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

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

In Friedman and Schwartz's study A Monetary History of the United States, they subject the money matters hypothesis to several historical tests. Three tests stand out relating to price behavior for 1879-1914, to the World War I and World War II periods, and to the Fed's tight required reserves policies in 1937-1938. To explain the inflation after 1896, we notice that prices declined between 1879-1896 by approximately -0.93 percent annually, and increased between 1897-1914 by approximately 2.08 percent annually. Money to output increased between 1879-1896 by 2.29 percent annually, and between 1897-1914 by 4.23 percent annually, being driven up by the new gold supply. Base money, defined as currency plus reserves, increased between 1879-1896 by 3.49 percent annually, and between 1897-1914 by 4.8 percent, annually. One cannot rule out the possibility, therefore, of some association between money and prices after 1896. In the second case, between 1914-1920 money to output increased 8.45 percent annually, while the price level rose 10.84 percent annually. But, the differences were reversed between 1939-1948, when money to output increased 7.90 percent annually and price level increased 6.65 percent annually. Yet, we can say that the correlation between money and prices appears similar. In the third case, during the 1937-1938 recession, the Fed doubled required reserves, resulting in a decrease in the money stock by -0.37, a decrease in prices by -0.50, and a decrease in output by -8.23 percent during that one year; thus shedding light on the causation between money and economic activities.

An issue pointed out recently by Paul Krugman (2007) concerns the period 1929-1933. The money base increased from $6.05 billion in 1929 to $7.02 billion in 1933, while the money supply fell from $26.6 billion to $19.9 billion, reflecting bank failures. People seemed to have a high liquidity preference. At issue is whether the Fed that increased the money base should be blamed for the fall in the money supply. Friedman's point was that the Fed could have prevented bank failures.

Friedman's policy roles have taken on a different manifestation in the modern economy. In the hands of Kydland and Prescott (1977) policy roles are used to improve social optimum. People's expectations change, for instance, with changes in new administrations in Washington. One frequent change in expectations of this sort is in regards to taxing policies. Such changes, however, lead to other changes that may not lead to an optimum situation. With Barro and Gordon (1983), policy rules have a home in efforts to eliminate surprise inflation. In adjusting their expectation of inflation to eliminate surprise inflation, people's actions can lead to higher money supply and inflation. Policy rules can stop such expectations-driven inflation from occurring. Such adjustments can occur within a gaming situation where policy makers can break rules and cheat in order to get more employment by lowering inflation. In such games, policy makers put their reputation and credibility on the line.