Milton Friedman The Supply Of Money, Friedman Money Supply and Inflation

In the early Sixties Friedman's writings on money shifted from the demand to the supply side, or rather to the influence of changes in the money supply. In a herculean effort, Friedman and Schwarz (1963a) constructed a series of money-supply statistics for the US ranging as far back in time as 1775 (although concentrating in particular on the period from 1867 onwards). A primary purpose of this magnum opus of historical-monetary research was to express and corroborate Friedman's often-expressed thesis that changes in the stock of money exert a powerful effect on the level of economic activity, albeit with a long and variable lag.

Interest in the Friedman-Schwarz findings centred, inevitably, on their interpretation of the 'Great Contraction' of 1929-33 in the US. This is a crucial test case in the dispute between Friedman and Keynesian orthodoxy, because the standard Keynesian interpretation is that this episode demonstrated the impotency of monetary policy under the supposed conditions of a depression-fired liquidity trap. Friedman's argument, to the contrary, is that the Great Contraction was the very consequence of the potency of monetary changes, (mis-)engineered by the FRB (the central bank of the US). Friedman and Schwarz (1963a) documented, in great detail, the factors which led the FRB to create or allow almost a one-third reduction in the US money stock in this short period -causing what might otherwise have been a mild recession to escalate into a major economic catastrophe. As Friedman (1970b, p. 97) himself puts the point:

The Great Contraction is tragic testimony to the power of monetary policy - not, as Keynes and so many of his con­temporaries believed, evidence of its impotence.

Conflict over the monetarist and Keynesian interpretations of history was further sharpened with the publication of a highly influential but controversial study by Friedman and Meiselman (1963). This assessed the comparative predictive performance of a simple Keynesian (multiplier) model and a simple money stock determination hypothesis of the level of 'induced' expenditures (i.e. private consumption in the main). Both hypotheses were estimated in linear form (for both levels and changes in the dependent variable) using data for the period 1897-1958. They found that, with the exception of the Thirties, the results were 'strikingly one-sided': the money stock clearly outperformed the autonomous expenditures variable. Critics fastened upon the potential simultaneous-equations bias implicit in such a one-equation estimation approach. Thus, Ando and Modigliani (1965) were able to demonstrate that if purportedly endogenous components were removed from the specification of the money supply, the balance of evidence on the predictive power of the two hypotheses was less one-sided than Friedman and Meiselman had claimed.

The same theme of money-stock endogeneity runs through criticisms of the use of the observed lead relationship between fluctuations in money and economic activity which Friedman and his collaborators (e.g. Friedman, 1958; Friedman and Schwarz, 1963b) have utilised to argue their hypothesis of the impulse dominance of money. The critics (e.g. Tobin, 1970) argue that to rely on such evidence is to fall foul of the post hoc ergo propter hoc fallacy, and that it is possible to generate the observed lead of money over economic activity in Keynesian-type models with an endogenous money supply. In the critics' view - most trenchantly expressed by the 'Old Cambridge' disciples of Keynes, Professor Lord Kaldor and Ms Joan Robinson-causation runs from income to money stock (the so-called 'reverse causation' hypothesis). Friedman has accepted that the lead of money does not demonstrate in itself the direction of causality, which must be inferred from an examination of the determinants of the money supply. However, Friedman and Schwarz (1963a) had in fact provided just such a detailed examination of this matter. Their historical evidence, and Cagan's (1965) associated study, pro­vides very substantial empirical support to the contention that (at least for the US, over the long time-period examined) the money supply is not primarily endogenously determined. The further research conducted on this matter to date also supports this position. It suggests that while there is a 'reverse causation' running from income to money, it is of relatively minor significance, and that the primary line of causation runs from money to income.

