Lesson 3 of 8
Money, and the lags
Monetary policy is powerful, its effects arrive on no reliable schedule, and it cannot hold unemployment below its natural rate. Friedman's statement.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The central claim is that monetary policy is powerful and that its power is easy to misuse, because the effects arrive with long and variable lags.
- There is a natural rate of unemployment, and policy can hold unemployment below it only while inflation is accelerating, which is not indefinitely.
- What policy can do is provide a stable background: avoid being a source of disturbance, and keep the price level roughly predictable.
Friedman's presidential address to the American Economic Association, delivered in December 1967 and published in the American Economic Review in March 1968, is the compact statement of this account. It is organised as a list of what monetary policy cannot do and then what it can.
Can and cannot, in the 1968 address
What it cannot do
- Peg the interest rate for more than a limited period.
- Peg the unemployment rate below its natural level for more than a limited period.
- Deliver a permanent trade of more inflation for less unemployment.
- Be fine tuned, because the lags are long and variable.
What it can do
- Prevent money itself from becoming a source of disturbance.
- Provide a stable background for the economy.
- Offset major disturbances from other sources, within limits.
- Follow a stated, steady course so that expectations can settle.
Money is powerful, and that is precisely why the claims made for fine tuning are rejected here.
The historical claim underneath it
Friedman's argument opens with a reading of history. The early enthusiasm for the Federal Reserve, he writes, gave way after the Great Contraction to the opposite extreme: the view that monetary policy was like a string, useful for pulling against inflation and useless for pushing against recession.
His position is that both extremes were wrong and that the second was an overreaction to a period in which policy had been badly conducted rather than impotent. That reading of the 1930s is the foundation of the monetarist account and it is what the larger monetary history he wrote with Anna Schwartz was for.
Why the lags matter so much
The claim that money is powerful sounds like an argument for active management. Friedman turns it into the opposite.
If the effects of a change in the money stock arrive after a delay that is both long and variable, then policy aimed at today's conditions lands on conditions that cannot be known when the decision is made. An authority that reacts vigorously to each disturbance will often be adding to the next one instead of offsetting it, and the more powerful the instrument, the larger that error.
The practical conclusion is a preference for steadiness over reaction: keep the money supply growing at a stated rate, avoid sharp swings, and let expectations adjust to a policy people can predict.
Where it sits relative to this track
The two accounts share more than either usually admits. Both hold that money is not neutral over the cycle, both hold that monetary disturbance is the main source of trouble, and both are sceptical of an authority that manages aggregate demand actively.
They differ on the mechanism. On the monetarist account the disturbance works through the quantity of money and the general price level, with the composition of spending largely an afterthought. On the Austrian account the injection point matters: new money enters through credit markets, moves the interest rate first, and changes which kinds of investment are undertaken before it changes prices generally.
Garrison's comparison puts the difference in capital theory: monetarism, on his reading, adopted a theory of capital in which production and consumption are not temporally distinct, which leaves no room for the composition effect the Austrian account needs. Whether that characterisation is fair is for the reader to check against the monetarist literature, and this course reports it as his.
Check yourself
What does the 1968 address say monetary policy cannot do?
- Affect nominal income
- Peg the interest rate or the unemployment rate below its natural level for more than a limited period
- Prevent inflation
Show the answer
Answer: B.
Those are the two headline items in the list of what it cannot do, and the natural rate concept is introduced to explain why.Why do long and variable lags argue against active management?
- Because they make money neutral
- Because policy aimed at today's conditions lands on conditions that cannot be known when it is decided
- Because they make interest rates unpredictable
Show the answer
Answer: B.
The conclusion drawn is a preference for steadiness: a powerful instrument with uncertain timing is likelier to add to disturbances than to offset them.What is the main mechanical difference from the account in this track?
- Whether money affects output at all
- Whether the point at which new money enters, and its effect on relative prices, is central or incidental
- Whether central banks exist
Show the answer
Answer: B.
Both accounts make monetary disturbance central. They differ on whether the composition of the resulting spending is the mechanism or a detail.Sources
- Friedman, 'The Role of Monetary Policy', American Economic Review, volume 58, number 1, March 1968, being the presidential address delivered in December 1967: the reading of the swing of opinion after the Great Contraction, the list of what monetary policy cannot do including pegging interest rates and unemployment, the natural rate of unemployment, the statement that both the time lag and the magnitude of a monetary action's effect vary with circumstances so that its timing cannot be predicted accurately, the instruction to avoid sharp swings, and the list of what monetary policy can do.
- Garrison, 'The Austrian Theory of the Business Cycle in the Light of Modern Macroeconomics', Review of Austrian Economics, volume three, section four, for the characterisation of monetarism as working with a capital theory in which production and consumption are not temporally distinct.
What this leaves out
- This is a heterodox tradition. The mainstream account of the same phenomenon differs, and nothing here is a forecast or a view on any security.
- Friedman and Schwartz's monetary history is named here because the address rests on that reading of the 1930s. The book was not obtained for this course and nothing is claimed about its contents.
- The characterisation of monetarist capital theory is Garrison's, reported as his. Monetarist writers state their own position in the works cited in the address.