A Macroeconomics Reader

By Brian Snowdon; Howard R. Vane | Go to book overview

7

The role of monetary policy

Milton Friedman

American Economic Review (1968) 58, March, pp. 1-17

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 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. Gov-

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