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Milton Friedman – Role of Monetary Policy
What effect does monetary policy have on our economies?
In 1968, the American economist Milton Friedman published a paper called The Role of Monetary
Policy.
Monetary policy attempts to control the size and rate of growth of an economy. The prevailing
opinion at the time was that when unemployment decreased, inflation increased – there was
a permanent trade-off.
But Friedman disagreed.
He challenged economic orthodoxy and argued that policy makers expected too much from
monetary policy.
Friedman believed that monetary policy could not have significant long-term impact on economic
growth, output and employment.
How can we demonstrate Friedman’s claim that monetary policy only has short-term effects?
Let’s imagine a group of lion cubs in a zoo. It competes for visitors with other attractions
in the town. The zoo manager decides that if she increases the lion’s diet, they will
grow faster – and attract a bigger crowd.
The cubs are fed extra meat, and they grow larger. But it’s an artificial effect.
By the time they reach adulthood, they are overweight and require more meat to sustain
them at their current size.
Increasing the food supply was supposed to be a temporary solution to a short term problem.
But now the zoo manager discovers that cutting back the lion’s diet makes them sluggish
– and in time they will all lose size.
This is the phenomenon that Friedman highlighted in his study of money supply.
Increasing the money supply makes the economy grow faster– just like the extra portion
of meat accelerated the lions’ growth. But as workers and investors adapt their expectations,
additional cheap money is needed – just to sustain the economy at that level. A wage-price
spiral begins – resulting in more inflation.
Friedman would have argued that the zoo manager was falling into the same trap that ensnares
many politicians. She wanted bigger lions to attract more visitors, just as political
parties want a faster-growing economy to attract more votes. But in reality, the zoo’s best
strategy would be to keep all the animals on a stable diet. This would have created
a more effective distribution of food resources throughout the zoo. And the lions would not
then permanently consume excessive amounts of food.
Friedman suggested that the solution to the problem of controlling inflation and employment
would be similar. By ensuring a ‘steady rate of growth’, swings and large fluctuations
could be avoided – ensuring a more stable growth with fewer disturbances.
Milton Friedman is widely remembered as one of the leading economic thinkers of the 20th
Century.
A more detailed examination of his ideas can be found in the MACAT analysis.