Ben S Bernanke: The influence of Milton Friedman's monetary framework on
contemporary monetary theory and practice
Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, at the Federal Reserve Bank of Dallas Conference on the Legacy of Milton and
Rose Friedman's Free to Choose, Dallas, Texas, 24 October 2003.
* * *
It is an honor and a pleasure to have this opportunity, on the anniversary of Milton and
Rose Friedman's popular classic, Free to Choose, to speak on Milton Friedman's monetary framework
and his contributions to the theory and practice of monetary policy. About a year ago, I also had the
honor, at a conference at the University of Chicago in honor of Milton's ninetieth birthday, to discuss
the contribution of Friedman's classic work with Anna Schwartz, A Monetary History of the United
States (Bernanke, 2002). I mention this earlier talk not only to indicate that I am ready and willing to
praise Friedman's contributions wherever and whenever anyone will give me a venue, but also
because of the critical influence of A Monetary History on both Friedman's own thought and on the
views of a generation of monetary policymakers.
In their Monetary History, Friedman and Schwartz reviewed nearly a century of American monetary
experience in painstaking detail, providing an historical analysis that demonstrated the importance of
monetary forces in the economy far more convincingly than any purely theoretical or even econometric
analysis could ever do. Friedman's close attention to the lessons of history for economic policy is an
aspect of his approach to economics that I greatly admire. Milton has never been a big fan of
government licensing of professionals, but maybe he would make an exception in the case of
monetary policymakers. With an appropriately designed licensing examination, focused heavily on the
fine details of the Monetary History, perhaps we could ensure that policymakers had at least some of
the appreciation of the lessons of history that always informed Milton Friedman's views on monetary
policy.
Today I will pass over Friedman's contributions to our knowledge of monetary history and focus
instead on how his ideas have influenced our understanding both of how monetary policy works and
how it should be used. That is, I will discuss both the positive and the normative implications of
Friedman's thought. The usual disclaimer applies, that is, I speak for myself and not necessarily for my
colleagues at the Federal Reserve.
In preparing this talk, I encountered the following problem. Friedman's monetary framework has been
so influential that, in its broad outlines at least, it has nearly become identical with modern monetary
theory and practice. I am reminded of the student first exposed to Shakespeare who complained to the
professor: "I don't see what's so great about him. He was hardly original at all. All he did was string
together a bunch of well-known quotations." The same issue arises when one assesses Friedman's
contributions. His thinking has so permeated modern macroeconomics that the worst pitfall in reading
him today is to fail to appreciate the originality and even revolutionary character of his ideas, in relation
to the dominant views at the time that he formulated them.
To illustrate, I begin with the descriptive or positive side of Friedman's work on monetary policy. Here
is a short summary of Friedman's own list of eleven key monetarist propositions, as put forth in the
conclusion to his 1970 (note well that date) lecture, "The Counter-Revolution in Monetary Theory".
These propositions are a reasonable description, I believe, of Friedman's basic views on how money
affects the economy. Here they are (in my summary of slightly more detailed language in the original):
1. There is a consistent though not precise relationship between the rate of growth of money
and the rate of growth of nominal income.
2. That relationship is not obvious, however, because there is a lag between money growth and
nominal income growth, a lag that itself can be variable.
3. On average, however, the lag between money growth and nominal income growth is six to
nine months.
4. The change in the rate of nominal income growth shows up first in output and hardly at all in
prices.
5. However, with a further lag of six to nine months, the effects of money growth show up in
prices.
6. Again, the empirical relationship is far from perfect.
7. Although money growth can affect output in the short run, in the long run output is
determined strictly by real factors, such as enterprise and thrift.
8. Inflation is always a monetary phenomenon, in the sense that it can be produced only by
money growth more rapid than output. However, there are many possible sources of money
growth.
9. The inflationary impact of government spending depends on its financing.
10. Monetary expansion works by affecting prices of all assets, not just the short-term interest
rate.
11. Monetary ease lowers interest rates in the short run but raises them in the long run.
Let me emphasize again that these propositions reflected Friedman's view as of some thirty-five years
ago. At the time, they were far from being the conventional wisdom, as suggested by the term
"Counter-Revolution" in the essay's title. What do we make of these propositions today?
