Milton Friedman: The Role of Monetary Policy

General Consensus on Goals: There is a wide agreement regarding the primary objectives of economic policy, which include:
  - Economic growth.
  - High levels of employment.
  - Price stability.
Disagreements on Compatibility: While the goals are agreed upon, there is significant disagreement on whether they are mutually compatible. Among those who view them as incompatible, there is a lack of consensus on the trade-offs at which they should be substituted for one another.
Disagreements on Policy Instruments: There is little agreement regarding the specific roles that various policy instruments should play in achieving these goals.
Primary Focus: The central topic is the role of monetary policy as a specific instrument of economic policy, its contribution potential, and how it should be conducted for maximum effectiveness.

Early Enthusiasm (1920s): Following the creation of the Federal Reserve System, observers attributed the relative stability of the 1920s to the system's capacity for "fine tuning" (a modern term applied retrospectively).
- Many believed a new era had arrived where business cycles were rendered obsolete by advances in monetary technology.
- This optimistic view was shared by both economists and laymen, with only a few dissenting voices.
Reaction to the Great Contraction: The economic collapse of 1929–1933 destroyed the naive belief in monetary stability. Opinion swung to the extreme opposite belief that monetary policy was impotent.
- The "String" Metaphor: Monetary policy was viewed as a string; you could pull on it to stop inflation, but you could not "push" on it to halt a recession.
- The Horse Metaphor: "You could lead a horse to water, but you could not make him drink."

Keynesian Theory: Keynes provided a rigorous framework that replaced simpler metaphors with a more sophisticated analysis of why monetary policy appeared to fail during the depression.
Liquidity Preference: Keynes argued that in times of heavy unemployment, liquidity preference might be absolute (or nearly so).
- In this state, interest rates cannot be lowered further by monetary measures.
Economic Response to Interest Rates: Keynes and his disciples believed that even if lower interest rates could be achieved, investment and consumption were relatively insensitive to them.
The "Twice Damned" Policy: Monetary policy was considered ineffective because:
1. It could not lower interest rates enough due to liquidity preference.
2. Lower rates would not stimulate investment or consumption significantly.
The Fiscal Alternative: The collapse of investment and investment opportunities was seen as a cause that monetary policy could not rectify. Instead, fiscal policy was proposed as the solution:
- Government Spending: Used to compensate for inefficient private investment.
- Tax Reductions: Used to undermine "stubborn thriftness."
Resulting Consensus: For approximately two decades, the prevailing view in the economics profession was that "money did not matter." The only role for money was a minor one: keeping interest rates low to hold down government interest payments and perhaps provide a slight stimulus to accurate demand.

Failure of "Cheap Money" Policies: Post-WWII, many countries adopted cheap money policies that eventually failed. Central banks found they could not indefinitely keep interest rates low.
The 1951 Accord: In the United States, the public turning point was the Federal Reserve-Treasury Accord in 1951, although the formal policy of supporting government bond prices wasn't abandoned until 1953.
Inflation Realization: Inflation stimulated by cheap money policies became a major concern, leading to a revival of belief in the potency of monetary policy.
Theoretical Developments (Haberler and Pigou): The revival was supported by developments initiated by Haberler and named for Pigou. These identified the "wealth effect," a channel through which the quantity of money can affect aggregate demand even if it does not alter interest rates.
- Impact on Keynesian Equilibrium: These developments undermined the Keynesian position that equilibrium at full employment might not exist in a world of flexible prices. It suggested that unemployment should be explained by market imperfections or rigidities rather than a natural outcome of market processes.

Previous Misconception: Keynes and other economists believed the Great Contraction occurred despite aggressive expansionary efforts by monetary authorities.
New Evidence: Recent studies demonstrated the opposite. The U.S. monetary authorities followed highly deflationary policies.
Quantitative Shift: The quantity of money in the United States fell by $\frac{1}{3}$ during the contraction.
Institutional Failure: The contraction was not caused by a "horse that would not drink," but because the Federal Reserve System permitted a sharp reduction in the monetary base and failed to provide liquidity to the banking system, as required by the Federal Reserve Act.
Revised Conclusion: The Great Contraction is seen as tragic testimony to the power of monetary policy, rather than its impotence.

Practical Limitations: Disillusionment grew not because fiscal policy lacked potential to affect demand, but because of its practical and political feasibility.
Time Lags: Expenditures responded sluggishly with long lags when trying to adjust economic activity.
Political Factors: Attempts to use tax adjustments were hindered by political factors, preventing prompt responses to economic needs.
The Reality of Fine Tuning: While "Fine Tuning" is described as a "marvelous book written [in the] electronic age," it bears little resemblance to what is actually possible in practice.

Goldenweiser (1945): Then director of the Research Division of the Federal Reserve Board, he stated the primary objective was maintaining the value of government bonds and suggested the country would have to adjust to a $2.5\%$ interest rate on safe long-term money.
Alvin Hansen (1945): In Financing American Prosperity, Hansen discussed savings and investment for nine pages without using the phrase "interest rate."
Fritz Machlup (1945): Wrote that questions regarding the interest rate were not among the most vital problems of the postwar period.
John H. Williams (1945): Stated he saw no prospect for a revival of general monetary control in the postwar period.
Lerner and Graham volume: In Planning and Paying for Full Employment, summary contributor Albert Halasi noted that contributors did not discuss the money supply or creditor policy significantly.
Arthur Smithies (1948): In A Survey of Contemporary Economics, he argued that fiscal policy must shoulder most of the load of compensatory action and that monetary policy was disqualified on institutional grounds, as the country was committed to low interest rates.