III. How Should Monetary Policy Be Conducted?
How should monetary policy be conducted to make the contribution
to our goals that it is capable of making? This is clearly not the occasion for presenting a detailed "Program for Monetary Stability"-to
use the title of a book in which I tried to do so [3]. I shall restrict
myself here to two major requirements for monetary policy that follow
fairly directly from the preceding discussion.
The first requiremrent is that the monetary authority should guide itself by magnitudes that it can control, not by ones that it cannot control. If, as the authority has often done, it takes interest rates or the
current unemployment percentage as the immediate criterion of policy,
FRIEDMAN: MONETARY POLICY
15
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. And so will the monetary authority. Of the various alternative magnitudes that it can control, the most appealing
guides for policy are exchange rates, the price level as defined by some
index, and the quantity of a monetary total-currency plus adjusted
demand deposits, or this total plus commercial bank time deposits, or a
still broader total.
For the United States in particular, exchange rates are an undesirable guide. It might be worth requiring the bulk of the economy to adjust to the tiny percentage consisting of foreign trade if that would
guarantee freedom from monetary irresponsibility-as it might under a
real gold standard. But it is hardly worth doing so simply to adapt to
the average of whatever policies monetary authorities in the rest of the
world adopt. Far better to let the market, through floating exchange
rates, adjust to world conditions the 5 per cent or so of our resources
devoted to international trade while reserving monetary policy to promote the effective use of the 95 per cent.
Of the three guides listed, the price level is clearly the most important in its own right. Other things the same, it would be much the best
of the alternatives-as so many distinguished economists have urged in
the past. But other things are not the same. The link between the policy actions of the monetary authority and the price level, while unquestionably present, is more indirect than the link between the policy actions of the authority and any of the several monetary totals.
Moreover, monetary action takes a longer time to affect the price level than
to affect the monetary totals and both the time lag and the magnitude
of effect vary with circumstances. As a result, we cannot predict at all
accurately just what effect a particular monetary action will have on
the price level and, equally important, just when it will have that effect.
Attempting to control directly the price level is therefore likely to make
monetary policy itself a source of economic disturbance because of
false stops and starts. Perhaps, as our understanding of monetary phenomena advances, the situation will change. But at the present stage of
our understanding, the long way around seems the surer way to our objective. Accordingly, I believe that a monetary total is the best currently available immediate guLide or criterion for monetary policy-and
I believe that it matters much less which particular total is chosen than
that one be chosen.
A second requirement for monetary policy is that the monetary authority avoid sharp swings in policy. In the past, monetary authorities
have on occasion moved in the wrong direction-as in the episode of
the Great Contraction that I have stressed. More frequently, they have
16 THE AMERICAN ECONOMIC REVIEW
moved in the right direction, albeit often too late, but have erred by
moving too far. Too late and too much has been the general practice.
For example, in early 1966, it was the right policy for the Federal Reserve to move in a less expansionary direction-though it should have
done so at least a year earlier. But when it moved, it went too far, producing the sharpest change in the rate of monetary growth of the postwar era. Again, having gone too far, it was the right policy for the Fed
to reverse course at the end of 1966. But again it went too far, not only
restoring but exceeding the earlier excessive rate of monetary growth.
And this episode is no exception. Time and again this has been the
course followed-as in 1919 and 1920, in 1937 and 1938, in 1953 and
1954, in 1959 and 1960.
The reason for the propensity to overreact seems clear: the failure of
monetary authorities to allow for the delay between their actions and
the subsequent effects on the economy. They tend to determine their
actions by today's conditions-but their actions will affect the economy
only six or nine or twelve or fifteen months later.
Hence they feel impelled to step on the brake, or the accelerator, as the case may be, too
hard.
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 precise
rate of growth, like the precise monetary total, is less important than
the adoption of some stated and known rate. I myself have argued for a
rate that would on the average achieve rough stability in the level of
prices of final products, which I have estimated would call for something like a 3 to 5 per cent per year rate of growth in currency plus all
commercial bank deposits or a slightly lower rate of growth in currency
plus demand deposits only.6 But it would be better to have a fixed rate
that would on the average produce moderate inflation or moderate deflation, provided it was steady, than to suffer the wide and erratic perturbations we have experienced.
Short of the adoption of such a publicly stated policy of a steady
rate of monetary growth, it would constitute a major improvement if
the monetary authority followed the self-denying ordinance of avoiding
wide swings. It is a matter of record that periods of relative stability in
the rate of monetary growth have also been periods of relative stability
in economic activity, both in the United States and other countries.
Periods of wide swings in the rate of monetary growth have also been
periods of wide swings in economic activity.
a In an as yet unpublished article on "The Optimum Quantity of Money,
" I conclude
that a still lower rate of growth, something like 2 per cent for the broader definition,
might be better yet in order to eliminate or reduce the difference between private and
total costs of adding to real balances.
FRIEDMAN: MONETARY POLICY 17
By setting itself a steady course and keeping to it, the monetary authority could make a major contribution to promoting economic stability. By making that course one of steady but moderate growth in the
quantity of money, it would make a major contribution to avoidance of
either inflation or deflation of prices. Other forces would still affect the
economy, require change and adjustment, and disturb the even tenor of
our ways. But steady monetary growth would provide a monetary climate favorable to the effective operation of those basic forces of enterprise, ingenuity, invention, hard work, and thrift that are the true
springs of economic growth. That is the most that we can ask from
monetary policy at our present stage of knowledge. But that muchand it is a great deal-is clearly within our reach.
REFERENCES
1. H. S. ELLIS, ed., A Survey of Contemporary Economics. Philadelphia 1948.
2. MILTON FRIEDMAN, "The Monetary Theory and Policy of Henry Simons,"
Jour. Law and Econ., Oct. 1967, 10, 1-13.
3. , A Program for Monetary Stability. New York 1959.
4. E. A. GOLDENWEISER, "Postwar Problems and Policies," Fed. Res. Bull.,
Feb. 1945, 31, 112-21.
5. P. T. HOMAN AND FRITZ MACHLUP, ed., Financing American Prosperity.
New York 1945.
6. A. P. LERNER AND F. D. GRAHAM, ed., Planning and Paying for Full Employment. Princeton 1946.
7. J. S. MILL, Principles of Political Economy, Bk. III, Ashley ed. New York
1929