First, the empirical description of the dynamic effects of money on the economy given in the first six
propositions would be viewed by most policymakers and economists today as being, as the British
would put it, "spot on". As a minor illustration of this point, in my own academic research I contributed
to a large modern econometric literature that has used vector autoregression and other types of time
series models to try to quantify how monetary policy affects the economy. The economic dynamics
estimated by these methods correspond very closely to those outlined in Friedman's propositions.
These methods confirm that a monetary expansion (for example) leads with a lag of one to two
quarters to an increase in nominal income. Perhaps more importantly, as Friedman emphasized, the
responses of the quantity and price components of nominal income have distinctly different timing. In
particular, as Friedman told us, a monetary expansion has its more immediate effects on real variables
such as output, consumption, and investment, with the bulk of these effects occurring over two to three
quarters. (I was going to say, as Friedman first told us, but perhaps the credit for that should go to
David Hume. Milton's work is, after all, part of a long and great tradition of classical monetary
analysis.) These real effects tend to dissipate over time, however, so that at a horizon of twelve to
eighteen months the effects of a monetary expansion or contraction are felt primarily on the rate of
inflation. The same patterns have been found in empirical studies for virtually all countries, not only by
vector autoregression analysis but by more structural methods as well. They are reflected in
essentially all contemporary econometric models used for forecasting and policy analysis, such as the
FRBUS model at the Federal Reserve. The lag between monetary policy changes and the inflation
response is the reason that modern inflation-targeting central banks, such as the Bank of England, set
a horizon of up to two years for achieving their inflation objectives.
Thus Friedman's description of the economic dynamics set in train by a monetary expansion or
contraction, summarized in his first six propositions, has been largely validated by modern research.
What about the other propositions? Friedman's seventh point, that money affects real outcomes in the
short run but that in the long run output is determined entirely by real factors, such as enterprise and
thrift, is of particular importance for both theory and policy. The proposition that money has no real
effects in the long run, referred to as the principle of long-run neutrality, is universally accepted today
by monetary economists. When Friedman wrote, however, the conventional view held that monetary
policy could be used to affect real outcomes - for example, to lower the rate of unemployment - for an
indefinite period. The idea that monetary policy had long-run effects - or, in technical language, that
the Phillips curve relationship between inflation and unemployment could be exploited in the long run -
proved not only wrong but quite harmful. Attempts to exploit the Phillips curve tradeoff, which persisted
despite Friedman's warnings in his 1968 presidential address to the American Economic Association,
contributed significantly to the Great Inflation of the 1970s - after the Great Depression, the second
most serious monetary policy mistake of the twentieth century.
The diagnosis of inflation in Friedman's eighth proposition, also controversial when he wrote, is
likewise widely accepted today. Of course, as we all know, Friedman noted the close connection
between inflation and money growth, though carefully acknowledging that excessive money growth
Free to
could have many causes. As Milton and Rose discussed in Chapter 9 of the 1980 edition of
Choose, popular views in the 1960s and 1970s (and even the views of some Federal Reserve
officials) held that inflation could arise from a variety of non-monetary sources, including the power of
unions and corporations and the greediness of oil-producing countries. An unfortunate implication of
these views, whose deficiencies were revealed by bitter experience under President Nixon, was that
wage-price controls and other administrative measures could successfully address inflation. We
understand today that the Great Inflation would simply not have been possible without the excessively
expansionist monetary policies of the late 1960s and 1970s.
Some of Friedman's descriptive propositions remain the subject of active research. For example,
much research has investigated both theoretically and empirically the interactions of fiscal policy,
monetary policy, and inflation. Friedman's view that fiscal deficits are inflationary only if they result in
money creation, his ninth proposition, remains broadly accepted, but work by scholars such as
Thomas Sargent, Neil Wallace, and Michael Woodford has shown that these links can be subtle. For
example, Sargent and Wallace's "unpleasant monetarist arithmetic" suggested that a near-term
tightening of monetary policy, by making the long-term fiscal situation less tenable, could (in principle
at least) lead to inflation, because the public will anticipate that the fiscal deficit must be financed
eventually by money creation. More recently, Woodford's fiscal theory of the price level suggests that
nonsustainable fiscal policies can drive inflation, even if the central bank resists monetization.
Following Woodford, Olivier Blanchard has recently argued that tight money policies in Brazil, by
raising the government's financing costs and thus worsening the fiscal situation, might have had
inflationary consequences. Although this subsequent work has refined our understanding of the
relationship between monetary and fiscal policy, these analyses are not inconsistent with the spirit of
monetarist propositions, which place the blame for inflation on overissuance of nominal government
liabilities.
