Milton Friedman's "The Role of Monetary Policy" explores the impact and effectiveness of monetary policy in achieving economic goals such as high employment and stable prices. The work critically analyzes historical perspectives on monetary policy, particularly its perceived impotence during economic downturns. Friedman argues for the importance of controlling the money supply to prevent economic disturbances and promote stability. This influential piece is essential for economists, policymakers, and students studying monetary theory and its practical applications in modern economies.

Key Points

  • Analyzes the historical effectiveness of monetary policy in the U.S. economy.
  • Discusses the relationship between money supply and inflation rates.
  • Explains the limitations of monetary policy in controlling unemployment.
  • Highlights the importance of avoiding erratic monetary policy shifts for economic stability.
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The
American
Economic
Review
Volume
LVIII
MARCH
1968
Number 1
THE
ROLE
OF
MONETARY
POLICY*
By
MILTON
FRIEDMAN**
There is
wide
agreement
about
the
major
goals
of
economic
policy:
high
employment,
stable
prices,
and
rapid
growth.
There is
less
agree-
ment
that
these
goals
are
mutually
compatible or,
among
those
who re-
gard
them
as
incompatible,
about the
terms at
which
they
can
and
should
be
substituted
for
one
another.
There is
least
agreement
about
the
role
that
various
instruments of
policy can
and
should
play in
achieving
the
several
goals.
My
topic for
tonight is
the
role of
one
such
instrument-monetary
policy.
What can
it
contribute?
And
how
should it
be
conducted
to
con-
tribute
the
most? Opinion
on
these
questions has
fluctuated
widely. In
the first
flush
of
enthusiasm
about the
newly
created
Federal Reserve
System,
many observers
attributed the
relative
stability
of the 1920s to
the
System's
capacity
for fine
tuning-to
apply
an
apt
modern
term.
It
came
to be
widely
believed
that
a new
era
had
arrived
in
which busi-
ness
cycles
had
been
rendered obsolete
by advances
in
monetary
tech-
nology. This
opinion was
shared
by
economist and
layman
alike,
though, of
course,
there
were some
dissonant voices.
The Great Con-
traction
destroyed this
naive
attitude.
Opinion
swung
to the other
ex-
treme.
Monetary
policy
was
a
string.
You could
pull
on it to
stop
infla-
tion
but
you
could not
push
on
it
to
halt
recession. You
could
lead a
horse
to
water
but
you
could
not
make him
drink.
Such
theory
by
aphorism was
soon
replaced
by
Keynes' rigorous
and
sophisticated
analysis.
Keynes
offered
simultaneously
an
explanation
for the
presumed
im-
potence
of
monetary
policy to
stem
the
depression,
a
nonmonetary
in-
terpretation of the
depression,
and
an
alternative to
monetary
policy
*
Presidential
address delivered at
the Eightieth
Annual
Meeting of the
American Eco-
nomic
Association,
Washington, D.C.,
December
29, 1967.
**
I am
indebted
for
helpful criticisms of
earlier drafts to
Armen Alchian,
Gary
Becker,
Martin
Bronfenbrenner, Arthur F.
Burns, Phillip
Cagan,
David D.
Friedman, Lawrence
Harris,
Harry G.
Johnson, Homer
Jones,
Jerry Jordan,
David
Meiselman, Allan H.
Meltzer,
Theodore W.
Schultz,
Anna J.
Schwartz, Herbert
Stein, George J.
Stigler, and
James
Tobin.
2 THE AMERICAN ECONOMIC REVIEW
for meeting the depression and his offering was avidly accepted. If
li-
quidity preference is absolute or nearly so-as Keynes believed likely
in times of heavy unemployment-interest rates cannot be lowered by
monetary measures. If investment and consumption are little affected
by interest rates-as Hansen and many of Keynes' other American dis-
ciples came to believe-lower interest rates, even if they could be
achieved,
would do little good. Monetary policy is twice damned. The
contraction, set in train, on this view, by a collapse of investment or by
a
shortage
of
investment opportunities or by stubborn thriftiness,
could
not, it
was
argued, have been stopped by monetary measures. But
there
was
available an alternative-fiscal policy. Government spending could
make up for insufficient private investment. Tax reductions could
un-
dermine
stubborn thriftiness.
The wide acceptance of these views in the economics profession
meant that for some two decades monetary policy was believed by all
but
a
few reactionary souls to have been rendered obsolete by new eco-
nomic knowledge. Money did not matter. Its only role was the minor
one of keeping interest rates low, in order to hold down interest pay-
ments in the government budget, contribute to the "euthanasia of the
rentier," and maybe, stimulate investment a bit to assist government
spending in maintaining a high level of aggregate demand.
These views produced a widespread adoption of cheap money poli-
cies after the war. And they received a rude shock when these policies
failed in country after country, when central bank after central
bank
was forced to
give up the pretense
that
it could indefinitely keep
"the"
rate of interest at a low level. In this country, the public denouement
came with
the Federal Reserve-Treasury Accord
in
1951, although
the
policy
of
pegging government bond prices
was not
formally
abandoned
until
1953. Inflation, stimulated by cheap money policies, not
the
widely
heralded
postwar depression,
turned out
to be the
order of the
day.
The
result
was the
beginning
of
a revival
of belief in
the
potency
of
monetary policy.
This revival was strongly fostered among economists by the theoreti-
cal developments
initiated
by
Haberler
but
named
for
Pigou
that
pointed
out a
channel-namely, changes
in
wealth-whereby changes
in the real
quantity
of
money
can
affect
aggregate
demand
even
if
they
do
not alter
interest rates.
These
theoretical
developments
did
not
un-
dermine
Keynes' argument against
the
potency
of
orthodox
monetary
measures
when
liquidity preference
is
absolute
since under
such
cir-
cumstances
the
usual
monetary operations
involve
simply substituting
money
for
other assets without
changing
total
wealth.
But
they
did
show
how
changes
in the
quantity
of
money produced
in other
ways
could
affect
total
spending
even under such circumstances.
And,
more
FRIEDMAN: MONETARY POLICY
3
fundamentally, they did
undermine Keynes' key theoretical
proposi-
tion, namely, that even in a
world of flexible prices, a position of
equi-
librium at full employment
might
not
exist. Henceforth,
unemployment
had again to be explained
by rigidities or imperfections, not as the
nat-
ural
outcome of a fully
operative market process.
The revival of belief in
the potency of monetary policy was
fostered
also by a re-evaluation of
the role money played from 1929 to
1933.
Keynes and most other
economists of the time believed that the
Great
Contraction in the
United
States occurred despite aggressive
expansion-
ary policies by the
monetary authorities-that they did their
best but
their best was not good
enough.' Recent studies have
demonstrated
that the facts are precisely
the reverse: the U.S. monetary
authorities
followed highly
deflationary policies. The quantity of money in
the
United States fell
by
one-third in the
course
of
the
contraction.
And it
fell
not because there were
no willing borrowers-not because the
horse
would
not
drink.
It fell
because the Federal Reserve System forced or
permitted a sharp reduction
in the monetary base, because it
failed to
exercise
the responsibilities
assigned to it in the Federal Reserve
Act to
provide liquidity to the
banking system.
The
Great Contraction is
tragic testimony
to the
power
of
monetary policy-not,
as
Keynes
and
so
many
of his
contemporaries believed, evidence of its impotence.
In the United States the
revival of belief in the potency of
monetary
policy
was
strengthened
also by increasing disillusionment
with fiscal
policy,
not
so
much
with
its
potential to affect aggregate
demand as
with
the practical and
political feasibility of so using it. Expenditures
turned out to
respond
sluggishly
and
with long lags
to
attempts
to
ad-
just
them
to the course of
economic activity, so emphasis shifted to
taxes. But here
political
factors entered with
a
vengeance
to
prevent
prompt adjustment to
presumed need, as has been so graphically illus-
trated in the months
since
I
wrote the first draft of
this talk. "Fine tun-
ing"
is
a
marvelously evocative
phrase
in this
electronic
age,
but
it has
little resemblance to
what
is
possible
in
practice-not,
I
might
add,
an
unmixed evil.
It is hard to realize how
radical has been the
change
in professional
opinion
on the role of
money.
Hardly
an
economist
today accepts
views
that were the common
coin
some two
decades
ago.
Let me
cite
a
f ew
examples.
In
a talk published
in
1945,
E.
A.
Goldenweiser,
then Director
of
the
Research
Division
of the
Federal Reserve
Board,
described
the
pri-
mary objective of monetary
policy as being to "maintain
the value of
Government
bonds....
This
country"
he
wrote,
"will have to
adjust
to
'In [2],
I
have
argued that Henry Simons
shared this view
with Keynes, and that
it
accounts for the policy
changes that he
recommended.
/ 17
End of Document
368

