Friedman 1968 at 50 Most Complete From Sopintar
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link : Friedman 1968 at 50 Most Complete From Sopintar
This month marks the 50th anniversary of Milton Friedman's The Role of Monetary Policy, one of the most influential essays in economics ever. To this day, economics students are well advised to go read this classic article, and carefully. The Journal of Economic Perspectives hosted three excellent articles, by Greg Mankiw and Ricardo Reis, by Olivier Blanchard, and by Bob Hall and Tom Sargent.
Friedman might have subtitled it "neutrality and non-neutrality." Monetary policy is neutral in the long run -- inflation becomes disconnected from anything real including output, employment, interest rates, and relative prices. But monetary policy is not neutral in the short run.
There are three big ingredients of the macroeconomic revolution of the 1960s and 1970s. 1) The remarkable neutrality theorems including the Modigliani Miller theorem (debt vs. equity does not alter the value of the firm), Ricardian equivalence (Barro, debt vs. taxes doesn't change stimulus), and the neutrality of money. 2) The economy operates intertemporally, not each moment in time on its own. 3) Basing macroeconomics in decisions by people, not abstract relationships among aggregates, such as the "consumption function" relating consumption to income. Efficient markets, rational expectations, real business cycles, etc. integrate these ingredients. You can see all three underlying this article.
As money is not neutral in the short run, the neutrality theorems are not true of the world in their raw form, but they form the supply and demand framework on which we must add frictions. Friedman's permanent income hypothesis really kicked off the latter, and The Role of Monetary Policy is a central part of the first.
I. The Phillips curve
Friedman's view on the Phillips curve is the most durable and justly famous contribution. William Phillips had observed that inflation and unemployment were negatively correlated. (The observation is often stated in terms of wage inflation, or in terms of the gap between actual and potential output.)
For fun, I plotted the relationship between inflation and unemployment in data up until 1968, with emphasis in red on the then most recent data, 1960-1968. This was the evidence available at the time.
The Keynesians of Friedman's day had integrated this idea into their thinking, and advocated that the US exploit the tradeoff to obtain lower unemployment by adopting slightly higher inflation.
Friedman said no. And, interestingly for an economist whose reputation is as a dedicated empiricist, his argument was largely theoretical. But it was brilliant, and simple.
There is no reason that people should work harder, or businesses produce more, in a time of general inflation. People work harder if you give them higher wages relative to prices, and companies may produce more if you give them higher prices relative to wages. But if both prices and wages are rising, there is no reason for either effect.
There could be, Friedman reasoned, a short run effect. Workers might see the wages go up and not realize prices were going up too. Firms might see prices going up and not see wages going up too. Each might be fooled to working harder and producing more. But you can't fool all the people all of the time, Friedman reasoned. So the Phillips curve can only be transitory.
If you push on it, it will fall apart, and you will just get more inflation with the same unemployment and output.
Like Babe Ruth's famous called home run, (picture at left) it's one of the most famous predictions in economics.
The original:
Here is inflation and unemployment from Friedman's speech onwards. First we just got inflation (to 70), then we got stagflation, inflation and unemployment. The minute policy pushed on it, the correlation turned out not to be structural.
Friedman's really was an audacious prediction. Look again at the first graph. That correlation between inflation and unemployment is really strong, far stronger than the evidence behind many of today's beliefs about monetary policy such as the effectiveness of QE. With that graph in memory, Friedman stood up in front of the AEA and said, if you push on this, it will move.
The Phillips curve today
For a long time, economists incorporated Friedman's view into graphs like the last one, by thinking there is still a negative relationship between inflation and unemployment, but it shifts up and down depending on the level of expected inflation. 77-80, for example, is the same curve as 66-69, shifted up and out, and 80-82.5 is another one. 84 represents the conquest of inflation expectations.
Here, for example, is the Phillips curve augmented with expected inflation as presented in Wikipedia. The horizontal lines represent expected inflation. If inflation is larger than expected, then unemployment is less than the natural rate. (Or output is above potential.)
In equations, \[ \pi_t = \pi^e_t - \kappa (u_t - \bar{u}) \] or \[ \pi_t = \pi^e_t + \kappa x_t\] where \(\pi\) is inflation, \(\pi^e\) is expected inflation (the vertical distance A and C in the graph) \(u\) is the unemployment rate, \(\bar{u}\) is the natural rate, \(x\) is the output gap (output less potential) and \(\kappa\) is a parameter.
