1
“The Counter-Revolution in Monetary Theory”
by Milton Friedman
IEA Occasional Paper, no. 33
© Institute of Economic Affairs. First published by the Institute of Economic Affairs, London,
1970.
It is a great pleasure to be with you today, partly because I am honored at being the first of the
Harold Wincott lecturers, partly because economics owes so much to the work that has been
done on this island. Coming back to Britain, as I am fortunate enough to be able to do from time
to time, always means coming back to a warm circle of friends or friendly enemies.
I am going to talk this afternoon primarily about a scientific development that has little
ideological or political content. This development nonetheless has great relevance to
governmental policy because it bears on the likely effects of particular kinds of governmental
policy regardless of what party conducts the policy and for what purpose.
A counter-revolution must be preceded by two stages: an initial position from which there was a
revolution, and the revolution. In order to set the stage, I would like first to make a few remarks
about the initial position and the revolution.
It is convenient to have names to describe these positions. The initial position I shall call the
quantity theory of money and associate it largely with the name of an American economist,
Irving Fisher, although it is a doctrine to which many prominent English economists also made
contributions. The revolution, as you all know, was made by Keynes in the 1930s. Keynes
himself was a quantity theorist, so that his revolution was from, as it were, within the governing
body. Keynes’s name is the obvious name to attach to the revolution. The counter-revolution also
needs a name and perhaps the one most widely used in referring to it is ‘the Chicago School’.
More recently, however, it has been given a name which is less lovely but which has become so
attached to it that I find it hard to avoid using it. That name is ‘monetarism’ because of the
renewed emphasis on the role of the quantity of money.
A counter-revolution, whether in politics or in science, never restores the initial situation. It
always produces a situation that has some similarity to the initial one but is also strongly
influenced by the intervening revolution. That is certainly true of monetarism which has
benefited much from Keynes’s work. Indeed I may say, as have so many others since there is no
way of contradicting it, that if Keynes were alive today he would no doubt be at the forefront of
the counter-revolution. You must never judge a master by his disciples.
I. Irving Fisher and the Quantity Theory
Let me then start briefly to set the stage with the initial position, the quantity theory of money as
developed primarily by Irving Fisher who is to my mind by far the greatest American economist.
He was also an extraordinarily interesting and eccentric man. Indeed, I suspect that his
professional reputation suffered during his life because he was not only an economist but also
involved in many other activities, including being one of the leading members of the American
prohibitionist party. He interviewed all potential presidential candidates for something like 30
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
2
years to find out what their position was on the subject of alcohol. His best-selling book, which
has been translated into the largest number of languages, is not about economics at all but about
health. It is about how to eat and keep healthy and is entitled How to Live (written jointly with Dr
E. L. Fisk). But even that book is a tribute to his science. When he was a young man in his early
thirties, he contracted tuberculosis, was given a year to live by his physicians, went out to the Far
West where the air was good and proceeded to immerse himself in the study of health and
methods of eating and so on. If we may judge the success of his scientific work by its results, he
lived to the age of 80. As you may know, he was also a leading statistician, developed the theory
of index numbers, worked in mathematics, economics and utility theory and had time enough
besides to invent the Kardex filing system, the familiar system in which one little envelope flaps
on another, so you can pull out a flat drawer to see what is in it. He founded what is now
Remington-Rand Corporation in order to produce and distribute his invention. As you can see, he
was a man of very wide interests and ability.
MV = PT
The basic idea of the quantity theory, that there is a relation between the quantity of money on
the one hand and prices on the other, is surely one of the oldest ideas in economics. It goes back
thousands of years. But it is one thing to express this idea in general terms. It is another thing to
introduce system into the relation between money on the one hand and prices and other
magnitudes on the other. What Irving Fisher did was to analyze the relationship in far greater
detail than had ever been done earlier. He developed and popularized what has come to be
known as the quantity equation: MV = PT, money multiplied by velocity equals prices multiplied
by the volume of transactions. This is an equation that every college student of economics used
to have to learn, then for a time did not, and now, as the counter-revolution has progressed, must
again learn. Fisher not only presented this equation, he also applied it in a variety of contexts. He
once wrote a famous article interpreting the business cycle as the ‘dance of the dollar’, in which
he argued that fluctuations in economic activity were primarily a reflection of changes in the
quantity of money. Perhaps even more pertinent to the present day, he analyzed in detail the
relation between inflation on the one hand and interest rates on the other. His first book on this
subject, Appreciation and Interest, published in 1896, can be read today with profit and is
immediately applicable to today’s conditions.
