What Remains of Milton Friedman’s Monetarism?
Robert L. Hetzel
Senior Economist
Federal Reserve Bank of Richmond
Research Department
P. O. Box 27622
Richmond VA 23261
804-697-8213
robert.hetzel@rich.frb.org
July 13, 2017
Working Paper No. 17-09
Abstract: From the early 1960s until the early 1970s with the emergence of rational expectations,
under the rubric of monetarism, Milton Friedman defined macroeconomic debate. Although the
Keynesian consensus that he challenged has disappeared, the current academic literature makes little
reference to monetarist ideas. What happened to them? The argument here is that those ideas remain
relevant but require translation into terms expressible in modern macroeconomic models and in the
monetary policies of central banks, neither of which contain any obvious references to money.
Moreover, the Friedman and Schwartz methodology for identifying shocks retains relevance.
JEL: B22
The author is senior economist and research advisor at the Federal Reserve Bank of Richmond. He
thanks Edward Nelson for helpful comments. The views in this paper are the author’s, not those of
the Federal Reserve Bank of Richmond or of the Federal Reserve System.
DOI: https://doi.org/10.21144/wp17-09
1
As exposited
by Milton Friedman, monetarism incorporated two hypotheses. One is that the
price level is a monetary phenomenon in that its behavior depends upon the institutions for
controlling money creation. The second is that the price system works well in order to attenuate
cyclical fluctuations provided the central bank follows a rule that creates a stable nominal anchor and
that allows market forces to determine real variables. Professional consensus seems assured over
Friedman’s view that the severity of the Great Depression owed to contractionary monetary policy
while the inflation of the 1970s owed to inflationary monetary policy. Following Friedman’s
challenge to Keynesianism, economists no longer attribute failure of the price system to the
replacement of competitive markets by monopolies and inflation to the exercise of monopoly power.
Nevertheless, monetarism today appears to be just a name for ideas consigned
to the history
of thought. The monetarist/Keynesian debate appears dated. In a PBS (2006) obituary, a newspaper
columnist characterized Milton Friedman as “a bookend to John Maynard Keynes.” Macroeconomic
research has moved away from empirical estimation of money demand functions. No one proposes
that central banks target money growth through the adoption of reserves-money multiplier
procedures. Much of the monetarist literature appears as event studies with little obvious relevance
to current central bank practices. Because of the absence of an explicit model, Friedman’s work in
monetary economics is difficult to read for the new generation of economists.
In addition, with the Great Recession, there has been a change in the intellectual environment
hostile to monetarist hypotheses. Some have argued that inflation targeting contributed to the Great
Recession by ignoring financial stability (Curdia and Woodford 2009; Woodford 2012). Market
commentators have argued that the appearance of the zero lower bound on interest rates has limited
the ability of central banks to achieve their inflation targets.
The argument here is that Friedman’s ideas can still stimulate debate. However, they need to
be translated into a language that is accessible to the new generation of economists.
Specifically, one
can use the New Keynesian (NK) model as a Rosetta stone for translating his ideas. Ultimately,
monetarist hypotheses will survive or decline based on the acceptance of the NK model. Moreover,
in choosing among models in monetary economics, it is essential to keep in mind the poor
experimental design that generates the data. It remains important to understand how Friedman’s
methodology for the identification of shocks dealt with that fact.
Section 1 offers reasons why economists today find Friedman hard to read. Section 2
discusses his methodology in the context of the Cowles Commission debate. Section 3 reviews his
critique of the stop-go monetary policy. Section 4 summarizes the data that monetarists drew upon in
this critique. Section 5 relates monetarist ideas to the NK model. Section 6 provides a monetarist
overview of the Great Recession. Section 7 concludes.
1.
Why is Friedman hard to read?
In the 1960s through the early 1970s with the advent of rational expectations, Milton
Friedman was the dominant voice challenging the Keynesian consensus (Nelson, forthcoming). The
debate addressed the fundamental issues of macroeconomics. When left to operate without
“management” by the fiscal and monetary authorities, can the price system stabilize macroeconomic
fluctuations? Alternatively, is that management itself destabilizing? What is the nature of inflation?
What is the nature of the interaction between inflation and unemployment? Despite the continued
relevance of these issues, economists today no longer read Friedman’s work. Why is that?