive but not conclusive evidence against the natural rate hypothesis. Policymakers should keep the natural rate hypothesis as their null hypothesis, but also keep an open mind and put some weight on the alternatives.

 argue that the short-run effect of the address was to stimulate many to check Friedman’s assertion that not only did expected inflation matter for actual inflation, it mattered point-for-point in the determination of actual inflation. Within the then-existing framework of the Phillips curve, as Friedman pointed out, the long-run Phillips curve became vertical and the unemployment rate or other measure of slack was invariant to the central bank’s inflation choice. In the longer run, Friedman’s hypothesis of a point-for-point shift of the Phillips curve gained full acceptance among economists. The more general assertion that real outcomes such as unemployment, employment, and output were invariant to the monetary regime began to be accepted, and that idea generalised and replaced the concept of monetary neutrality. Hall and Sargent believe that Friedman’s main message, the invariance hypothesis about long-term outcomes, has prevailed over the last half-century based on evidence from many economies over many years. Subsequent research has modified Friedman’s ideas about transient effects and has not been kind to the Phillips curve, but Hall and Sargent argue that the invariance hypothesis has stood up well, even though the Phillips curve has not held up as a structural equation in macro models.

 has a long post discussing Friedman’s contribution, which he believes might have been subtitled “neutrality and non-neutrality”: monetary policy is neutral in the long run but not in the short run. But what would Friedman, the empiricist, have said today, with the wild behaviour of 1980s velocity and the amazing stability of inflation at the zero bound in the rear view mirror? How would he adapt to John Taylor’s innovation that moving interest rates more than one for one with inflation, operating exactly within the framework he laid out, stabilises the price level in theory, and, apparently in the practice of the 1980s? Cochrane thinks that despite later events, Friedman’s view of monetary policy has had enduring influence – even more than his view of the Phillips curve. The view that central banks are immensely powerful, not only for controlling inflation but as the prime instrument of macroeconomic micromanagement, is common now but Friedman reminds us that it was not always so. Now the Fed is credited or blamed as the main cause of long-run interest rate movements, exchange rates, stock markets, commodity markets, and house prices, and voices inside and outside the Fed are starting to look at labour force participation, inequality and other ills. There is a natural human tendency to look for agency, for someone behind the curtain pulling all the strings. Cochrane thinks we shall look back and realise the Fed is much less powerful than all this commentary suggests.

discusses seven fallacies concerning Friedman’s article, i.e: (1) “The Role of Monetary Policy” was Friedman’s first public statement of the natural rate hypothesis; (2) The Friedman-Phelps Phillips curve was already presented in Samuelson and Solow’s (1960) analysis; (3) Friedman’s specification of the Phillips curve was based on perfect competition and no nominal rigidities; (4) Friedman’s (1968) account of monetary policy in the Great Depression contradicted the Monetary History’s version. (5) Friedman (1968) stated that a monetary expansion will keep the unemployment rate and the real interest rate below their natural rates for two decades. (6) The zero lower bound on nominal interest rates invalidates the natural rate hypothesis. (7) Friedman’s (1968) treatment of an interest-rate peg was refuted by the rational expectations revolution. The discussion lays out the reasons why each of these seven items is a fallacy and infers key aspects of the framework underlying Friedman’s (1968) analysis.

draws attention to footnote 2 in Friedman’s 1968 article, which he takes as an anticipation of why inflation or NGDP might be superior to money. Sumner has a second  discussing his view that replacing inflation with NGDP targeting would solve many conundrums. The empirical relationship Friedman cites broke down about a decade after his paper was published in 1968: recessions are no longer preceded by sharp slowdowns in M2 growth. Sumner argues that the breakdown in the empirical relationship that motivated Friedman’s advocacy of money supply targeting helps to explain why late in his life he became more supportive of Greenspan’s inflation targeting approach: Friedman was a pragmatist, so when the facts changed, he changed his views.