The early Keynesians took \(\pi^e\) as a constant, not even identifying it as expected inflation, and ignoring that it would rise after inflation rose. Friedman and later Keynesians thought of expectations as adapting slowly to actual inflation, most simply \[\pi^e_t = \pi_{t-1} \] or \[ \pi^e_t = \sum_{j=1}^\infty a_j \pi_{t-j}.\]
Then the time index on expected inflation started moving slowly forward. Bob Lucas' rational expectation model moved the index forward one, \[\pi^e_t = E_{t-1}\pi_t.\] The later new-Keynesian sticky price models including Calvo, and epitomized in Mike Woodford's book, have fully rational firms setting prices in a forward-looking way. That moves the index forward even more with \[\pi^e_t = E_t \pi_{t+1}.\] (There is often a constant \(\beta\) slightly less than one in front of the latter, but it's not important for this discussion.)
Moving time indices forward is not innocuous. It turns the dynamics around. Mankiw and Reis pointed out that the New-Keynesian version it means output is high and unemployment is low when inflation is high relative to the future, i.e. when inflation is decreasing. The facts of the 1970s and 1980s seem opposite, that output is high and unemployment is low when inflation is increasing. They argued for ``sticky information'' as a way to go back to adaptive expectations, i.e. to put some lagged inflation back in \(\pi^e_t\). Xavier Gabaix, Mike Woodford, and others are working on learning and other deviations from rationality to the same end. This is a tip of a huge iceberg that finds reasons to put some \(\pi_{t-1}\) back in the Phillips curve. So the trend seems to be finding reasons to step back towards Friedman's adaptive expectations, and thus allowing the Fed at least a regular and systematically exploitable temporary effect.
Friedman didn't comment much on rational expectations, but if we take the same attitude he showed towards historical correlations vs. simple theory in the "Role of Monetary Policy," he might argue for some caution. Slow adaptation may describe the correlations of the 1970s, as no adaptation described the correlations of the 1960s. But, he might warn, beware pushing on it too far or calling it too quickly "always and everywhere." That view also leaves out the salient big episodes, arguably some of the stagflation of the 1970s, the quick victory over inflation in 1982, and certainly Sargent and Wallace's ends of hyperinflations, in which expectations collapsed and both unemployment and inflation improved together.
The Fed has pretty much embraced Friedman's view, with a fairly eclectic view of where expectations come from. It believes there is a Phillips curve tradeoff, and that it centers around expected inflation. However, it believes that expected inflation \(\pi^e\) is now "anchored" at 2%. Just what "anchored" means is a bit more nebulous and what would unanchor it is a bit more mysterious. At best it reflects people's belief in the Fed's reputation for inflation toughness gained in the 1980s.
All this standard argument is about the location of the curve. The facts above and the last 10 years pose a greater challenge. The curve itself seems to have become flat, i.e. a non-curve. From 2008 to now, unemployment jumped up and back down again, with nary a movement in inflation. The slope of the Phillips curve has disappeared, let alone the vertical location about which we have debated so long. Compare the slope in the Wikipedia graph to that of the 2008-2018 experience.
Looking back, perhaps that is true more generally. The curve was flat from 1983 to 1990 and other episodes as well. How do we know that the downward sloping parts have stable inflation expectations and the upward sloping or flat parts represent the curve? Perhaps the flat parts are the ones with stable expectations. Identifying the slope of a curve in a cloud like this is always tricky business.
I interpret the flat slope to say, there just isn't much of a reliable relationship between unemployment and inflation to start with. Inflation does what it does, unemployment does what it does, and when inflation is stable you see a flat curve. That interpretation is not ironclad. A sharp Fed economist countered with, no, the very flat curve really is an exploitable curve. It means that if we could just raise inflation half a percent we'd get a huge reduction in unemployment. Hmm.
(Greg Mankiw and Ricardo Reis' JEP review gives a very nice history of the influence of Friedman's paper, echoing many of the points here though more concisely. They discuss monetary policy as well as the Phillips curve, including the observation that financial markets are frictions are now at the center of macroeconomics, what they call a "new monetarism ... being built on the role of liquidity in financial markets and on the role that reserves play in these markets." Olivier Blanchard's review has a lot more detail, emphasizing that maybe economies do not return to the natural rates -- recessions seem to have very long lasting if not permanent effects, questioning the "accelerationist" dynamics, and also confronting the zero bound era. Bob Hall an Tom Sargent offer an elegant capsule history of the Phillips curve, and address the lack of a curve in the data.)
Meanwhile, despite the last 10 years, the Fed's belief in the Phillips curve seems as strong as ever. Interestingly, the Fed largely reads the curve as causal from unemployment to inflation, not the other way around. The Fed sets interest rates, interest rates move aggregate demand, aggregate demand moves output and employment, and then "tight" or "slack" markets move inflation. Friedman, above, clearly read the correlation as causation from inflation to unemployment. People respond to unexpected inflation by working or producing more. Friedman also clearly thought that money growth was the ultimate cause of inflation. The Fed's choice of a different causal mechanism reflects how money growth has vanished from monetary economics -- rightly I think -- but leaving a gaping hole about just what does then cause inflation.
