Jon’s Blog

Milton Friedman’s 1968 article “The Role of Monetary Policy” from the American Economic Review shows why he is one of the leading economists of all time. The article would be very easy to read and understand even if the one doing so was not too sharp on his or her economics. At the same time, however, it does an excellent job in providing information it intends to and it is very convincing throughout. Even if I was a direct opponent to Monetarism, I would have to stop and re-think my own opinions for a second after reading the article. I can see now why Friedman was a leader in the revival of monetary policy.

Friedman starts the article off with a brief summary of economic viewpoints in the United States during the 20th century. He provided various reasons why monetary policy had been abandoned for years because of Keynesian ideas. Keynes did a good job at exploiting the weaknesses of monetary policy, as there are many, and ignored the positive effects which it could have. Therefore, the general thought about the economy shyed away from monetary policy. However, studies performed decades after the Great Depression showed that monetary policy during that time did not fail, and that the opposite was actually true.

The US economy had a very Keynesian view up until the 1950’s, when people realized that it too had many flaws. One of those flaws, inflation, was a huge issue following World War II. Around this time there was a resurgence of monetary policy. However, the new monetary policy was slightly different than in the 1920’s. Before, its goals were to promoted price stability and the gold standard, along with analyzing the “state of the money market”. Friedman’s monetary policy tried to promote full employment and prevent inflation (although a secondary measure). Friedman also notes that the “pendulum” of beliefs cannot swing too far, as any extreme in monetary policy many put too much stress on monetary policy and its chance at success.

The rest of the article served one purpose; to seperate what monetary policy can and cannot do. This to me was the most convincing point in the article. Rather than look past the flaws or limits of monetary policy, Friedman confronted the issues. His theories were not perfect, but if used correctly could be very efficient. The first thing that Friedman said monetary poiicy cannot accomplish was to peg interest rates a specific level. At first, increasing the rate of monetary policy will indeed lower interest rates in the short term. However, as interest rates lower, people will start to spend and invest more. This could raise prices across the board thus lowering the real supply of money. Within a year or two interest rates would be right back to their higher levels. Even worse, if consumers expect prices to continue to rise they would want to borrow more and more money. The increased levels of borrowing would cause the lenders to demand even high interest rates. Basically, it is impossible to hold IR’s at one level. Friedman also goes into the fact that monetary policy cannot peg unemployment level. Many of his first reasons are very similar to the interest rate case. The effects of a change in monetary policy could lower unemployment in the short run, but the results would be different on a longer term. The second point Friedman gets into has to deal with real and nominal rates. He states that monetary policy can control nominal rates of unemployment, interest rates, etc., but cannot control real rates.

The last couple pages dealt with what monetary policy can do. Monetary policy can prevent money itself from being a major disturnbance in the economy. Unlike John Stuart Mill’s belief, money is a very powerful tool. Better monetary policy can reduce the errors that would allow money to have a negative effect. Monetary policy can also provide a stable background for the economy. Friedman compares it to the gold standard. The gold standard used to provide a stable backing for the United States economy, but is no longer in use. He states that monetary policy could provide the same effects. Lastly, Friedman says that monetary policy can help to deflect distubances from other sources. One example is if the government spends way to much and puts itself into a large deficit. Monetarism could slow the growth of money by temporarily raising interest rates. The long run effect, however, would be to lower inflation, prices, and interest rates in the long run.

Friedman, “The Role of Monetary Policy,” American Economic Review, 1968, IN THE READER