 argues that the standard interpretation of the Friedman argument is that since attempts to increase output and employment by monetary expansion are futile, the best policy for a monetary authority to pursue is a stable and predictable one that keeps the economy at or near the optimal long-run growth path that is determined by real factors. Thus, the best policy is to find a clear and predictable rule for how the monetary authority will behave, so that monetary mismanagement doesn’t inadvertently become a destabilizing force causing the economy to deviate from its optimal growth path. In the 50 years since Friedman’s address, this message has been taken to heart by monetary economists and monetary authorities, leading to a broad consensus in favour of inflation targeting with the target now almost always set at 2% annual inflation. But this interpretation, clearly the one that Friedman himself drew from his argument, doesn’t actually follow from the argument that monetary expansion can’t affect the long-run equilibrium growth path of an economy. The monetary neutrality argument is a pure comparative-statics exercise, which teaches us something but not as much as Friedman and his followers thought.

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33 comments

  1. Jim Haygood

    Rebel economist Daniel Nevins (who’s actually an engineer):

    Instead of continuing to channel M63, [Friedman and Schwartz] directed economists toward measures such as M2, which better matched the profession’s long-time fascination with the intrinsic characteristics of money such as liquidity, stability and value as a medium of exchange.

    Economists were well accustomed to treating money as an independent force that’s mostly unrelated to bank lending, and a close look at ninety-four years of history wasn’t powerful enough to break old habits.

    Up-to-date research reaffirms Friedman and Schwartz’s original conclusions about M63 while refuting the supposed value of M2, adding to the ample evidence that M2 failed as an economic indicator.

    Three facts that mainstreamers typically sweep aside or deny:

    Bank charters authorize commercial banks to create money from nothing when they extend loans, making bank lending fundamentally different than other types of lending [as Michael Hudson noted in an NC post yesterday]

    We can measure the amount of money that banks create.

    Bank-created money is often uncorrelated with the money measures you hear about in the media, such as M2.

    Friedman and Schwartz produced their seminal research using M63, not M2, for which data didn’t exist over the full period of study. Plot twists like that almost make the history of economic thought entertaining, as if written by Stephen King or M. Night Shyamalan.

    What would Uncle Miltie have thought of Bubble Ben Bernanke’s mad science QE experiment, followed by Lord Japewell’s mad science normalization pogrom program? I reckon Milt would have penned a scathing rant. But since he ain’t around, ol’ Jim’s gonna have to pinch hit for him as we flame the Fed.

    1. Jim Haygood

      Bullard capitulates:

      The U.S. central bank doesn’t have to raise interest rates further, as monetary policy is close to “neutral,” said St. Louis Fed President James Bullard on Wednesday.

      “It is not necessary in this circumstance to raise the policy rate further in order to put downward pressure on inflation, since inflation is already below target,” Bullard said in a speech.

      While the U.S. and other large economies achieved better-than-expected growth in 2017, “this surprise has stalled so far in 2018,” Bullard said.

      First, U.S. real GDP growth looks “uncertain” in the first quarter, he said. And markets are trying to discern the direction of U.S. trade policy and are also contemplating possible tech sector regulation.

      Bullard also said that the threat of an inversion of the yield curve remains a possibility later this year.

      Translation from central planner speak: we’re screwed.

      1. djrichard

        This will be interesting. Because the 3m/13w treasury relative high was on March 20th, right when the Fed Reserve did the last rate hike. So who knows, maybe the 3m/13w is anticipating that the Fed Reserve is going to cool their jets for awhile.

        That said, the 3M/13w is still within the channel trend that was started back in Sep 2016, so who knows it could still break higher. If that happens (it breaks higher), and Bullard changes his narrative to be consistent with that new reality, we’ll know who actually is in charge of short-term rates. The Libor and commercial paper markets will be trend lines to watch too.

        “Bullard also said that the threat of an inversion of the yield curve remains a possibility later this year.”

        If that happens, it’s more likely to be triggered by Fed Reserve rate increases than the 10Y yield dropping significantly. So it seems like Bullard is speaking out of both sides of his mouth. But who knows, maybe Bullard is worried about the 10Y retrenching, which could be why they’re signaling that they’re thinking of cooling their jets.