Phillips curve influence
Still, the influence of these few paragraphs was immense. Just how many Nobel prizes stem directly or indirectly from this work? Surely we should count Lucas' and Phelps' prizes, each of which elucidated different parts of the Phillips curve and how it adjusts, Lucas focusing more on expectations and Phelps on labor markets.
The concept of the natural rate itself is a bombshell. Economists at the time pretty much thought all unemployment was bad. No, reasoning by analogy with Wicksells' "natural" rate of interest,
II. Monetarism and the effects of monetary policy
Friedman's view of monetary policy was just as important at the time, and if it has not lasted as long that is worth appreciating as well. In fact, unemployment was Friedman's second proposition. The first was, how does monetary policy work:
1) A nominal interest rate peg is unstable. This has been a core doctrine of monetary policy ever since. It must result in galloping inflation or deflation.
2) You see here Friedan's (1968) view that expectations are adaptive, and in fact much slower to adapt -- "several decades" -- than they turned out to be! These two views are interestingly inconsistent. With the latter, one could get away with a peg for a few decades.
3) You can also see an almost Fisherman prescription in the last paragraph. Reduce money growth, lower inflation, and with only a quick trip in the other direction, lower nominal rates.
4) Most of all, monetary policy operates through, well, the quantity of money, MV=PY. It's a mistake to even look at interest rates, let alone to target them. Of the options
Just which aggregate is "money" proved elusive. Policy-invariance proved more so. When the Fed arguably pushed on M in the early 1980s, V instantly took up the slack and one more historical correlation bit the dust of policy exploitation, in true Friedman spirit. V = PY/M.
With perhaps a brief interlude in the early 1980s, our central banks have resolutely targeted interest rates all along and continue to do so.
Theoretically, though interest rate pegs might not work, John Taylor's rule inaugurated the idea that Friedman's instability would be avoided if interest rate targets move enough with inflation. Current monetary economics is considered entirely in the context of such an interest rate rule. Yes, there are new ideas in monetary policies that even Friedman hadn't thought of, and an interest rate target that varies with the rate of inflation is one, and has provided a once-in-century genuinely new idea in monetary economics. That Friedman does not mention it is noteworthy. However, just how interest rates alone produce aggregate demand, without Friedman's MV=PY connection, remains a bit of a weak point of the theory.
Identifying monetary policy with growth in monetary aggregates nonetheless had an amazing hold over the academic imagination. Money only started to disappear from New-Keynesian models in the early 1990s. But plenty of monetary theory and VAR empirical work continued to identify monetary expansion with increase in monetary aggregates through at least the 1990s.
The last 10 years have, in my view at least, really damaged these views.
At the cost of repeating graphs from earlier blog posts (but good ones!) here is the history inflation during our period of zero interest rates -- effectively a peg -- and immense increase in reserves, from $10 billion to $3,000 billion. Inflation did... nothing.
Japan's 25 years at the zero bound speak even more loudly.
I conclude that Friedman was right -- monetary policy cannot peg real interest rates. The relation nominal rate = real rate + expected inflation \[i_t = r_t + \pi^e_t \]holds and the real rate is eventually released from monetary influences. But, beyond neutrality, Friedman also saw this as an unstable relation. The data suggest it's stable -- yes, an interest rate peg can last, and inflation will eventually adjust. Like the Phillips curve, moving time indices around has a big effect on stability properties.
However interpreted, the zero bound experience has taught us that an interest rate peg can be consistent with stable inflation, at least for a much longer time than previously thought. We have also learned that arbitrary -- increase from 10 to 3,000! -- amounts of interest-paying money does not cause inflation. V = PY/M again, times 1,000. We can live the Friedman rule (another classic).
I do not view it as any denigration to suggest that not every word of a 50 year old paper has panned out. We do learn, however, from experience, as Friedman did. Economics does advance like a science. It does not produce unchangeable holy writ.
What would Friedman think?
Friedman was a very empirically oriented economist. His views were heavily influenced by history to that date. In the great depression, as he and Anna Schwartz so magnificently documented, a collapse in money accompanied deflation and depression, with interest rates at zero, in a way that the huge expansion of reserves in the last decade absolutely did not accompany inflation and boom. Friedman was also influenced by postwar interest rate pegs that quickly fell apart,
But what would Friedman, the empiricist, have said today, with the wild behavior 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, stabilizes the price level in theory, and, apparently in the practice of the 1980s?
We cannot fault Friedman for not knowing the future, and I like to think his views would have adapted too.
III Influence on our view of central banks
Despite these later events, Friedman's view of monetary policy has, really, had even more enduring influence 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 as common now as the view that the sun comes up in the east. But, as Friedman reminds us, it was not always so.
We forget now that in the 1960s, prevailing Keynesian opinion held that monetary policy was fairly impotent to do much of anything. Inflation, if considered at all, was some mysterious wage-price spiral to be addressed by telling people not to raise prices or wages. Fiscal stimulus was regarded as the main macroeconomic tool. And Friedman is happy to document this for us
Friedman won, totally and overwhelmingly, and to the point that I think today most economic commentary vastly overestimates the power of the Federal reserve to control inflation, let alone to micromanage the economy and financial markets.
