Term Paper: Milton Friedman

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Milton Friedman and the Rise of Monetarism

Monetarism, an economic doctrine that stresses on the important role played by money supply in promoting economic stability and growth, was largely developed by Milton Friedman in the mid-twentieth century. Countering Keynesian thought, Friedman postulated that the "quantity theory of money," developed by the economist Simon Newcomb, did, in fact, illuminate most questions on inflation or deflation (Ross, 1998). Therefore, Friedman proposed that regulating the supply of money could have a real effect on economic factors such as inflation, deflation, output, and employment.

Prior to the work done by Friedman and other economists, known as the Chicago school of monetarists, the role played by monetary factors in regulating economic change had fallen in disrepute. So much so, that the view became widespread that "money does not matter," and that the stock of money was a purely passive concomitant of economic change. Therefore, most economists came to believe that the only role assigned to monetary policy should be to keep whatever interest rates it affected low, so that investments were unaffected (Friedman, p. 1).

The view that monetary factors played only a minor role in regulating the economy was developed largely as a fall out of the Great Depression of the 1930s. By this time, the United States had passed the Federal Reserve Act (1913), established the Federal Reserve System, and assigned it the primary responsibility of achieving monetary stability or, at the least, of preventing pronounced periods of instability. This action was taken post the banking panic of 1907. The relative stability of the 1920s, post the economic fluctuations created by World War I, created a great deal of confidence in the ability of monetary policy to bring about positive economic change (Friedman, p. 13-17). However, the economic collapse and chaos that followed in the 1930s reversed that confidence and instead, created skepticism over the role money supply could play in preventing or reversing economic contraction. This skepticism led to the theory that monetary policy could be used to stop inflation but not deflation (Friedman (a), p. 95-6).

Thus, the experience of the Great Depression led to the search for alternative economic models. One such model was found in Keynesian economics. Based on Keynes' premise that the preference for liquidity is likely to be absolute, or nearly so, in times of high unemployment, Hansen and several other Keynesians, posited that lower interest rates could not stimulate either investment or consumption. Therefore, they proposed that the only answer lay in fiscal policy, or an increase in government spending accompanied by lower taxes (Friedman (a), p. 96).

Indeed, it was the view that fiscal policy was a more important determinant in economic growth, which provided the framework for Roosevelt's economics (Ross, 1998) and subsequently produced a worldwide trend of cheap money policies. This trend ultimately came to a halt only after worldwide experience with inflation proved that interest rates could not indefinitely be kept at low rates (Friedman, p. 2). Inflation, as Ross (1998) points out, erodes the value of savings and reduces the return on loans. Therefore, economies world over were forced to realize the damaging consequences of cheap money policies and the neglect of monetary controls. Indeed, no country succeeded in checking the price rise other than those, such as Germany, who restrained the growth of money supply (Friedman, p. 2).

The global economic experience of the 1950s, thus, led to a revival of interest in monetary policy as an effective instrument in achieving economic stability and prosperity. This interest was encouraged by Milton Friedman's work in establishing the role played by money supply in creating periods of economic instability. for, Friedman's analysis of inflationary periods caused by the Revolutionary War, the War of 1812, the Civil War, World War I, and World War II clearly revealed that the price rises and associated economic disturbances were, in large measure, attributable to governmental action in financing its expenditures and controlling the money supply (Friedman, p. 9).

Friedman's analysis similarly addressed periods of contraction such as the late 1830s to the early 1840s; 1873-79; mid-1890s; 1907-08; and the Great Depression. In each of these periods, Friedman's analysis showed that the reduction in money supply had been a major factor in accelerating, if not creating, the contraction of the economy. In fact, Friedman's rigorous analysis clearly establishes that the supply of money fell by over a third between July 1929 and March 1933, with over two-thirds of the decline coming after England's departure from the gold standard and the accompanying deflationary action by the Federal System (Friedman, p. 9-19). Based on this, Friedman drew the conclusion that the Great Depression was tragic testimony to the power of monetary policy, and not, as Keynes and many of his followers believed, evidence of its impotence (Friedman (a), p. 97).

Friedman's analysis of the monetary history of the United States also led him to define one of the central problem of monetary arrangements as preventing monetary factors from themselves becoming a primary source of instability (Friedman, p. 23). Thus, the actual global experience post World War II, along with Milton Friedman's work succeeded in resurrecting interest in the "quantity theory of money," which is often expressed as an equation: MV = PT. The equation describes the stock of money (M) and the frequency or velocity with which it changes hands (V) in terms of the average price (P) and the number of transactions (T). Friedman, through his work on the role of money supply in periods of inflation and deflation demonstrated the validity of the "quantity theory of money," and even said that the equation has "the same foundation stone role in monetary theory that Einstein's E=MC2 does in physics." (Warsh, 1992)

However, Friedman did not just resurrect the "quantity theory of money," but used it as a basis to further explore the effect of monetary policy on prices, output and employment. for, as he points out, the "quantity theory of money" is a theory of the demand of money. It is not a theory of output, money income, or of the price level. Any statement of these variables requires combining the quantity theory with some specifications about the conditions of the supply of money and other variables (Friedman (a), p. 52). Since the primary concerns of monetary policy in the context of a changed world were employment and the prevention of continued inflation (Friedman (a), p. 99), Friedman set out to develop his theory of monetarism to address these factors.

Essentially, Friedman's work resulted in the theory that the supply of money could affect prices, independent of the velocity of money or the number of transactions.

Leading from this, Friedman suggested that monetary policy cannot be used to indefinitely peg interest rates at a low level, as it would lead to inflation with little or no effect on output. Based on this insight, Friedman also postulated that the rate of change of money should be used as a far more reliable indicator of whether monetary policy was easy or tight (Friedman (a), p. 100). Friedman also demonstrated that increases in money supply could only increase employment and output in the short-term because of a time lag between nominal wages and real wages. By pointing out the role of expectations in adjusting wages to anticipated price rises (Friedman (a), p. 101-3), Friedman developed the traditionally accepted "Phillips curve" to show each level of expected inflation. This led to his "expectations augmented Phillips curve." (Biz/ed). In fact, Friedman's work in this area explained why the "Phillips curve" relation of inflation to employment broke down during periods of economic stagnation (Ross, 1998).

Friedman's theory that inflation was caused by money creation rather than factors such as an overheated economy and that economic growth was created by capital investments in a free… [END OF PREVIEW]

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