        If that’s what’s going on, they’re simply buying more time. But to what end? Are they actually buying Trump more time to engage in his trade war? Assuming the short-end is truly driven by the Fed Reserve (rather than the other way around), my sense is that the Fed Reserve usually waits to invert the yield curve when there’s some other culprit who can be blamed for the mess (e.g. dot com bubble, housing bubble). When the time comes to take the punch bowl away (and invert the yield curve), Trump’s trade war could be the perfect cover.

        1. Summer

          “when there’s some other culprit who can be blamed for the mess…”

          other than the entire speculative enterprise.

          1. djrichard

            LoL, there’s a reason they call it taking the punch bowl away. The party wouldn’t be happening without that punch bowl.

        2. Jim Haygood

          Bond king Jeffrey Gundlach in a CNBC interview this afternoon:

          So here we are and we are raising interest rates, late in the cycle, we have a yield curve that is now inside of 50 basis points twos to tens which historically when you go through 50 twos tens you pretty much always end up going flatter, which typically leads to inverted.

          So we’ve got that going on. Ladle on top of that quantitative tightening, which in fiscal 2019, which starts in October, could be as much as $600 billion of quantitative tightening. And on top of that we’re now talking about tariffs. So one can put together a scenario that we’re making – stumbling through into a policy mistake and that is perhaps what Mr. Navarro was talking about, that maybe the feds shouldn’t raise interest rates three times this year.

          So it’s interesting how the bond market seems okay with this even though we have some indications on a historical precedent back to the 1930s that suggests that, you know, a trade war with the fed tightening, a quantitative tightening, maybe a recession will come during the Trump administration, which of course, would be historically likely given the fact this is the second longest economic expansion in the postwar era.

          We could have something on the order of $2 trillion of treasury bonds being floated in fiscal 2019 potentially, with corporate bond maturities starting to ramp up and all of this going on, right? So, what if there’s a recession on top of that?

          Then there will be three or four trillion of Treasuries to float. But … to whom?

    2. Jamie

      Bank charters authorize commercial banks to create money from nothing when they extend loans, making bank lending fundamentally different than other types of lending

      I have been struggling for several years now to square this idea that banks create money from nothing with the basic insight of MMT that money comes from the monetary sovereign. I finally achieved a kind of peace of mind about it when I realized that the money banks create by making loans is extinguished when the loans are repaid or defaulted. I see it as a kind of froth within the domestic sector that plays a different role from that of money injected into the sector by sovereign spending. But, pace, that is clearly not what the above is referring to.

      If bank lending is different from other kinds of lending, it is surely because in other kinds of lending, one needs first to have possession of some article before one can lend it. The distinction between loans of articles already in possession and articles created de novo by the act of lending is similar to the difference between intellectual property and other kinds of property. If I loan you my plow, for instance, I necessarily forgo its use for the period while you are using it. There is only one article and only one of us can use it at a time. But if I show you my new design for an improved plow, you can go off and construct one of your own without impeding in any way my own ability to make and use one simultaneously for myself. Even though there is only one design, it can be used by multiple people simultaneously. Thus IP is not “property” in the same sense that “this chair” is property, i.e. in the sense that only one person can have its use at any given time. And IP law is an attempt to “force” IP to behave as if it were physical instead of abstract.

      In the case of IP, I think a good argument can be made that there is no real justification for protecting an arbitrary right of exclusivity for an article that in principle can be shared without harming or depriving the original inventor of the use of their own invention. But I see no analogous argument that there is no justification for bank lending just because it is different from other forms of lending. It seems to me that, by and large, the wide dissemination of technology is a good thing and the attempt to create and maintain artificial monopolies through IP is a bad thing. And it seems to me that, again by and large, the authorization of banks to make loans is a good thing, and either forbidding that or “neutralizing” it by allowing anyone to do it would be a bad thing.

      I guess what I am trying to get at with all this rambling is that, while one can highlight that bank lending is different from other kinds of lending, I don’t see how that leads one to any useful conclusion about whether or how banks ought to be regulated. I do see that there are some implications for how “money” is measured and how different metrics might apply, but I can’t quite grasp the significance of this.

      1. Alejandro

        Banks mostly seem to ‘create’ debt on things already made, but mostly don’t seem to extend credit to make (‘create’) anything.

      2. José

        A good starting point is the notion of a pyramid, a “hierarchy of money and credit” as explained by Perry Mehrling.

