6
economy only six or nine months later. Hence they feel impelled
to step on the brake, or the
accelerator, as the case may be, too hard.
The monetarist narrative identified stop-go policy with cyclical inertia in the adjustment of
the Fed’s funds rate target (see, for example, Poole 1978, 105).
6
Friedman (1984, 27) wrote:
Rising concern about inflation, and growing recognition of the role played by monetary
growth in producing inflation, led Congress in 1975 to require the Federal Reserve to specify
targets for monetary growth…. In practice, it continued to target interest rates, specifically
the federal funds rate, rather than monetary aggregates, and continued to adjust its interest
rate targets only slowly and belatedly to changing market pressure. The result was that the
monetary aggregates tended on average to rise excessively, contributing to inflation.
However, from time to time, the Fed was too slow in lowering rather than raising the federal
funds rate. The results were a sharp deceleration in the monetary aggregates and an
economic recession. [italics added]
In his second critique, Friedman (1981 [1983], 244-247) criticized the Fed’s practice of
“pegging the federal-funds rate” with the result that “mistakes are cumulative and self-reinforcing.”
[I]f the Fed picks too high a funds rate, it must drain an excessive amount from the
[monetary] base, discouraging spending,
decreasing demand for loans, and ultimately adding
to downward pressure on interest rates…. [I]n using the federal-funds rate as its operating
target, the Fed is always balancing on a knife-edge…. [C]ontrolling the base directly and
letting the market determine interest rates could produce steady and predictable monetary
growth…. The belief that the Fed can or does control interest rates is a myth….
Friedman (1975 [1983], 230) wrote earlier, “So long as the Fed tries to control monetary growth
through the federal-funds rate, it will fail.”
In his third critique of activist policy, Friedman (1968 [1969]) criticized the idea of assuming
predictable trade-offs between inflation and unemployment represented by the Samuelson-Solow
(1960 [1966]) Phillips curve. As part of the hypothesis that a market economy does not assure full
employment, Keynesians assumed the pervasiveness of institutionally determined nominal prices
including wages. The resulting taxonomic classification of inflation included demand-pull, cost-
push, and wage-price spiral. As a result of demand-pull inflation, fluctuations in aggregate demand,
real or nominal, would cause inverse movements in inflation and unemployment while cost-push
inflation would shift inflation upward for a given level of unemployment (Hetzel 2013a).
Friedman criticized the implication of the above reasoning that real variables lack well-
defined values but rather fluctuate in response to variation in aggregate demand. In doing so, he
reintroduced the idea of natural values. The price system works well to determine unique, market-
clearing values of real variables. The Phillips-curve correlations between prices and output result
6
Fève et al. (2009, 13) repeat for Europe this monetarist critique: “[T]he form of monetary policy,
namely monetary policy inertia, has played an important role in the large and persistent increase of
the real interest rate and the sizeable output losses that have followed from disinflation policies of the
eighties.” See also Fève et al. (2010).
7
from central bank behavior that causes the price level to evolve in an unpredictable manner. Over a
period long enough to identify changes in aggregate nominal demand due to monetary policy, firms
undo the effects of monetary policy on output and employment.
The pre-1981 period constituted an extraordinary period for testing monetarist hypotheses.
Because the real demand for the monetary aggregate M1 was interest insensitive,
nominal money
bore a fairly stable relationship to nominal output. Money then served as a reliable indicator of the
stance of monetary policy.
7
The ability of money to predict nominal GDP and inflation is consistent
with variations in money arising from discrepancies between the real value of the Fed’s funds rate
target and the natural rate of interest. (See Figures 1 and 2.)
4.
Identification of episodes of contractionary monetary policy as event studies
Friedman’s methodology for identifying fluctuations in money as arising independently of
nominal income and prices used the intuition of price fixing in an individual market applied to Fed
interference with the market determination of the real interest rate (Friedman 1968 [1969], Sec. I. A;
1981 [1983], 244-247 cited above). In the absence of a structural model of the economy capable of
measuring a divergence between the real rate of interest implied by the central bank’s interest rate
target and the natural rate of interest, Friedman and Schwartz (1963b) highlighted the associated
monetary accelerations and decelerations. Following them, Figures 4 and 5 show annualized M1
growth rates using step functions fitted to the monthly observations as a visual aid to seeing the
alternations in money growth rates. As shown, monetary contractions predict cyclical peaks.
As noted in footnote 7, this method of identification lost relevance in the early 1980s. In
order to give continued empirical content to the monetarist view that the price system works well to
attenuate cyclical fluctuations in the absence of monetary disturbances, it is useful to note that
recessions are infrequent events. It follows that the central bank must possess a baseline rule that
allows the price system to work. That rule was never one of explicit monetary control but rather, in
the words of William McChesney Martin, was one of “lean-against-the-wind” (LAW). In a
measured, persistent way, the Fed raises the funds rate above its prevailing value when output grows
at a sustained rate in excess of potential (rates of resource utilization are increasing and the
unemployment rate is falling) and conversely in the case of sustained economic weakness.
The lag in lowering rates after cyclical peaks resulted in monetary deceleration while the lag
in raising rates after cyclical troughs resulted in monetary acceleration (Friedman 1984, 27, cited
above). That cyclical inertia originated in the Fed’s periodic attempt to manipulate an output gap.
As reflected in the appellation “stop-go” monetary policy and as criticized by Friedman (1968
[1969]), the Fed wanted to create a negative output gap in order to lower inflation after cyclical peaks
and wanted to speed reduction in the magnitude of the negative output gap after cyclical troughs
(Hetzel 2008, Chs. 23-25).
7
With the deregulation of interest rates legislated in the
Monetary Control Act of 1980, real money
demand became interest sensitive and the behavior of M1 became countercyclical. For example, in
recession, which calls for cyclically low interest rates, M1 growth rises.