A Response to Friedman’s “The role of monetary policy”

Milton Friedman’s article hopes to achieve two things–how can monetary policy contribute to the business cycle and how it should be conducted so that it is the most effective.  Friedman makes the readers aware from the start that Keynes recognized that the monetary policy in place in the 1920s could do little to mitigate the Great Depression because it was a useful tool to stop inflation, but would have done little to curb the recession.  During Keynes time of the Great Depression, he also realized that the liquidity preference for holding money was much higher during times of unemployment, but little could be done in way of monetary policy.  That is where he realized the benefits of government spending to make up for “insufficient private investment” due to the higher interest rates.  It wasn’t until after WWII when monetary policy was realized to be “potent” (as Friedman puts it) because of the inflation sparked by the “cheap money policies.”

In the article, Friedman strongly suggests that the Great Depression, or the Great Contraction as he calls it in this article, was brought on in great part due to the Federal Reserve engaging in deflationary policies, which contracted the money supply by one-third.  Essentially, the Federal Reserve failed to provide liquidity to the banking system.   In Friedman’s era, the role of monetary policy is to promote full employment first and foremost.  Second in the objectives of monetary policy is the prevention of inflation.  However, Friedman feels that the role of the Federal Reserve and monetary policy may be too vast–that is, perhaps the Federal Reserve can’t take on such a big challenge.

Two limitations that monetary policy have a hard time addressing are pegging interest rates for a long period of time as well as pegging unemployment for a long period of time.  Rather than letting the U.S. government pegging war and post-war bonds at a certain price, which turned out to be a mistake, the Fed should engage in open market operations by buying and selling securities.  Of particular concern is a way to keep interest rates low–meaning that the Fed should buy securities to make more money available for banks to loan out.  Friedman recognizes that by allowing the Fed to engage in open market operations, there would be a cyclical adjustment period because as the story goes, if there is more money in the economy, more people will be spending money, which in turn will lead to higher real wages and eventually higher prices.  This would cause spending to decrease and interest rates will have to return to a higher level in perhaps one to two years.  An interesting point that Friedman makes is the country comparison to interest rate levels.  He notes that countries that have higher interest rates have looser monetary policies in place than those countries that have lower interest rates.  This has to do with the fact that outrageous inflation levels have to be curbed by higher interest rates, but in order to achieve those high inflation levels in the first place, the central banking system of that country had to be irresponsible by trying to stimulate growth or “patch up a debt” through the printing of money.  The second limitation that Friedman discusses is the level of pegged unemployment in the long run.  Friedman asks why monetary policy cannot peg the unemployment at a consistent level, say three percent (which is his example).  The reason being is the same reason as pegging interest rates in the long run–in the long run the economy will react to those subsequent policies, but those reactions will be lagged and delayed.  Excess supply or demand will force the real wage rate lower and higher, respectively, than would otherwise be experienced in a state of equilibrium.  (An interesting note about the wage rate is Friedman’s argument regarding minimum wage rates and the strength of labor unions, all of which make the natural rate of unemployment higher than the market would otherwise dictate.)

One thing that Friedman stresses is that monetary policy, though it sounds negative, may prevent money from being a “source of economic disturbance.”  Essentially, the Great Contraction may have occurred on a lesser scale or not at all if deflationary measures weren’t used by the Federal Reserve System.  The second thing that monetary policy can do that will help the economy is to keep it running, to keep it “well oiled.”  That is to say, monetary policy can ensure price stability, which is important for consumers and businesses alike because they will consume more rationally and predictably if the economy is presumed to be stable.  Lastly, monetary policy works as a countermeasure.  For example, if there are presumed federal budget deficits–which means an increased spending–then monetary policy could work to offset the expected increases in inflation.

 When looking at how monetary policy should be conducted, there are two responsibilities: controlling factors in the environment that it can more easily control (i.e. price level) and stay away from those that it has a harder time controlling (i.e. unemployment levels) and avoiding “sharp swings” in policy (i.e. over correcting the market by being too expansionary and too contractionary).  All in all, short of publicly stating a fixed monetary growth, stable monetary policy is needed to promote economic stability.  However, Friedman does recognize the shortcoming, which is sometimes unavoidable–that is, there are other exogenous factors that will influence the domestic economy (i.e. exchange rates, currency markets, and foreign economic trends).

Source: Friedman, Milton.  1968.  The role of monetary policy.  American Economic Review 58 (March): 1-17.  (This can be found in Snowdon’s Macroeconomic Reader.)

One Response to “A Response to Friedman’s “The role of monetary policy””

  1. tphayden says:

    Having read the same article as you did Brandon, I feel like Friedman in this article was giving us an outline for how monetary policy should be maintained. I think that setting a target rate and somewhere around the “natural rate of unemployment” and maintaining that stability can be a smart way to go. I think the problem with that is that the people at the FED have very little control over Fiscal Policy and that when lawmakers take Fiscal Policy way too far, the FED has to step in with monetary policy to clean up the mess that Congress made.