        At the top of the pyramid there is sovereign money, a liability of the central bank.

        One step down we have commercial bank money, deposits created by bank lending – they are promises to pay central bank money on demand and at par value.

        Finally, at the bottom of the hierarchy (the base of the pyramid) there is the third tier, credit – promises to pay in bank deposits at a later date and with an embedded interest rate.

        1. Jamie

          Thanks for this. It helps to organize the elements one has to understand. I never before considered that using a credit card is also “creating money out of thin air” which is “extinguished” on paying the bill.

      3. Jim Haygood

        ‘I don’t see how that leads one to any useful conclusion about whether or how banks ought to be regulated.’

        One regulatory aspect would be to limit imprudent lending.

        Nevins’ main focus on bank lending is to observe how it’s affecting the credit cycle. When banks stopped lending in 2008, the economy fell apart.

        1. Jamie

          “to limit imprudent lending”

          Which is what underwriting is supposed to do… OK I can see that. Thanks!

      4. perpetualWAR

        “I finally achieved a kind of peace of mind about it when I realized that the money banks create by making loans is extinguished when the loans are repaid or defaulted.”

        Sorry to wreck that peace of mind, but it appears that the “money” banks create may not be being extinguished. We are seeing instances of the debt not being paid off unless the seller (of the property) ensures that the note be taken out of circulation. This is an important step and must be requested by the purported debtor.

        1. Jamie

          That sounds like an irregularity, if not an outright fraud. And it certainly disturbs one’s peace of mind. But even if one is dinged twice for the same loan, that does not represent creating money out of thin air. We would still be talking about a simple redistribution of existing funds within the domestic sector.

      5. HotFlash

        that the money banks create by making loans is extinguished when the loans are repaid or defaulted

        Well, yes. But the interest which is paid on the loan, and often greater that the original loan amount — banks do not create that, so where does it come from?

        1. Jamie

          Yeah, it has to be accounted for. Ultimately it must come from the sovereign. In most cases it is already existing money simply changing hands. It usually comes from selling one’s labor, but can also come from selling some other asset, from an inheritance or gift… or from thievery. Since it is already extant, it neither adds to nor detracts from the existing money supply. At least that is how I understand the matter.

    3. paulmeli

      For me the main shortcoming of Neo-classical economists – they haven’s studied nor do they understand thermodynamic systems (with a few exceptions), therefore they don’t have the tools to understand the dynamics of systems.

      Their understanding of economic systems is unlikely to ever resemble reality. Most people (including economists) seem to believe in behaviors or processes that can be classified as mathematical versions of perpetual motion (they have no mass or energy, but transactional systems have internal frictions, which makes self-sustaining processes impossible…savings is the main friction). One difference that stands out is that with physical systems matter and energy can neither be created nor destroyed, while with monetary systems a fiat currency is created from nothing. As far as analysis is concerned this “creation” can be thought of as a transfer of “energy” from one system to another, not unlike the transfer of energy from the Sun to the Earth.

      This energy creates the incentive and the ability to engage in commerce. Motivation alone is not enough. We want good health care but if we don’t have the cash…

      Every system is at it’s root a closed system. Within this context it is axiomatic that no system in the known universe can grow itself. The growth of any systems relies upon transfers from other system(s).

      The concepts are not particularly difficult, but can be counterintuitive. Once one has worked with various aspects of different types of systems one realizes that their behavior is governed by essentially the same mathematical relationships.

      FWIW, I’m an engineer (Mechanical, minor in Electrical, Structural in practice).

  2. The Rev Kev

    Milton Friedman’s predictions are kinda like Trotsky’s predictions. They were never wrong. It is just that both men were so far-sighted that their predictions have not yet come true.

      1. Synoia

        Also the Dark Age in Europe. That was s libertarian experiment. No rule of law and all had weapons.

  3. Susan the other

    Very interesting that Mankiw has such clarity. Hindsight is 20-20, but at least he looked.

  4. Forces

    Every time an economist say ”natural” something you know it is a scam. Nothing quth the economy is natural, it is always social and therefore under pressure and negotiation by psychological, legal, political, economical, ecological, technical etc forces.