Another area of pressing current interest derives from Friedman's tenth proposition, that monetary
policy works by affecting all asset prices, not just the short-term interest rate. This classical monetarist
view of the monetary transmission process has become highly relevant in Japan, for example, where
the short-term interest rate has reached zero, forcing the Bank of Japan to use so-called quantitative
easing methods. The idea behind quantitative easing is that increases in the money stock will raise
asset prices and stimulate the economy, even after the point that the short-term nominal interest rate
has reached zero. There is some evidence that quantitative easing has beneficial effects (including
evidence drawn from the Great Depression by Chris Hanes and others), but the magnitude of these
effects remains an open and hotly debated question.
The only aspect of Friedman's 1970 framework that does not fit entirely with the current conventional
wisdom is the monetarists' use of money growth as the primary indicator or measure of the stance of
monetary policy. Clearly, monetary policy works in the first instance by affecting the supply of bank
reserves and the monetary base. However, in the financially complex world we live in, money growth
per
rates can be substantially affected by a range of factors unrelated to monetary policy se, including
such things as mortgage refinancing activity (in the short run) and the pace of financial innovation (in
the long run). Hence, it would not be safe to conclude (for example) that the recent decline in M2 is
indicative of a tight-money policy by the Fed.
The imperfect reliability of money growth as an indicator of monetary policy is unfortunate, because we
don't really have anything satisfactory to replace it. As emphasized by Friedman (in his eleventh
proposition) and by Allan Meltzer, nominal interest rates are not good indicators of the stance of policy,
as a high nominal interest rate can indicate either monetary tightness or ease, depending on the state
of inflation expectations. Indeed, confusing low nominal interest rates with monetary ease was the
source of major problems in the 1930s, and it has perhaps been a problem in Japan in recent years as
well. The real short-term interest rate, another candidate measure of policy stance, is also imperfect,
because it mixes monetary and real influences, such as the rate of productivity growth. In addition, the
value of specific policy indicators can be affected by the nature of the operating regime employed by
the central bank, as shown for example in empirical work of mine with Ilian Mihov.
The absence of a clear and straightforward measure of monetary ease or tightness is a major problem
in practice. How can we know, for example, whether policy is "neutral" or excessively "activist"? I will
return to this issue shortly.
Besides describing the effects of money on the economy, Friedman also made recommendations for
monetary policy - the normative part of his framework. I will discuss just three of the most important of
these.
First, Friedman has emphasized the Hippocratic principle for monetary policy: "First, do no harm."
Chapter 9 of Free to Choose contains a famous quote of John Stuart Mill, as follows: "Like many other
kinds of machinery, (money) only exerts a distinct and independent influence of its own when it gets
out of order." On this quote, Milton and Rose commented: "Perfectly true, as a description of the role
of money, provided we recognize that society possesses hardly any other contrivance that can do
more damage when it gets out of order."
Friedman's emphasis on avoiding monetary disruptions arose, like many of his other ideas, from his
study of U.S. monetary history. He had observed that, in many episodes, the actions of the monetary
authorities, despite possibly good intentions, actively destabilized the economy. The leading case, of
course, was the Great Depression, or as Friedman and Schwartz called it, the Great Contraction, in
which the Fed's tightening in the late 1920s and (most importantly) its failure to prevent the bank
failures of the early 1930s were a major cause of the massive decline in money, prices, and output. It
is likely that Friedman's study of the Depression led him to look for means, such as his proposal for
constant money growth, to ensure that the monetary machine did not get out of order. I hope, though
of course I cannot be certain, that two decades of relative monetary stability have not led
contemporary central bankers to forget the basic Hippocratic principle.
A second normative recommendation, worth recalling here, was Friedman's preference for floating
rather than fixed exchange rates. At times, at least in popular writing, Friedman rationalized this
position as following from free market principles. This argument is a bit disingenuous, I think, as a
fixed nominal exchange rate is just one method of anchoring the aggregate price level and is perfectly
consistent with free adjustment of the relative prices of goods and services. In a more serious vein,
Friedman understood that, in a world in which monetary policymakers put domestic economic stability
above balance of payments considerations, a fixed exchange rate system is likely to be unstable
during periods of economic stress. He saw that this was the case during the 1930s, when the world
was on a modified gold standard called the gold exchange standard, and it was likewise the case
under the postwar Bretton Woods system. To reconcile a fixed exchange rate and an emphasis on
domestic stability, policymakers must impose capital controls or restrictions on trade, which have
undesirable effects on economic efficiency.
