finite world of negation, I have selected two limitations
of monetary policy to discuss: (1) It cannot peg interest rates for more
than very limited periods; (2) It cannot peg the rate of unemployment
for more than very limited periods. I select these because the contrary
has been or is widely believed, because they correspond to the two main
unattainable tasks that are at all likely to be assigned to monetary policy, and because essentially the same theoretical analysis covers both.
Pegging of Interest Rates
History has already persuaded many of you about the first limitation. As noted earlier, the failure of cheap money policies was a major
source of the reaction against simple-minded Keynesianism. In the
United States, this reaction involved widespread recognition that the
wartime and postwar pegging of bond prices was a mistake, that the
abandonment of this policy was a desirable and inevitable step, and
that it hiad none of the disturbing and disastrous consequences that
were so freely predicted at the time.
The li'mitation derives from a much misunderstood feature of the relation between money and interest rates. Let the Fed set out to keep
6 THE AMERICAN ECONOMIC REVIEW
interest rates down. How will it try to do so?
By buying securities.
This raises their prices and lowers their yields. 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. That
is why central bankers in particular, and the financial community
more broadly, generally believe that an increase in the quantity of
money tends to lower interest rates. Academic economists accept the
same conclusion, but for different reasons. They see, in their mind's
eye, a negatively sloping liquidity preference schedule. How can people
be induced to hold a larger quantity of money? Only by bidding down
interest rates.
Both are right, up to a point. 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, both
through the impact on investment of lower market interest rates and
through the impact on other spending and thereby relative prices of
higher cash balances than are desired. But one man's spending is another man's income. Rising income will raise the liquidity preference
schedule and the demand for loans; it may also raise prices, which
would reduce the real quantity of money. These three effects will
reverse the initial downward pressure on interest rates fairly promptly, say, in something less than a year. Together they will tend, after
a somewhat longer interval, say, a year or two, to return interest
rates to the level they would otherwise have had. Indeed, given the tendency for the economy to overreact, they are highly likely to raise interest rates temporarily beyond that level, setting in motion a cyclical
adjustment process.
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. They explain why,
historically, high and rising nominal interest rates have been associated
FRIEDMAN: MONETARY POLICY 7
with rapid growth in the quantity of money, as in Brazil or Chile or in
the United States in recent years, and why low and falling interest
rates have been associated with slow growth in the quantity of money,
as in Switzerland now or in the United States from 1929 to 1933. As an
empirical matter, low interest rates are a sign that monetary policy has
been tight-in the sense that the quantity of money has grown slowly;
high interest rates are a sign that monetary policy has been easy-in
the sense that the quantity of money has grown rapidly.
The broadest
facts of experience run in precisely the opposite direction from that
which the financial community and academic economists have all generally taken for granted.
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." For
that, it is far better to look at the rate of change of the quantity of
money.'
Employment as a Criterion of Policy
The second limitation I wish to discuss goes more against the grain
of current thinking. Monetary growth, it is widely held, will tend to
stimulate employment; monetary contraction, to retard employment.
Why, then, cannot the monetary authority adopt a target for employment or unemployment-say, 3 per cent unemployment; be tight when
unemployment is less than the target; be easy when unemployment is
higher than the target; and in this way peg unemployment at, say, 3
per cent? The reason it cannot is precisely the same as for interest
rates-the difference between the immediate and the delayed consequences of such a policy.
Tlhanks to Wicksell, we are all acquainted with the concept of a
"natural" rate of interest and the possibility of a discrepancy between
the "natural" and the "market" rate.
The preceding analysis of interest
rates can be translated fairly directly into Wickse]lian terms. The monetary authority can make the market rate less than the natural rate
2 This is partly an empirical not theoretical judgment. In principle, "tightness" or "ease"
depends on the rate of change of the quantity of money supplied compared to the rate of
change of the quantity demanded excluding effects on demand from monetary policy itself.
However, empirically demand is highly stable, if we exclude the effect of monetary policy,
so it is generally sufficient to look at supply alone.