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FAQs

What are the main arguments presented by Milton Friedman regarding monetary policy?
Milton Friedman argues that monetary policy plays a crucial role in managing economic stability and achieving goals such as high employment and stable prices. He emphasizes that controlling the money supply is essential to prevent economic disturbances and inflation. Friedman critiques past economic theories that downplayed the significance of monetary policy, particularly during the Great Depression, asserting that poor monetary decisions exacerbated economic downturns. He advocates for a steady growth rate in the money supply to foster a stable economic environment.
How does Friedman differentiate between monetary policy and fiscal policy?
Friedman distinguishes monetary policy from fiscal policy by highlighting their different mechanisms and impacts on the economy. While fiscal policy involves government spending and taxation to influence economic activity, monetary policy focuses on controlling the money supply and interest rates. He argues that monetary policy can be more effective in managing inflation and unemployment, as it directly affects the liquidity in the economy. Additionally, Friedman points out that fiscal policy often faces political hurdles, making it less reliable in times of economic crisis.
What limitations does Friedman identify regarding monetary policy?
Friedman identifies several limitations of monetary policy, particularly its inability to peg interest rates or unemployment levels for extended periods. He explains that while monetary expansion can temporarily lower interest rates, it ultimately leads to inflationary pressures that can raise rates again. Furthermore, he argues that monetary policy cannot effectively target real economic variables like unemployment without causing unintended consequences. This highlights the complexity of economic management and the need for careful policy implementation.
What historical examples does Friedman use to support his arguments?
Friedman uses the Great Depression as a key historical example to illustrate the consequences of poor monetary policy decisions. He argues that the Federal Reserve's failure to provide adequate liquidity during this period led to a severe contraction in the money supply, exacerbating the economic downturn. Additionally, he references post-war monetary policies that resulted in inflation, demonstrating the need for a more stable approach to monetary management. These examples serve to reinforce his thesis on the importance of effective monetary policy.
What recommendations does Friedman make for future monetary policy?
Friedman recommends that monetary authorities adopt a steady growth rate for the money supply to promote economic stability. He argues that avoiding sharp swings in policy can help prevent economic disturbances and maintain confidence in the monetary system. Additionally, Friedman suggests that policymakers focus on controlling nominal quantities rather than trying to influence real economic variables directly. His insights advocate for a more systematic and predictable approach to monetary policy to achieve long-term economic goals.

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