If policymakers' first priority is stability of the domestic economy, Friedman reasoned, then why not
adopt a system - namely, flexible exchange rates - that provides the necessary monetary
independence without restrictions on the flow of capital or goods? When Friedman wrote about fixed
and flexible exchange rates, a switch from the Bretton Woods fixed-exchange-rate system to a
floating-rate system seemed quite unlikely. In this, as in many other matters, he was prescient, as the
major currencies have now been successfully floating since the breakup of the Bretton Woods system
in the early 1970s.
These two recommendations have had major effects on institutional design and policy practice.
However, in my view, the most fundamental policy recommendation put forth by Milton Friedman is the
injunction to policymakers to provide a stable monetary background for the economy. I take this to be
a stronger statement than the Hippocratic injunction to avoid major disasters; rather, there is a positive
argument here that monetary stability actively promotes efficiency and growth. (Hence Friedman's
suggestion that the long-run Phillips curve, rather than vertical, might be positively sloped.) Also
implicit in Friedman's focus on nominal stability is the view that central banks should avoid excessively
ambitious attempts to manage the real economy, which in practice may exacerbate both nominal and
A Program for Monetary
real volatility. In Friedman's classic 1960 work, Stability, he suggested that
monetary stability might be attained by literally keeping money stable: that is, by fixing the rate of
growth of a specific monetary aggregate and forswearing the use of monetary policy to "fine-tune" the
economy.
Do contemporary monetary policymakers provide the nominal stability recommended by Friedman?
The answer to this question is not entirely straightforward. As I discussed earlier, for reasons of
financial innovation and institutional change, the rate of money growth does not seem to be an
adequate measure of the stance of monetary policy, and hence a stable monetary background for the
economy cannot necessarily be identified with stable money growth. Nor are there other instruments
of monetary policy whose behavior can be used unambiguously to judge this issue, as I have already
noted. In particular, the fact that the Federal Reserve and other central banks actively manipulate their
instrument interest rates is not necessarily inconsistent with their providing a stable monetary
background, as that manipulation might be necessary to offset shocks that would otherwise endanger
nominal stability.
Ultimately, it appears, one can check to see if an economy has a stable monetary background only by
looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it
appears that modern central bankers have taken Milton Friedman's advice to heart. Over the past two
decades, inflation has fallen sharply and stabilized around the world, not only in the industrialized
nations but in emerging-market economies and in even the poorest developing nations. Some central
banks, so-called inflation targeters, have set explicit, quantitative targets for inflation; but all central
banks, certainly including the Federal Reserve, have emphasized the importance of achieving and
maintaining price stability. On the issue of inflation control, Friedman may be judged to have been a bit
too pessimistic; his concerns that central banks would have neither the technical ability nor the correct
incentives to control inflation led him to recommend his money-growth rule, for which a central bank
could certainly be held accountable. Evidently, however, determined central banks can stabilize
inflation directly, at least they have been able to do so thus far.
However, on the benefits of monetary stability, or as I would prefer to say, nominal stability, Friedman
was not wrong. Many theories popular even today might lead one to conclude that increased stability
in inflation could be purchased only at the cost of reduced stability in output and employment. In fact,
over the past two decades, increased inflation stability has been associated with marked increases in
the stability of output and employment as well, both in the United States and elsewhere.
It has been argued that a lower incidence of exogenous shocks explains these favorable
developments, and that may be part of the story. But I believe that there is an important causal
relationship as well. For example, low and stable inflation has not only promoted growth and
productivity, but it has also reduced the sensitivity of the economy to shocks. One important
mechanism has been the anchoring of inflation expectations. When the public is confident that the
central bank will maintain low and stable inflation, shocks such as sharp increases in oil prices or large
exchange rate movements tend to have at most transitory price-level effects and do not result in
sustained inflationary surges. In contrast, when inflation expectations are poorly anchored, as was the
case in the 1970s, shocks of these types can destabilize inflation expectations, increasing the
inflationary impact and leading to greater volatility in both inflation and output.
In summary, one can hardly overstate the influence of Friedman's monetary framework on
contemporary monetary theory and practice. He identified the key empirical facts and he provided us
with broad policy recommendations, notably the emphasis on nominal stability, that have served us
well. For these contributions, both policymakers and the public owe Milton Friedman an enormous
debt.