In that work, Fisher made a distinction which again is something that went out of favor and has
now come back into common use, namely the distinction between the nominal interest rate in
pounds per year per hundred pounds and the real interest rate, i.e., corrected for the effect of
changing prices. If you lend someone £100 today and in 12 months receive back £106, and if in
the meantime prices rise by 6 per cent then your £106 will be worth no more than your £100
today. The nominal interest rate is 6 per cent, but the real interest rate is zero. This distinction
between the nominal interest rate and the real interest rate is of the utmost importance in
understanding the effects of monetary policy as well as the behavior of interest rates. Fisher also
distinguished sharply between the actual real rate, the rate realized after the event, and the
anticipated real rate that lenders expected to receive or borrowers expected to pay. No one would
lend money at 6 per cent if he expected prices to rise by 6 per cent during the year. If he did lend
at 6 per cent, it must have been because he expected prices to rise by less than 6 per cent: the
realized real rate was less than the anticipated real rate. This distinction between the actual real
rate and the anticipated real rate is of the greatest importance today in understanding the course
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
3
of events. It explains why inflation is so stubborn once it has become imbedded, because as
inflation accelerates, people come to expect it. They come to build the expected inflation into the
interest rates that they are willing to pay as borrowers or that they demand as lenders.
Wide Consensus
Up to, let us say, the year 1930, Irving Fisher’s analysis was widely accepted. In monetary
theory, that analysis was taken to mean that in the quantity equation MV = PT the term for
velocity could be regarded as highly stable, that it could be taken as determined independently of
the other terms in the equation, and that as a result changes in the quantity of money would be
reflected either in prices or in output. It was also widely taken for granted that short-term
fluctuations in the economy reflected changes in the quantity of money, or in the terms and
conditions under which credit was available. It was taken for granted that the trend of prices over
any considerable period reflected the behavior of the quantity of money over that period.
In economic policy, it was widely accepted that monetary policy was the primary instrument
available for stabilizing the economy. Moreover, it was accepted that monetary policy should be
operated largely through a combination of two blades of a scissors, the one blade being what we
in the USA call ‘discount rate’ and you in Britain call ‘Bank rate’, the other blade being open-
market operations, the purchase and sale of government securities.
That was more or less the initial doctrinal position prior to the Keynesian revolution. It was a
position that was widely shared. Keynes’s A Tract on Monetary Reform,
2
which I believe
remains to this day one of his best books, reflects the consensus just described.
II. The Keynesian Revolution
Then came the Keynesian revolution. What produced that revolution was the course of events.
My colleague, George Stigler, in discussing the history of thought, has often argued that major
changes within a discipline come from inside the discipline and are not produced by the impact
of outside events. He may well be right in general. But in this particular instance I believe the
basic source of the revolution and of the reaction against the quantity theory of money was a
historical event, namely the great contraction or depression. In the United Kingdom, the
contraction started in 1925 when Britain went back on gold at the pre-war parity and ended in
1931 when Britain went off gold. In the United States, the contraction started in 1929 and ended
when the USA went off gold in early 1933. In both countries, economic conditions were
depressed for years after the contraction itself had ended and an expansion had begun.
Wrong Lessons from Great Depression
The Great Depression shattered the acceptance of the quantity theory of money because it was
widely interpreted as demonstrating that monetary policy was ineffective, at least against a
decline in business. All sorts of aphorisms were coined that are still with us, to indicate why it
was that providing monetary ease would not necessarily lead to economic expansion, such as
‘You can lead a horse to water but you can’t make him drink’ or ‘Monetary policy is like a
string: you can pull on it but you can’t push on it’, and doubtless there are many more.
