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4.5 The Orthodox Monetarist School and Stabilization Policy

In conclusion it would be useful to assess the development of orthodox

monetarism and how this school influenced the ongoing debate on the role

and conduct of stabilization policy. The development of orthodox monetarism

can be appraised in a positive light, given that it displayed both theoretical

and empirical progress over the period of the mid-1950s to the early 1970s

(see, for example, Cross, 1982a, 1982b). The reformulation of the quantity

theory of money approach (QTM), the addition of the expectations-augThe

orthodox monetarist school 193

mented Phillips curve analysis (EAPC), using the adaptive expectations hypothesis

(AEH), and the incorporation of the monetary approach to the balance

of payments theory and exchange rate determination (MTBE), generated a

large amount of real-world correspondence and empirical support (see Laidler,

1976). We can therefore summarize the main characteristics of orthodox

monetarism (OM) as:


In contrast to orthodox monetarism, towards the close of this period, in the

early 1970s, the orthodox Keynesian position was looking increasingly degenerative

given (i) its failure to explain theoretically the breakdown of the

Phillips curve relationship and (ii) its willingness to retreat increasingly into

non-economic explanations of accelerating inflation and rising unemployment

(see for example, Jackson et al., 1972).

We can draw together the discussion contained in sections 4.2–4.4 and

seek to summarize the central distinguishing beliefs within the orthodox

monetarist school of thought (see also Brunner, 1970; Friedman, 1970c;

Mayer, 1978; Vane and Thompson, 1979; Purvis, 1980; Laidler, 1981, 1982;

Chrystal, 1990). These beliefs can be listed as follows:

1. Changes in the money stock are the predominant, though not the only,

factor explaining changes in money income.

2. The economy is inherently stable, unless disturbed by erratic monetary

growth, and when subjected to some disturbance, will return fairly rapidly

to the neighbourhood of long-run equilibrium at the natural rate of


3. There is no trade-off between unemployment and inflation in the long

run; that is, the long-run Phillips curve is vertical at the natural rate of


4. Inflation and the balance of payments are essentially monetary phenomena.

5. In the conduct of economic policy the authorities should follow some

rule for monetary aggregates to ensure long-run price stability, with

fiscal policy assigned to its traditional roles of influencing the distribution

of income and wealth, and the allocation of resources. In the former

case, Laidler (1993, p. 187) has argued that the authorities must be

prepared to adapt the behaviour of the supply of whatever monetary

aggregate they chose to control (that is, in response to shifts in the

demand for money resulting from, for example, institutional change)

rather than pursue a rigid (legislated) growth rule for a chosen monetary

aggregate as suggested by Friedman.

The monetarist aversion to activist stabilization policy, both monetary and

fiscal policy (and prices and incomes policy), which derives both from the

interrelated theoretical propositions and from empirical evidence discussed in

sections 4.2–4.4, is the central issue which distinguishes orthodox monetarists

from Keynesians.

Throughout the period 1950–80, a key feature of the Keynesian–monetarist

debate related to disagreement over the most effective way of managing

aggregate demand so as to limit the social and economic waste associated

with instability and also over the question of whether it was desirable for

governments to try to ‘fine-tune’ the economy using counter-cyclical policies.

In this debate Friedman was one of the earliest critics of activist discretionary

policies. Initially he focused on some of the practical aspects of implementing

such policies. As early as 1948 Friedman noted that ‘Proposals for the

control of the cycle thus tend to be developed almost as if there were no other

objectives and as if it made no difference within what framework cyclical

fluctuations take place’. He also drew attention to the problem of time lags

which in his view would in all likelihood ‘intensify rather than mitigate

cyclical fluctuations’. Friedman distinguished between three types of time

lag: the recognition lag, the action lag, and the effect lag. These inside and

outside lags, by delaying the impact of policy actions, would constitute the

equivalent of an ‘additional random disturbance’. While Friedman argued

that monetary policy has powerful effects and could be implemented relatively

quickly, its effects were subject to a long outside lag. Discretionary

fiscal adjustments, particularly in a political system like that of the USA,

could not realistically be implemented quickly. In principle, accurate forecasts

could help to overcome this problem by enabling the authorities to

adjust monetary and fiscal policy in anticipation of business cycle trends.

However, poor forecasts would in all probability increase the destabilizing

impact of aggregate demand management. As Mankiw (2003) emphasizes,

‘the Great Depression and the (US) recession of 1982 show that many of the

most dramatic economic events are unpredictable. Although private and public

decision-makers have little choice but to rely on economic forecasts, they

must always keep in mind that these forecasts come with a large margin of

error’. These considerations led Friedman to conclude that activist demand

management policies are more likely to destabilize than stabilize a decentralized

market economy.

