Memorializing Milton Friedman: a review of his major works, 1912-2006

American Economist, Spring, 2008 by Lall Ramrattan, Michael Szenberg

[M.sup.d.sub.t] = f([y.sub.t], [R.sub.it] ... [R.sub.nt]) (5)

where there are now many interest rates on financial assets, ranging from the shortest maturity, t = 1, to the longest t = n. Equation 4 reduces the variables by restricting the parameters.

Both the Keynesian and the Friedman paradigms are still active for empirical research. Friedman's major argument against discretionary monetary policy is that it tends to be destabilizing because of lags. Modern extensions of macroeconomics within the CGE (Computable General Equilibrium) domain of research maintain this position (Blanchard and Fischer 1990, 581).

The predictions of the quantity theory were backed by theoretical arguments. In 1969, Friedman advanced a model of his monetary theory is search of the optimum quantity of money. He likened it to a Japanese garden, characterized by simplicity and unity of a complex reality. He simplified monetary theory by making 13 assumptions. The fixed assumptions included: 1. Population. 2. Taste. 3. Physical resources. 4. Technique, 5. A stationary state. He assumed 6. Competition, 7. Durable capital goods. The do not assumptions included: 8. No exchange of capital goods. 9. No lending or borrowing. 10. Only exchanges of money for services and vice versa allowed. The operational assumptions included: 11. Prices are flexible. 12. Money is a fiat, and 13. Money is a fixed number of pieces of paper, $10,000 (Friedman 1969, 2-3).

In this economy, people can hold money as a medium of circulation, or as a reserve. Assumption 5 posits a stationary but not a static economy, where the latter would imply that people would conduct all transactions at one time, obviating the need for a circulatory function of money and even eliminating uncertainty. The amount of money citizens will want to hold depends on its velocity, which is assumed as 10 percent. Therefore, given fiat money, citizens will want to hold $1,000 (10,000*0.1).

To see the model evolve, we introduce some money into the economy via a helicopter, which makes a one-time drop of a $1,000. Individuals will gather money equal in proportion to what they held before, which in this case will double their cash balance. But individuals are in stable equilibrium. Had they wished to double their cash balance, they would have done so by some adjustment in the past. Individuals would now want to spend their excess cash balance, thanks to the helicopter incident. When others receive their spending, they too will be in the same situation of wanting to hold less cash balance. In this way the amount of money injected into the economy by the helicopter will translate into a proportional increase in prices, given the other fixed assumptions.

The bottom-line argument from Friedman's monetary theory is that monetary policies have strong influences on the economy. This potent influence has given birth to the aphorism that 'money matters,' whether in its weak form "money too matters" or in its strong form "only money matters." Because of the strong influence of money on economic activities, Friedman wanted to guard against the mismanagement of monetary policies. One thing to safeguard against is the lags with which changes in the money supply influence the economy. Because of these lags, Friedman thought the good intentions of the monetary policy makers to stabilize the economy might result in destabilization. He, therefore, became a staunch advocate for monetary policy rules, arguing against discretionary policies. Briefly, the debate of rules versus discretion started at the University of Chicago with the economist Henry Simons (1936). For Simons, the essential point for a test is to find stable and definite legislative rules of the game for economic freedom (Simons 1936, 3). Given a tendency to hoard or dishoard money, or if many substitutes for currency and deposits exist, "near moneys" then the fixed scheme is easily defeated. Friedman (1969, 48) advocated the "5 percent and the 2 percent rules." In the 5 percent rule, "the aggregate quantity of money is automatically determined by the requirements of domestic stability" (Friedman 1948, 252). The 5 percent rule addresses short run phenomena such as rigidities and lags. The 2 percent rule is aimed at more long run phenomena that require nominal interest rates to equal the opportunity cost of producing money for the interest rate to be approximately zero.