The transmission process underlying this monetary impulse-propagation mechanism is visualized by Friedman and his collaborators (e.g. Friedman and Meiselman, 1963; Friedman and Schwarz, 1963b) to be a general portfolio adjustment process affecting the entire balance-sheet of decision makers. This is a logical complement of Friedman's (1956) theoretical treatment of the demand for money - and thus is simultaneously to be seen as but a generalization of the Keynesian view of the monetary transmission process, which concentrates on a narrower range of asset adjustments in 'credit' markets.

On this point, as with many others, Friedman's 'monetarist' treatment is to be seen properly as an outgrowth, or sophisti­cation of Keynes's own basic theoretical framework, and not as some radical, fundamentally antithetical departure. On the analysis of inflation, however, Friedman's work does represent a break with the Keynesian heritage. In the General Theory Keynes was primarily concerned with a depression scenario and gave little (clear) scrutiny to the determination of the money wage and price level. Friedman's macro-economics, on the other hand, makes the price level an explicit endogenous variable. An analysis of the inflation-unemployment nexus, incorporating an explicit treat­ment of short-run dynamics of the inflation process was presented in Friedman's (1967) highly influential presidential address to the American Economics Association. This re-introduced the role of price expectations in inflation theory,6 and presented a taut verbal statement of Friedman's 'natural rate' (of unemployment) hypothesis. As the very titling suggests, this hypothesis lies in the tradition of Wicksell's quantity theory rather than Keynes General Theory.

The natural rate hypothesis was presented by Friedman as a challenge to the concept of a stable, negatively-sloped Phillips curve - a concept which itself may be seen as a 'curved' generaliz­ation of Keynes's (1936) apparent dichotomisation of wage-price determination into less than/greater than full employment states. Friedman's argument was that monetary policy could not be used to reduce unemployment below its equilibrium ('natural') level permanently (as the Phillips curve idea suggested) unless an ever-accelerating inflation was to be engineered by the monetary authorities. His argument rests upon the premise that decision­makers will seek to set the prices they 'command' (or negotiate) with a view to their real value over the future transaction period -that is, with a view to the expected future course of the price level. Consequently, 'the' Phillips curve will shift according to the state of inflationary expectations. Furthermore, if (as seems plausible) people come to fully anticipate - and thus compensate for - any stable inflation rate, unemployment will move back to its equilibrium level. Thus the long-run full-equilibrium Phillips curve is vertical.

Friedman's re-introduction of price expectations to inflation analysis was greatly to affect the subsequent direction of em­pirical research in this area. To summarize the matter briefly, a very large body of evidence now corroborates the hypothesis that inflationary expectations are a significant factor in the in­flationary process, but that whether the long-run Phillips curve is strictly vertical - or just more steeply sloped than 'the' short-run Phillips curve-is still a matter of econometric dispute.
In his Nobel lecture, Friedman (1977) was to offer a further 'modest elaboration' of his earlier natural rate hypothesis, in order to account for the apparent, long-term positive association of rising inflation and rising unemployment witnessed in the western economies from the mid-Sixties onwards (a 'positively-sloped', very long-term 'Phillips curve'). His explanation is that higher secular rates of inflation are likely to be accompanied (due to political forces) by greater instability in the inflation rate and thus greater uncertainty. Friedman sees this greater volatility as leading directly (in the economic arena) and indirectly (via adjustments in the entire politico-institutional framework) to a higher equilibrium rate of unemployment, at least during the present 'adjustment phase' (which might be decades long) to the current era of volatile inflation. This hypothesis would seem to warrant entitling as a significant generalisation rather than a 'modest elaboration', dealing as it does with a very long-run perspective, and adjustment processes to inflation lying outside the narrow area of pecuniary markets (Burton, 1980). Research, stimulated by Friedman's conjecture, into the connection be­tween the secular inflation rate, its volatility, and politico-economic consequences, is now beginning to open up.

To conclude, what should be said about Friedman's contri­bution to macro-economics in general? I shall first try to define the underlying general themes of his work, and then point out the 'loose ends' that exist in it.