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 agreement that these goals are mutually compatible or, among those who regard 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 contribute 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 business cycles had been rendered obsolete by advances in monetary technology. This opinion was shared by economist and layman alike,
though, of course, there were some dissonant voices. The Great Contraction destroyed this naive attitude. Opinion swung to the other extreme. Monetary policy was a string. You could pull on it to stop inflation 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 impotence of monetary policy to stem the depression, a nonmonetary interpretation of the depression, and an alternative to monetary policy
* Presidential address delivered at the Eightieth Annual Meeting of the American Economic 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 liquidity 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 disciples 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 undermine 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 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.
These views produced a widespread adoption of cheap money policies 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 theoretical 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 undermine Keynes' argument against the potency of orthodox monetary
measures when liquidity preference is absolute since under such circumstances 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 proposition, namely, that even in a world of flexible prices, a position of equilibrium at full employment might not exist. Henceforth, unemployment
had again to be explained by rigidities or imperfections, not as the natural 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 expansionary 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 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 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 primary 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.
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a 212 per cent interest rate as the return on safe, long-time money, because the time has come when returns on pioneering capital can no
longer be unlimited as they were in the past" [4, p. 1 17].
In a book on Financing A merican 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 to this volume, Fritz Machlup wrote,
"Questions regarding the rate of interest, in particular regarding its
variation or its stability, may not be among the most vital problems of
the postwar economy, but they are certainly among the perplexing
ones" [5, p. 466]. 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 ].
These quotations suggest the flavor of professional thought some two
decades ago. If you wish to go further in this humbling inquiry, I recommend that you compare the sections on money-when you can find
them-in the Principles texts of the early postwar years with the
lengthy sections in the current crop even, or especially, when the early
and recent Principles are different editions of the same work.
The pendulum has swung far since then, if not all the way to the position of the late 1920s, at least much closer to that position than to the
position of 1945. There are of course many differences between then
and now,
less in the potency attributed to monetary policy than in the
FRIEDMAN: MONETARY POLICY 5
roles assigned to it and the criteria by which the profession believes
monetary policy should be guided. Then, the chief roles assigned monetary policy were to promote price stability and to preserve the gold
standard; the chief criteria of monetary policy were the state of the
"money market," the extent of "speculation" and the movement of
gold. Today, primacy is assigned to the promotion of full employment,
with the prevention of inflation a continuing but definitely secondary
objective. And there is major disagreement about criteria of policy,
varyino from emphasis on money market conditions, interest rates, and
the quantity of money to the belief that the state of employment itself
should be the proximate criterion of policy.
I stress nonetheless the similarity between the views that prevailed in
the late 'twenties and those that prevail today because I fear that, now
as then, 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.
Unaccustomed as I am to denigrating the importance of money, I
therefore shall, as my first task, stress what monetary policy cannot do.
I shall then try to outline what it can do and how it can best make its
contribution, in the present state of our knowledge-or ignorance