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 labor 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. That desire does not make it so.
I think we shall look back and realize the Fed is much less powerful than all this commentary suggests.
Friedman warned as much with a very contemporary feel:
The Fed's first task is, don't screw up.
And on the common idea that monetary policy needs to offset shocks coming from elsewhere
We rediscovered in 2008 that "shovel ready" "targeted, temporary, and timely" fiscal interventions do not exist. The California high-speed train still has not left the station.
(Note, my blog posts often evolve as I correspond with people. This one is likely to have such a fate.)
link : Friedman 1968 at 50 Most Complete From Sopintar
This month marks the 50th anniversary of Milton Friedman's The Role of Monetary Policy, one of the most influential essays in economics ever. To this day, economics students are well advised to go read this classic article, and carefully. The Journal of Economic Perspectives hosted three excellent articles, by Greg Mankiw and Ricardo Reis, by Olivier Blanchard, and by Bob Hall and Tom Sargent.
Friedman might have subtitled it "neutrality and non-neutrality." Monetary policy is neutral in the long run -- inflation becomes disconnected from anything real including output, employment, interest rates, and relative prices. But monetary policy is not neutral in the short run.
There are three big ingredients of the macroeconomic revolution of the 1960s and 1970s. 1) The remarkable neutrality theorems including the Modigliani Miller theorem (debt vs. equity does not alter the value of the firm), Ricardian equivalence (Barro, debt vs. taxes doesn't change stimulus), and the neutrality of money. 2) The economy operates intertemporally, not each moment in time on its own. 3) Basing macroeconomics in decisions by people, not abstract relationships among aggregates, such as the "consumption function" relating consumption to income. Efficient markets, rational expectations, real business cycles, etc. integrate these ingredients. You can see all three underlying this article.
As money is not neutral in the short run, the neutrality theorems are not true of the world in their raw form, but they form the supply and demand framework on which we must add frictions. Friedman's permanent income hypothesis really kicked off the latter, and The Role of Monetary Policy is a central part of the first.
I. The Phillips curve
Friedman's view on the Phillips curve is the most durable and justly famous contribution. William Phillips had observed that inflation and unemployment were negatively correlated. (The observation is often stated in terms of wage inflation, or in terms of the gap between actual and potential output.)
The Keynesians of Friedman's day had integrated this idea into their thinking, and advocated that the US exploit the tradeoff to obtain lower unemployment by adopting slightly higher inflation.
Friedman said no. And, interestingly for an economist whose reputation is as a dedicated empiricist, his argument was largely theoretical. But it was brilliant, and simple.
There is no reason that people should work harder, or businesses produce more, in a time of general inflation. People work harder if you give them higher wages relative to prices, and companies may produce more if you give them higher prices relative to wages. But if both prices and wages are rising, there is no reason for either effect.
If you push on it, it will fall apart, and you will just get more inflation with the same unemployment and output.
Like Babe Ruth's famous called home run, (picture at left) it's one of the most famous predictions in economics.
The original:
Let us assume that the monetary authority tries to peg the "market" rate of unemployment at a level below the "natural" rate.... the authority increases the rate of monetary growth. This will be expansionary... Income and spending will start to rise.And this is exactly what happened.
To begin with, much or most of the rise in income will take the form of an increase in output and employment rather than in prices. People have been expecting prices to be stable, and prices and wages have been set for some time in the future on that basis. It takes time for people to adjust to a new state of demand. Producers will tend to react to the initial expansion in aggregate demand by increasing output, employees by working longer hours, and the unemployed, by taking jobs now offered at former nominal wages. This much is pretty standard doctrine.
But it describes only the initial effects.... Employees will start to reckon on rising prices of the things they buy and to demand higher nominal wages for the future. "Market" unemployment is below the "natural" level. There is an excess demand for labor so real wages [wage/price] will tend to rise toward their initial level.
...the rise in real wages will reverse the decline in unemployment, and then lead to a rise, which will tend to return unemployment to its former level. In order to keep unemployment at its target level of 3 per cent, the monetary authority would have to raise monetary growth still more. As in the interest rate case, the "market" rate can be kept below the "natural" rate only by inflation. And, as in the interest rate case, too, only by accelerating inflation.
Here is inflation and unemployment from Friedman's speech onwards. First we just got inflation (to 70), then we got stagflation, inflation and unemployment. The minute policy pushed on it, the correlation turned out not to be structural.
Friedman's really was an audacious prediction. Look again at the first graph. That correlation between inflation and unemployment is really strong, far stronger than the evidence behind many of today's beliefs about monetary policy such as the effectiveness of QE. With that graph in memory, Friedman stood up in front of the AEA and said, if you push on this, it will move.