    1. Jim Haygood

      In his book Economics for Independent Thinkers, Nevins quotes Steve Keen, who demolishes a 2012 paper by Kurgman and Eggertsson where (according to Nevins) “[Kurgman] claimed to channel Minsky but without reflecting Minsky’s knowledge of banks.”

      Nevins continues:

      “Using the term neoclassicals for mainstream economists, Keen said,

      ‘Neoclassicals like Kurgman read Minsky, and then proceed to build equilibrium models without banks, and think they’re modeling Minsky.

      ‘No they’re not …

      ‘One key component of Minsky’s thought is the capacity for the banking sector to create spending power “out of nothing.”‘

  5. Ape

    You know what an economy at equilibrium looks like?

    What is the equilibrium solution for a human being?

    (Hint – it stinks)

  6. Stephen Gardner

    To pretend that economics is a science with immutable laws like physics, independent of political decisions on how to distribute the goods, is the first mistake of all modern economists. And Friedman is probably the most egregious example. Of course pretending such market laws exist independent of human decisions is in itself a political decision that results in redistribution of income upward. Problem solved: it’s not us, it’s the laws of the universe that picking your pocket. Ha. This ideology masquerading as “non-ideological science” reminds me of what Verbal said in “The Usual Suspects”: “The greatest trick the Devil ever pulled was convincing the world he didn’t exist. And like that, poof. He’s gone.”

  7. Summer

    “Friedman’s view of monetary policy has had enduring influence – even more than his view of the Phillips curve. The view that central banks are immensely powerful, not only for controlling inflation but as the prime instrument of macroeconomic micromanagement, is common now but Friedman reminds us that it was not always so. Now the Fed is credited or blamed as the main cause of long-run interest rate movements, exchange rates, stock markets, commodity markets, and house prices, and voices inside and outside the Fed are starting to look at labour force participation, inequality and other ills. There is a natural human tendency to look for agency, for someone behind the curtain pulling all the strings. Cochrane thinks we shall look back and realise the Fed is much less powerful than all this commentary suggests.”

    Can anyone really have an honest discussion about the Fed without talking about the dependence on war?

  8. Alejandro

    The loftiness in ‘economese’ abstracting may explain their phantasmic hypothesizing and the consequent hypoxic policy effects, eg, “natural-rate” etc…

    Meanwhile, closer to where the oxygen is more abundant, the observations seem much clearer, eg., #FiveMoreBonz

  9. ebbflows

    By Michael Olenick, a research fellow at INSEAD. Originally published at his website

    On September 13, 1970, Milton Friedman published one of the most arguably economically destructive articles in history, “The Social Responsibility Of Business Is to Increase Its Profits,” in the New York Times. The article is available, in PDF form, for subscribers from the New York Times website.

    Friedman advanced the idea that managers are agents of shareholders and that the only purpose of for-profit businesses is to increase stock price.

    Managers have been debating Friedman’s “Shareholder Value Theory” for ages but nobody seems to have found the most obvious flaw from the seminal article. Milton’s sermon was directed at GM management who listened, decimating their brand, market share, and share price.

    Specifically, Friedman raved against the notion that corporations have “social responsibilities” that, in this specific case, meant they should build safer, more fuel efficient and environmentally friendly cars. One can surmise this notion eventually extended, during a time when planned obsolesce was part of a business model, to quality.

    http://cfdtrade.info/2018/04/milton-friedmans-role-monetary-policy-50-years-later.html

    Proceeded by investigation into lobbying activities in 1950, called the Buchanan Committee, one has to be concerned about this persons duplicitous nature.

  10. Steven Greenberg

    What happened to Keynes’ insight that putting liquidity out there is like pushing on a string as long was there is no demand for investment? If the spenders, the middle-class, are not getting the money, there will be slack consumer demand. With the increasing size of the Chinese economy and its tendency to suck up all manufacturing as an excuse to keep salaries low, I don’t know how much of Friedman’s analysis can apply anymore. None of the forces driving the world economy now were large enough to have an impact when Friedman looked at the data.

    It just amazes me that we can have these economic discussions without ever mentioning the elephant in the room.

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