Another important contribution made by Friedman, not directly related to

his theoretical and empirical work on monetary economics, but with important

implications for stabilization policy, is his book A Theory of the

Consumption Function, published in 1957. An important assumption in the

orthodox Keynesian theory of fiscal policy is that the fiscal authorities can

stimulate aggregate demand by boosting consumption expenditure via tax

The orthodox monetarist school 195

cuts that raise disposable income (or vice versa). This presumes that current

consumption is largely a function of current disposable income. Friedman

argued that current income (Y) has two components, a temporary component

(YT) and a permanent component (YP). Since people regard YP as their average

income and YT as a deviation from average income, they base their consumption

decisions on the permanent component. Changes in Y brought about by

tax-induced changes in YT will be seen as transitory and have little effect on

current consumption (C) plans. So in Friedman’s model we have:

Y YT YP (4.14)

C YP (4.15)

If consumption is proportional to permanent income, this obviously reduces

the power of tax-induced changes in aggregate demand. This further weakens

the Keynesian case for activist fiscal policy.

Friedman has also always been very sympathetic to the public choice

literature that suggested that structural deficits, with damaging effects on

national saving and hence long-run growth, would be the likely result of

discretionary fiscal policy operating within a democracy (see Buchanan and

Wagner, 1978). Politicians may also deliberately create instability when they

have discretion since within a democracy they may be tempted to manipulate

the economy for political profit as suggested in the political business cycle

literature (Alesina and Roubini with Cohen, 1997; see Chapter 10).

Although theoretical and empirical developments in economics facilitated

the development, by Klein, Goldberger, Modigliani and others, of the highly

aggregative simultaneous-equation macroeconometric models used for forecasting

purposes, many economists remained unconvinced that such forecasts

could overcome the problems imposed by the problem of time lags and the

wider political constraints. Friedman concluded that governments had neither

the knowledge nor the information required to conduct fine-tuning forms of

discretionary policy in an uncertain world and advocated instead that the

monetary authorities adopt a passive form of monetary rule whereby the

growth in a specified monetary aggregate be predetermined at some stated

known (k per cent) rate (Friedman, 1968a, 1972). While Friedman (1960)

argued that such a rule would promote greater stability, ‘some uncertainty

and instability would remain’, because ‘uncertainty and instability are unavoidable

concomitants of progress and change. They are one face of a coin of

which the other is freedom.’ DeLong (1997) also concludes that it is ‘difficult

to argue that “discretionary” fiscal policy has played any stabilising role at all

in the post-World war II period’ in the US economy. However, it is generally

accepted that automatic stabilizers have an important role to play in mitigat196

ing the impact of economic shocks. The debate over the role and conduct of

stabilization policy as it stood in the 1970s is neatly summarized in the

following passage, taken from Modigliani’s (1977) Presidential Address to

the American Economic Association:

Nonmonetarists accept what I regard to be the fundamental practical message of

The General Theory: that a private enterprise economy using an intangible money

needs to be stabilized, can be stabilized, and therefore should be stabilized by

appropriate monetary and fiscal policies. Monetarists by contrast take the view

that there is no serious need to stabilize the economy; that even if there were a

need, it could not be done, for stabilization policies would be more likely to

increase than decrease instability.

Despite its considerable achievements, by the late 1970s/early 1980s, monetarism

was no longer regarded as the main rival to Keynesianism within

academia. This role was now taken up at the theoretical level during the

1970s by developments in macroeconomics associated with the new classical

school. These developments cast further doubt on whether traditional

stabilization policies can be used to improve the overall performance of the

economy. However, monetarism was exercising a significant influence on the

policies of the Thatcher government in the UK (in the period 1979–85) and

the Fed in the USA (in the period 1979–81). Of particular significance to the

demise of monetarist influence was the sharp decline in trend velocity in the

1980s in the USA and elsewhere. The deep recession experienced in the USA

in 1982 has been attributed partly to the large and unexpected decline in

velocity (B.M. Friedman, 1988; Modigliani, 1988a; Poole 1988). If velocity

is highly volatile, the case for a constant growth rate monetary rule as advocated

by Friedman is completely discredited. Therefore, there is no question

that the collapse of the stable demand for money function in the early 1980s

proved to be very damaging to monetarism. As a result monetarism was

‘badly wounded’ both within academia and among policy makers (Blinder,

1987) and subsequently ‘hard core monetarism has largely disappeared’ (Pierce,

1995). One important result of the unpredictability of the velocity of circulation

of monetary aggregates has been the widespread use of the short-term

nominal interest rate as the primary instrument of monetary policy (see Bain

and Howells, 2003). In recent years activist Taylor-type monetary-feedback

rules have been ‘the only game in town’ with respect to the conduct of

monetary policy. As Buiter notes, ‘Friedman’s prescription of a constant

growth rate for some monetary aggregate is completely out of favour today

with both economic theorists and monetary policy makers, and has been for

at least a couple of decades’ (see Buiter, 2003a and Chapter 7).