The Phillips curve today
For a long time, economists incorporated Friedman's view into graphs like the last one, by thinking there is still a negative relationship between inflation and unemployment, but it shifts up and down depending on the level of expected inflation. 77-80, for example, is the same curve as 66-69, shifted up and out, and 80-82.5 is another one. 84 represents the conquest of inflation expectations.
In equations, \[ \pi_t = \pi^e_t - \kappa (u_t - \bar{u}) \] or \[ \pi_t = \pi^e_t + \kappa x_t\] where \(\pi\) is inflation, \(\pi^e\) is expected inflation (the vertical distance A and C in the graph) \(u\) is the unemployment rate, \(\bar{u}\) is the natural rate, \(x\) is the output gap (output less potential) and \(\kappa\) is a parameter.
The early Keynesians took \(\pi^e\) as a constant, not even identifying it as expected inflation, and ignoring that it would rise after inflation rose. Friedman and later Keynesians thought of expectations as adapting slowly to actual inflation, most simply \[\pi^e_t = \pi_{t-1} \] or \[ \pi^e_t = \sum_{j=1}^\infty a_j \pi_{t-j}.\]
Then the time index on expected inflation started moving slowly forward. Bob Lucas' rational expectation model moved the index forward one, \[\pi^e_t = E_{t-1}\pi_t.\] The later new-Keynesian sticky price models including Calvo, and epitomized in Mike Woodford's book, have fully rational firms setting prices in a forward-looking way. That moves the index forward even more with \[\pi^e_t = E_t \pi_{t+1}.\] (There is often a constant \(\beta\) slightly less than one in front of the latter, but it's not important for this discussion.)
Moving time indices forward is not innocuous. It turns the dynamics around. Mankiw and Reis pointed out that the New-Keynesian version it means output is high and unemployment is low when inflation is high relative to the future, i.e. when inflation is decreasing. The facts of the 1970s and 1980s seem opposite, that output is high and unemployment is low when inflation is increasing. They argued for ``sticky information'' as a way to go back to adaptive expectations, i.e. to put some lagged inflation back in \(\pi^e_t\). Xavier Gabaix, Mike Woodford, and others are working on learning and other deviations from rationality to the same end. This is a tip of a huge iceberg that finds reasons to put some \(\pi_{t-1}\) back in the Phillips curve. So the trend seems to be finding reasons to step back towards Friedman's adaptive expectations, and thus allowing the Fed at least a regular and systematically exploitable temporary effect.
Friedman didn't comment much on rational expectations, but if we take the same attitude he showed towards historical correlations vs. simple theory in the "Role of Monetary Policy," he might argue for some caution. Slow adaptation may describe the correlations of the 1970s, as no adaptation described the correlations of the 1960s. But, he might warn, beware pushing on it too far or calling it too quickly "always and everywhere." That view also leaves out the salient big episodes, arguably some of the stagflation of the 1970s, the quick victory over inflation in 1982, and certainly Sargent and Wallace's ends of hyperinflations, in which expectations collapsed and both unemployment and inflation improved together.
The Fed has pretty much embraced Friedman's view, with a fairly eclectic view of where expectations come from. It believes there is a Phillips curve tradeoff, and that it centers around expected inflation. However, it believes that expected inflation \(\pi^e\) is now "anchored" at 2%. Just what "anchored" means is a bit more nebulous and what would unanchor it is a bit more mysterious. At best it reflects people's belief in the Fed's reputation for inflation toughness gained in the 1980s.
All this standard argument is about the location of the curve. The facts above and the last 10 years pose a greater challenge. The curve itself seems to have become flat, i.e. a non-curve. From 2008 to now, unemployment jumped up and back down again, with nary a movement in inflation. The slope of the Phillips curve has disappeared, let alone the vertical location about which we have debated so long. Compare the slope in the Wikipedia graph to that of the 2008-2018 experience.
Looking back, perhaps that is true more generally. The curve was flat from 1983 to 1990 and other episodes as well. How do we know that the downward sloping parts have stable inflation expectations and the upward sloping or flat parts represent the curve? Perhaps the flat parts are the ones with stable expectations. Identifying the slope of a curve in a cloud like this is always tricky business.
I interpret the flat slope to say, there just isn't much of a reliable relationship between unemployment and inflation to start with. Inflation does what it does, unemployment does what it does, and when inflation is stable you see a flat curve. That interpretation is not ironclad. A sharp Fed economist countered with, no, the very flat curve really is an exploitable curve. It means that if we could just raise inflation half a percent we'd get a huge reduction in unemployment. Hmm.
