II. What Monetary Policy Can Do
Monetary policy cannot peg these real magnitudes at predetermined
levels. But monetary policy can and does have important effects on
these real magnitudes. The one is in no way inconsistent with the other.
12 THE AMERICAN ECONOMIC REVIEW
My own studies of monetary history have made me extremely sympathetic to the oft-quoted, much reviled, and as widely misunderstood,
comment by John Stuart Mill. "There cannot . .. ," he wrote, "be intrinsically a more insignificant thing, in the economy of society, than
money; except in the character of a contrivance for sparing time and
labour.
It is a machine for doing quickly and commodiously, what
would be done, though less quickly and commodiously, without it: and
like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order" [7, p. 488].
True, money is only a machine, but it is an extraordinarily efficient
machine. Without it, we could not have begun to attain the astounding
growth in output and level of living we have experienced in the past
two centuries-any more than we could have done so without those
other marvelous machines that dot our countryside and enable us, for
the most part, simply to do more efficiently what could be done without
them at much greater cost in labor.
But money has one feature that these other machines do not share.
Because it is so pervasive, when it gets out of order, it throws a monkey wrench into the operation of all the other machines. The Great
Contraction is the most dramatic example but not the only one.
Every
other major contraction in this country has been either produced by
monetary disorder or greatly exacerbated by monetary disorder. Every
major inflation has been produced by monetary expansion-mostly to
meet the overriding demands of war which have forced the creation of
money to supplement explicit taxation.
The first and most important lesson that history teaches about what
monetary policy can do-and it is a lesson of the most profound importance-is that monetary policy can prevent money itself from being a
major source of economic disturbance. This sounds like a negative
proposition: avoid major mistakes. In part it is. The Great Contraction
might not have occurred at all, and if it had, it would have been far less
severe, if the monetary authority had avoided mistakes, or if the monetary arrangements had been those of an earlier time when there was no
central authority with the power to make the kinds of mistakes that the
Federal Reserve System made. The past few years, to come closer to
home,
would have been steadier and more productive of economic wellbeing if the Federal Reserve had avoided drastic and erratic changes of
direction, first expanding the money supply at an unduly rapid pace,
then, in early 1966, stepping on the brake too hard, then, at the end of
1966, reversing itself and resuming expansion until at least November,
1967, at a more rapid pace than can long be maintained without appreciable inflation.
Even if the proposition that monetary policy can prevent money it-
FRIEDMAN: MONETARY POLICY 13
self from being a major source of economic disturbance were a wholly
negative proposition, it would be none the less important for that. As it
happens, however, it is not a wholly negative proposition.
The monetary machine has gotten out of order even when there has been no central authority with anything like the power now possessed by the Fed.
In the United States, the 1907 episode and earlier banking panics are
examples of how the monetary machine can get out of order largely on
its own. There is therefore a positive and important task for the monetary authority-to suggest improvements in the machine that will reduce the chances that it will get out of order, and to use its own powers
so as to keep the machine in good working order.
A second thing monetary policy can do is provide a stable background for the economy-keep the machine well oiled, to continue Mill's
analogy. Accomplishing the first task will contribute to this objective,
but there is more to it than that. Our economic system will work best
when producers and consumers, employers and employees, can proceed
with full confidence that the average level of prices will behave in a
known way in the future-preferably that it will be highly stable.
Under any conceivable institutional arrangements, and certainly under
those that now prevail in the United States, there is only a limited
amount of flexibility in prices and wages. We need to conserve this flexibility to achieve changes in relative prices and wages that are required
to adjust to dynamic changes in tastes and technology. We should not
dissipate it simply to achieve changes in the absolute level of prices
that serve no economic function.
In an earlier era, the gold standard was relied on to provide confidence in future monetary stability. In its heyday it served that function
reasonably well. It clearly no longer does, since there is scarce a country in the world that is prepared to let the gold standard reign unchecked-and there are persuasive reasons why countries should not do
so. The monetary authority could operate as a surrogate for the gold
standard, if it pegged exchange rates and did so exclusively by altering
the quantity of money in response to balance of payment flows without
"sterilizing" surpluses or deficits and without resorting to open or concealed exchange control or to changes in tariffs and quotas. But again,
though many central bankers talk this way, few are in fact willing to
follow this course-and again there are persuasive reasons why they
should not do so. Such a policy would submit each country to the vagaries not of an impersonal and automatic gold standard but of the policies-deliberate or accidental-of other monetary authorities.
In today's world, if monetary policy is to provide a stable background for the economy it must do so by deliberately employing its
powers to that end. I shall come later to how it can do so.
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Finally, monetary policy can contribute to offsetting major disturbances in the economic system arising fromi other sources.
If there is an
independent secular exhilaration-as the postwar expansion was described by the proponents of secular stagnation-monetary policy can
in principle help to hold it in check by a slower rate of monetary
growth than would otherwise be desirable. If, as now, an explosive federal budget threatens unprecedented deficits, monetary policy can hold
any inflationary dangers in check by a slower rate of monetary growth
than would otherwise be desirable.
This will temporarily mean higher
interest rates than would otherwise prevail-to enable the government
to borrow the sums needed to finance the deficit-but by preventing the
speeding up of inflation, it may well mean both lower prices and lower
nominal interest rates for the long pull. If the end of a substantial war
offers the country an opportunity to shift resources from wartime to
peacetime production, monetary policy can ease the transition by a
higher rate of monetary growth than would otherwise be desirablethough experience is not very encouraging that it can do so without
going too far.
I have put this point last, and stated it in qualified terms-as referring to major disturbances-because I believe that the potentiality of
monetary policy in offsetting other forces making for instability is far
more limited than is commonly believed.
We simply do not know
enough to be able to recognize minor disturbances when they occur or
to be able to predict either what their effects will be with any precision
or what monetary policy is required to offset their effects. We do not
know enough to be able to achieve stated objectives by delicate, or even
fairly coarse, changes in the mix of monetary and fiscal policy. In this
area particularly the best is likely to be the enemy of the good. Experience suggests that the path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a "clear and present danger."