Finally, it is worth reflecting on what remains today of the monetarist

counter-revolution. As a result of the ‘Great Peacetime Inflation’ in the 1970s

many key monetarist insights were absorbed within mainstream models (see,

for example, Blinder, 1988b; Romer and Romer, 1989; Mayer, 1997; DeLong,

2000). According to DeLong, the key aspects of monetarist thinking that now

form a crucial part of mainstream thinking in macroeconomics are the natural

rate of unemployment hypothesis, the analysis of fluctuations as movements

about trend rather than deviations below potential, the acceptance that under

normal circumstances monetary policy is ‘a more potent and useful tool’ for

stabilization than fiscal policy, the consideration of macroeconomic policy

within a rules-based framework, and the recognition of the limited possibilities

for success of stabilization policies. Therefore, although within academia

monetarism is no longer the influential force it was in the late 1960s and early

1970s (as evidenced by, for example, the increasing scarcity of journal articles

and conference papers on monetarism), its apparent demise can, in large

part, be attributed to the fact that a significant number of the insights of

‘moderate’ monetarism have been absorbed into mainstream macroeconomics.

Indeed, two leading contributors to the new Keynesian literature, Greg

Mankiw and David Romer (1991), have suggested that new Keynesian economics

could just as easily be labelled ‘new monetarist economics’ (see

Chapter 7 for a discussion of the new Keynesian school).

Monetarism has therefore made several important and lasting contributions

to modern macroeconomics. First, the expectations-augmented Phillips curve

analysis, the view that the long-run Phillips curve is vertical and that money

is neutral in the long run are all now widely accepted and form an integral

part of mainstream macroeconomics. Second, a majority of economists and

central banks emphasize the rate of growth of the money supply when it

comes to explaining and combating inflation over the long run. Third, it is

now widely accepted by economists that central banks should focus on controlling

inflation as their primary goal of monetary policy. Interestingly, since

the 1990s inflation targeting has been adopted in a number of countries (see

Mishkin, 2002a and Chapter 7). What has not survived the monetarist counter-

revolution is the ‘hard core’ belief once put forward by a number of

leading monetarists that the authorities should pursue a non-contingent ‘fixed’

rate of monetary growth in their conduct of monetary policy. Evidence of

money demand instability (and a break in the trend of velocity, with velocity

becoming more erratic), especially since the early 1980s in the USA and

elsewhere, has undermined the case for a fixed monetary growth rate rule.

Finally, perhaps the most important and lasting contribution of monetarism

has been to persuade many economists to accept the idea that the potential of

activist discretionary fiscal and monetary policy is much more limited than

conceived prior to the monetarist counter-revolution.

Milton Friedman was born in 1912 in New York City and graduated from

Rutgers University with a BA in 1932, before obtaining his MA from the

University of Chicago in 1933 and his PhD from Columbia University in

1946. Between 1946 and 1977 (when he retired) he taught at the University

of Chicago and he has lectured at universities throughout the world. He is

currently a Senior Research Fellow at the Hoover Institution (on War, Revolution

and Peace) at Stanford University, California. Along with John Maynard

Keynes he is arguably the most famous economist of the twentieth century.

Professor Friedman is widely recognized as the founding father of monetarism

and an untiring advocate of free markets in a wide variety of contexts. He

has made major contributions to such areas as methodology; the consumption

function; international economics; monetary theory, history and policy; business

cycles and inflation. In 1976 he was awarded the Nobel Memorial Prize

in Economics: ‘For his achievements in the fields of consumption analysis,

monetary history and theory and for his demonstration of the complexity of

stabilization policy’.

Among his best-known books are: Essays in Positive Economics (University

of Chicago Press, 1953); Studies in the Quantity Theory of Money

(University of Chicago Press, 1956); A Theory of the Consumption Function

(Princeton University Press, 1957); Capitalism and Freedom (University of

Chicago Press, 1962); A Monetary History of the United States, 1867–1960