(Greg Mankiw and Ricardo Reis' JEP review gives a very nice history of the influence of Friedman's paper, echoing many of the points here though more concisely. They discuss monetary policy as well as the Phillips curve, including the observation that financial markets are frictions are now at the center of macroeconomics, what they call a "new monetarism ... being built on the role of liquidity in financial markets and on the role that reserves play in these markets." Olivier Blanchard's review has a lot more detail, emphasizing that maybe economies do not return to the natural rates -- recessions seem to have very long lasting if not permanent effects, questioning the "accelerationist" dynamics, and also confronting the zero bound era. Bob Hall an Tom Sargent offer an elegant capsule history of the Phillips curve, and address the lack of a curve in the data.)
Meanwhile, despite the last 10 years, the Fed's belief in the Phillips curve seems as strong as ever. Interestingly, the Fed largely reads the curve as causal from unemployment to inflation, not the other way around. The Fed sets interest rates, interest rates move aggregate demand, aggregate demand moves output and employment, and then "tight" or "slack" markets move inflation. Friedman, above, clearly read the correlation as causation from inflation to unemployment. People respond to unexpected inflation by working or producing more. Friedman also clearly thought that money growth was the ultimate cause of inflation. The Fed's choice of a different causal mechanism reflects how money growth has vanished from monetary economics -- rightly I think -- but leaving a gaping hole about just what does then cause inflation.
Phillips curve influence
Still, the influence of these few paragraphs was immense. Just how many Nobel prizes stem directly or indirectly from this work? Surely we should count Lucas' and Phelps' prizes, each of which elucidated different parts of the Phillips curve and how it adjusts, Lucas focusing more on expectations and Phelps on labor markets.
The concept of the natural rate itself is a bombshell. Economists at the time pretty much thought all unemployment was bad. No, reasoning by analogy with Wicksells' "natural" rate of interest,
... The "natural rate of unemployment," ... is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on.'And later presciently warning,
What if the monetary authority chose the "natural" rate-either of interest or unemployment-as its target? One problem is that it cannot know what the "natural" rate is.The current effort to divine the "natural" real rate of interest and the continuing debate over just where "natural" or "neutral" unemployment come to mind.
...by using the term "natural" rate of unemployment, I do not mean to suggest that it is immutable and unchangeable. On the contrary, many of the market characteristics that determine its level are man-made and policy-made. In the United States, for example, legal minimum wage rates, the Walsh- Healy and Davis-Bacon Acts, and the strength of labor unions all make the natural rate of unemployment higher than it would otherwise be. Improvements in employment exchanges, in availability of information about job vacancies and labor supply, and so on, would tend to lower the natural rate of unemployment.You can see roots of modern search and matching models in the labor market, Diamond Mortensen and Pissarides' Nobel Prize, as well as a yet-unheeded warning that perhaps the "frictions" that make monetary policy potent should be the subject of microeconomic reform not just monetary management.
II. Monetarism and the effects of monetary policy
Friedman's view of monetary policy was just as important at the time, and if it has not lasted as long that is worth appreciating as well. In fact, unemployment was Friedman's second proposition. The first was, how does monetary policy work:
It [monetary policy] cannot peg interest rates for more than very limited periods...
Let the Fed set out to keep interest rates down. How will it try to do so? By buying securities. This raises their prices and lowers their yields. [QE!] In the process, it also increases the quantity of reserves available to banks, hence the amount of bank credit, and, ultimately the total quantity of money....Later
The initial impact of increasing the quantity of money at a faster rate than it has been increasing is to make interest rates lower for a time than they would otherwise have been. But this is only the beginning of the process not the end. The more rapid rate of monetary growth will stimulate spending,...
A fourth effect, when and if it becomes operative, will go even farther, and definitely mean that a higher rate of monetary expansion will correspond to a higher, not lower, level of interest rates than would otherwise have prevailed. Let the higher rate of monetary growth produce rising prices, and let the public come to expect that prices will continue to rise. Borrowers will then be willing to pay and lenders will then demand higher interest rates-as Irving Fisher pointed out decades ago. This price expectation effect is slow to develop and also slow to disappear. Fisher estimated that it took several decades for a full adjustment and more recent work is consistent with his estimates.
These subsequent effects explain why every attempt to keep interest rates at a low level has forced the monetary authority to engage in successively larger and larger open market purchases.
Paradoxically, the monetary authority could assure low nominal rates of interest-but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy. Similarly, it could assure high nominal interest rates by engaging in an inflationary policy and accepting a temporary movement in interest rates in the opposite direction. These considerations not only explain why monetary policy cannot peg interest rates; they also explain why interest rates are such a misleading indicator of whether monetary policy is "tight" or "easy."
If, as the authority has often done, it takes interest rates or the current unemployment percentage as the immediate criterion of policy, it will be like a space vehicle that has taken a fix on the wrong star. No matter how sensitive and sophisticated its guiding apparatus, the space vehicle will go astray.
My own prescription is still that the monetary authority go all the way in avoiding such swings by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total.There's a lot in these paragraphs.