8 THE AMERICAN ECONOMIC REVIEW
only by inflation. It can mnake the market rate higher than the natural
rate only by deflation. We have added only one wrinkle to Wicksellthe Irving Fisher distinction between the nominal and the real rate of
interest. Let the monetary authority keep the nominal market rate for a
time below the natural rate by inflation. That in turn will raise the
nominal natural rate itself, once anticipations of inflation become widespread, thus requiring still more rapid inflation to hold down the market rate. Similarly, because of the Fisher effect, it will require not
merely deflation but more and more rapid deflation to hold the market
rate above the initial "natural" rate.
This analysis has its close counterpart in the employment market. At
any moment of time, there is some level of unemployment which has
the property that it is consistent with equilibrium in the structure of
real wage rates. At that level of unemployment, real wage rates are
tending on the average to rise at a "normal" secular rate, i.e., at a rate
that can be indefinitely maintained so long as capital formation, technological improvements, etc., remain on their long-run trends. A lower
level of unemployment is an indication that there is an excess demand
for labor that will produce upward pressure on real wage rates. A
higher level of unemployment is an indication that there is an excess
supply of labor that will produce downward pressure on real wage
rates. The "natural rate of unemployment," in other words, 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.'
You will recognize the close similarity between this statement and
the celebrated Phillips Curve. The similarity is not coincidental. Phillips' analysis of the relation between unemployment and wage change is
deservedly celebrated as an important and original contribution. But,
unfortunately, it contains a basic defect-the failure to distinguish between nominal wages and real wages-just as Wicksell's analysis failed
to distinguish between nominal interest rates and real interest rates.
Implicitly, Phillips wrote his article for a world in which everyone anticipated that nominal prices would be stable and in which that anticipation remained unshaken and immutable whatever happened to actual
prices and wages. Suppose, by contrast, that everyone anticipates that
prices will rise at a rate of more than 75 per cent a year-as, for exam3It is perhaps worth noting that this "natural" rate need not correspond to equality
between the number unemployed and the number of job vacancies. For any given structure
of the labor mnarket,here will be some equilibrium relation between these two magnitudes,
but there is no reason why it should be one of equality.
FRIEDMAN: MONETARY POLICY 9
ple, Brazilians did a few years ago. Then wages must rise at that rate
simply to keep real wages unchanged. An excess supply of labor will be
reflected in a less rapid rise in nominal wages than in anticipated
prices,4 not in an absolute decline in wages. When Brazil embarked on
a policy to bring down the rate of price rise, and succeeded in bringing
the price rise down to about 45 per cent a year, there was a sharp initial rise in unemployment because under the influence of earlier anticipations, wages kept rising at a pace that was higher than the new rate
of price rise, though lower than earlier. This is the result experienced,
and to be expected, of all attempts to reduce the rate of inflation below
that widely anticipated.5
To avoid misunderstanding, let me emphasize that 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 WalshHealy 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. I use the term "natural" for the
same reason Wicksell did-to try to separate the real forces from monetary forces.
Let us assume that the monetary authority tries to peg the "market"
rate of unemployment at a level below the "natural" rate. For definiteness, suppose that it takes 3 per cent as the target rate and that the
"natural" rate is higher than 3 per cent. Suppose also that we start out
at a time when prices have been stable and when unemployment is
higher than 3 per cent. Accordingly, the authority increases the rate of
monetary growth. This will be expansionary. By making nominal cash
4 Strictly speaking, the rise in nominal wages will be less rapid than the rise in anticipated nominal wages to make allowance for any secular changes in real wages.
'Stated in terms of the rate of change of nominal wages, the Phillips Curve can be
expected to be reasonably stable and well defined for any period for which the average
rate of change of prices, and hence the anticipated rate, has been relatively stable. For
such periods, nominal wages and "real" wages move together. Curves computed for different periods or different countries for each of which this condition has been satisfied will
differ in level, the level of the curve depending on what the average rate of price change
was. The higher the average rate of price change, the higher will tend to be the level of
the curve. For periods or countries for which the rate of change of prices varies considerably, the Phillips Curve will not be well defined.