1) A nominal interest rate peg is unstable. This has been a core doctrine of monetary policy ever since. It must result in galloping inflation or deflation.
2) You see here Friedan's (1968) view that expectations are adaptive, and in fact much slower to adapt -- "several decades" -- than they turned out to be! These two views are interestingly inconsistent. With the latter, one could get away with a peg for a few decades.
3) You can also see an almost Fisherman prescription in the last paragraph. Reduce money growth, lower inflation, and with only a quick trip in the other direction, lower nominal rates.
4) Most of all, monetary policy operates through, well, the quantity of money, MV=PY. It's a mistake to even look at interest rates, let alone to target them. Of the options
If, as the authority has often done, it takes interest rates or the current unemployment percentage as the immediate criterion of policy, it will be like a space vehicle that has taken a fix on the wrong star. No matter how sensitive and sophisticated its guiding apparatus, the space vehicle will go astray.
My own prescription is still that the monetary authority go all the way in avoiding such swings by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total.The subsequent decades have not been that kind to these views. (Though hang on for a later appreciation of their immense and enduring influence.)
Just which aggregate is "money" proved elusive. Policy-invariance proved more so. When the Fed arguably pushed on M in the early 1980s, V instantly took up the slack and one more historical correlation bit the dust of policy exploitation, in true Friedman spirit. V = PY/M.
With perhaps a brief interlude in the early 1980s, our central banks have resolutely targeted interest rates all along and continue to do so.
Theoretically, though interest rate pegs might not work, John Taylor's rule inaugurated the idea that Friedman's instability would be avoided if interest rate targets move enough with inflation. Current monetary economics is considered entirely in the context of such an interest rate rule. Yes, there are new ideas in monetary policies that even Friedman hadn't thought of, and an interest rate target that varies with the rate of inflation is one, and has provided a once-in-century genuinely new idea in monetary economics. That Friedman does not mention it is noteworthy. However, just how interest rates alone produce aggregate demand, without Friedman's MV=PY connection, remains a bit of a weak point of the theory.
Identifying monetary policy with growth in monetary aggregates nonetheless had an amazing hold over the academic imagination. Money only started to disappear from New-Keynesian models in the early 1990s. But plenty of monetary theory and VAR empirical work continued to identify monetary expansion with increase in monetary aggregates through at least the 1990s.
At the cost of repeating graphs from earlier blog posts (but good ones!) here is the history inflation during our period of zero interest rates -- effectively a peg -- and immense increase in reserves, from $10 billion to $3,000 billion. Inflation did... nothing.
I conclude that Friedman was right -- monetary policy cannot peg real interest rates. The relation nominal rate = real rate + expected inflation \[i_t = r_t + \pi^e_t \]holds and the real rate is eventually released from monetary influences. But, beyond neutrality, Friedman also saw this as an unstable relation. The data suggest it's stable -- yes, an interest rate peg can last, and inflation will eventually adjust. Like the Phillips curve, moving time indices around has a big effect on stability properties.
However interpreted, the zero bound experience has taught us that an interest rate peg can be consistent with stable inflation, at least for a much longer time than previously thought. We have also learned that arbitrary -- increase from 10 to 3,000! -- amounts of interest-paying money does not cause inflation. V = PY/M again, times 1,000. We can live the Friedman rule (another classic).
I do not view it as any denigration to suggest that not every word of a 50 year old paper has panned out. We do learn, however, from experience, as Friedman did. Economics does advance like a science. It does not produce unchangeable holy writ.
What would Friedman think?
Friedman was a very empirically oriented economist. His views were heavily influenced by history to that date. In the great depression, as he and Anna Schwartz so magnificently documented, a collapse in money accompanied deflation and depression, with interest rates at zero, in a way that the huge expansion of reserves in the last decade absolutely did not accompany inflation and boom. Friedman was also influenced by postwar interest rate pegs that quickly fell apart,
... 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.His views fit naturally in to this experience.
But what would Friedman, the empiricist, have said today, with the wild behavior 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, stabilizes the price level in theory, and, apparently in the practice of the 1980s?
We cannot fault Friedman for not knowing the future, and I like to think his views would have adapted too.
III Influence on our view of central banks
Despite these later events, Friedman's view of monetary policy has, really, had even more enduring influence 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 as common now as the view that the sun comes up in the east. But, as Friedman reminds us, it was not always so.
We forget now that in the 1960s, prevailing Keynesian opinion held that monetary policy was fairly impotent to do much of anything. Inflation, if considered at all, was some mysterious wage-price spiral to be addressed by telling people not to raise prices or wages. Fiscal stimulus was regarded as the main macroeconomic tool. And Friedman is happy to document this for us
... for some two decades monetary policy was believed by all but a few reactionary souls to have been rendered obsolete by new economic knowledge. Money did not matter. Its only role was the minor one of keeping interest rates low, in order to hold down interest payments 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....(Friedman introduced these comments with a brilliant rhetorical technique.