My impression is that these statements
accord reasonably well with the experience of the economists who have explored empirical
Phillips Curves.
Restate Phillips' analysis in terms of the rate of change of real wages-and even more
precisely, anticipated real wages-and it all falls into place. That is why students of
empirical Phillips Curves have found that it helps to include the rate of change of the
price level as an independent variable.
10 THE AMERICAN ECONOMIC REVIEW
balances higher than people desire, it will tend initially to lower interest
rates and in this and other ways to stimulate spending. Income and
spending will start to rise.
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. Because selling prices of
products typically respond to an unanticipated rise in nominal demand
faster than prices of factors of production, real wages received have
gone down-though real wages anticipated by employees went up, since
employees implicitly evaluated the wages offered at the earlier price
level. Indeed, the simultaneous fall ex post in real wages to employers
and rise ex ante in real wages to employees is what enabled employment to increase. But the decline ex post in real wages will soon come
to affect anticipations. 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 will tend to rise toward their initial level.
Even though the higher rate of monetary growth continues, 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 onaly by inflation. And, as in the interest rate case, too, only by
acceleratin(g inflation. Conversely, let the monetary authority choose a
target rate of unemployment that is above the natural rate, and they will
be led to produce a deflation, and an accelerating deflation at that.
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. Unfortunately, we have as yet devised no method to estimate accurately and readily the natural rate of
either interest or unemployment. And the "natural" rate will itself
change from time to time. But the basic problem is that even if the
monetary authority knew the "natural" rate, and attempted to peg the
market rate at that level, it would not be led to a determinate policy.
The "market" rate will vary from the natural rate for all sorts of reasons other than monetary policy. If the monetary authority responds to
FRIEDMAN: MONETARY POLICY I I
these variations, it will set in train longer term effects that will make
any monetary growth path it follows ultimately consistent with the rule
of policy. The actual course of monetary growth will be analogous to a
random walk, buffeted this way and that by the forces that produce
temporary departures of the market rate from the natural rate.
To state this conclusion differently, there is always a temporary
trade-off between inflation and unemployment; there is no permanent
trade-off. The temporary trade-off comes not from inflation per se, but
from unanticipated inflation, which generally means, from a rising rate
of inflation. The widespread belief that there is a perma ient trade-off
is a sophisticated version of the confusion between "high" and "rising"
that we all recognize in simpler forms. A rising rate of inflation may
reduce unemployment, a high rate will not.
But how long, you will say, is "temporary"?
For interest rates, we
have some systematic evidence on how long each of the several effects
takes to work itself out. For unemployment, we do not. I can at most
venture a personal judgment, based on some examination of the historical evidence, that the initial effects of a higher and unanticipated rate
of inflation last for something like two to five years; that this initial
effect then begins to be reversed; and that a full adjustment to the new
rate of inflation takes about as long for employment as for interest
rates, say, a couple of decades. For both interest rates and employment,
let me add a qualification. These estimates are for changes in the rate
of inflation of the order of magnitude that has been experienced in the
United States. For much more sizable changes, such as those experienced in South American countries, the whole adjustment process is
greatly speeded up.
To state the general conclusion still differently, the monetary authority controls nominal quantities-directly, the quantity of its own liabilities. In principle, it can use this control to peg a nominal quantity-an
exchange rate, the price level, the nominal level of national income, the
quantity of motney by one or another definition-or to peg the rate of
change in a nominal quantity-the rate of inflation or deflation, the
rate of growth or decline in nominal national income, the rate of growth
of the quantity of money. It cannot use its control over nominal quantities to peg a real quantity-the real rate of interest, the rate of unemployment, the level of real national income, the real quantity of money,
the rate of growth of real national income, or the rate of growth of the
real quantity of money.