In a book on Financing American Prosperity, edited by Paul Homan and Fritz Machlup and published in 1945, Alvin Hansen devotes nine pages of text to the "savings-investment problem" without finding any need to use the words "interest rate" or any close facsimile thereto [5, pp. 218-27]... In his contribution, John H. Williams-not only professor at Harvard but also a long-time adviser to the New York Federal Reserve Bank- wrote, "I can see no prospect of revival of a general monetary control in the postwar period" [5, p. 383].
Another of the volumes dealing with postwar policy that appeared at this time, Planning and Paying for Full Employment, was edited by Abba P. Lerner and Frank D. Graham [6] and had contributors of all shades of professional opinion-from Henry Simons and Frank Graham to Abba Lerner and Hans Neisser. Yet Albert Halasi, in his excellent summary of the papers, was able to say, "Our contributors do not discuss the question of money supply. . . . The contributors make no special mention of credit policy to remedy actual depressions.... Inflation ... might be fought more effectively by raising interest rates.... But . . . other anti-inflationary measures . . . are preferable" [6, pp. 23-24]. A Survey of Contemporary Economics, edited by Howard Ellis and published in 1948, was an "official" attempt to codify the state of economic thought of the time. In his contribution, Arthur Smithies wrote, "In the field of compensatory action, I believe fiscal policy must shoulder most of the load. Its chief rival, monetary policy, seems to be disqualified on institutional grounds. This country appears to be committed to something like the present low level of interest rates on a long-term basis" [1, p. 208 ].
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.Of course, more than half of the economists sitting in the room were precisely of the sort that still thought fiscal policy primary and monetary policy secondary, and would go on throughout the 70s to advocate wage-price controls, "incomes policies" and anything but monetary policy to control inflation, and to warn that disinflation in the 80s would cost another great depression. If everyone agreed with Friedman he would hardly have had to give the talk.)
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 labor 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. That desire does not make it so.
I think we shall look back and realize the Fed is much less powerful than all this commentary suggests.
Friedman warned as much with a very contemporary feel:
I fear that, now as then [1920s], the pendulum may well have swung too far, that, now as then, we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and, as a result, in danger of preventing it from making the contribution that it is capable of making..Friedman offers much wisdom of central banking, also as fresh today as in 1968.
The Fed's first task is, don't screw up.
Because it [money] is so pervasive, when it gets out of order, it throws a monkey wrench into the operation of all the other machines. The Great Contraction is the most dramatic example but not the only one. Every other major contraction in this country has been either produced by monetary disorder or greatly exacerbated by monetary disorder. Every major inflation has been produced by monetary expansion-mostly to meet the overriding demands of war which have forced the creation of money to supplement explicit taxation.(That last comment is really interesting. Here Friedman recognizes that historically, most inflations are due to fiscal problems, not to central banker stupidity. He left that out of his description of postwar pegs that blew up, and it took Sargent and Wallace, Woodford, and the fiscal theorists to reemphasize fiscal-monetary coordination.)
The first and most important lesson that history teaches about what monetary policy can do-and it is a lesson of the most profound importance- is that monetary policy can prevent money itself from being a major source of economic disturbance. This sounds like a negative proposition: avoid major mistakes.When Ben Bernanke thanked Milton Friedman and said he (Bernanke) was not going to repeat the Fed's mistake of the 1930s, he fulfilled this lesson.
The past few years, to come closer to home, would have been steadier and more productive of economic wellbeing if the Federal Reserve had avoided drastic and erratic changes of direction, first expanding the money supply at an unduly rapid pace, then, in early 1966, stepping on the brake too hard, then, at the end of 1966, reversing itself and resuming expansion until at least November, 1967, at a more rapid pace than can long be maintained without appreciable inflationStop and go policy, what we now call "discretion" vs. "rules" is a particular danger.
And on the common idea that monetary policy needs to offset shocks coming from elsewhere
Finally, monetary policy can contribute to offsetting major disturbances in the economic system arising from other sources....
I have put this point last, and stated it in qualified terms-as referring to major disturbances-because I believe that the potentiality of monetary policy in offsetting other forces making for instability is far more limited than is commonly believed. We simply do not know enough ... Experience suggests that the path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a "clear and present danger."Friedman's assessment of fiscal stimulus has a contemporary ring as well:
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 adjust 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 illustrated in the months since I wrote the first draft of this talk. "Fine tuning" is a marvelously evocative phrase in this [1968!] electronic age, but it has little resemblance to what is possible in practice.
(Note, my blog posts often evolve as I correspond with people. This one is likely to have such a fate.)
This is the article Friedman 1968 at 50 Most Complete From Sopintar
So many articles Friedman 1968 at 50 Most Complete From Sopintar this time, hopefully it can benefit you all. OK, see you in another article.