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
4
As it happens, this interpretation of the depression was completely wrong. It turns out, as I shall
point out more fully below, that on re-examination, the depression is a tragic testament to the
effectiveness of monetary policy, not a demonstration of its impotence. But what mattered for the
world of ideas was not what was true but what was believed to be true. And it was believed at the
time that monetary policy had been tried and had been found wanting.
In part that view reflected the natural tendency for the monetary authorities to blame other forces
for the terrible economic events that were occurring. The people who run monetary policy are
human beings, even as you and I, and a common human characteristic is that if anything bad
happens it is somebody else’s fault. In the course of collaborating on a book on the monetary
history of the United States, I had the dismal task of reading through 50 years of annual reports
of the Federal Reserve Board. The only element that lightened that dreary task was the cyclical
oscillation in the power attributed to monetary policy by the system. In good years the report
would read ‘Thanks to the excellent monetary policy of the Federal Reserve…’ In bad years the
report would read ‘Despite the excellent policy of the Federal Reserve…’, and it would go on to
point out that monetary policy really was, after all, very weak and other forces so much stronger.
The monetary authorities proclaimed that they were pursuing easy money policies when in fact
they were not, and their protestations were largely accepted. Hence Keynes, along with many
others, concluded that monetary policy had been tried and found wanting. In contrast to most
others, he offered an alternative analysis to explain why the depression had occurred and to
indicate a way of ameliorating the situation.
Keynes’s Critique of the Quantity Theory
Keynes did not deny Irving Fisher’s quantity equation. What Keynes said was something
different. He said that, while of course MV equals PT, velocity, instead of being highly stable, is
highly adaptable. If the quantity of money goes up, he said, what will happen is simply that the
velocity of circulation of money will go down and nothing will happen on the other side of the
equation to either prices or output. Correspondingly, if something pushes the right-hand side of
the equation, PT or income, up without an increase in the quantity of money, all that will happen
will be that velocity will rise. In other words, he said, velocity is a will-of-the-wisp. It can move
one way or the other in response to changes either in the quantity of money or in income. The
quantity of money is therefore of minor importance. (Since I am trying to cover highly technical
material very briefly, I am leaving out many qualifications that are required for a full
understanding of either Fisher or Keynes. I do want to stress that the statements I am making are
simplifications and are not to be taken as a full exposition of any of the theories.)
What matters, said Keynes, is not the quantity of money. What matters is the part of total
spending which is independent of current income, what has come to be called autonomous
spending and to be identified in practice largely with investment by business and expenditures by
government.
Keynes thereby directed attention away from the role of money and its relation to the flow of
income and toward the relation between two flows of income, that which corresponds to
autonomous spending and that which corresponds to induced spending. Moreover, he said, in the
modern world, prices are highly rigid while quantities can change readily. When for whatever
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
5
reason autonomous spending changes, the resulting change in income will manifest itself
primarily in output and only secondarily and only after long lags in prices. Prices are determined
by costs consisting mostly of wages, and wages are determined by the accident of past history.
The great contraction, he said, was the result of a collapse of demand for investment which in
turn reflected a collapse of productive opportunities to use capital. Thus the engine and the motor
of the great contraction was a collapse of investment transformed into a collapse of income by
the multiplier process.
The Implications for Policy
This doctrine had far-reaching implications for economic policy. It meant that monetary policy
was of little importance. Its only role was to keep interest rates down, both to reduce the pressure
on the government budget in paying interest on its debts, and also because it might have a tiny
bit of stimulating effect on investment. From this implication of the doctrine came the cheap
money policy which was tried in country after country following World War II.
A second implication of the doctrine was that the major reliance for economic stabilization could
not be on monetary policy, as the quantity theorists had thought, but must be on fiscal policy,
that is, on varying the rate of government spending and taxing.
A third implication was that inflation is largely to be interpreted as a cost-push phenomenon. It
follows, although Keynes himself did not draw this conclusion from his doctrine, that the way to
counteract inflation is through an incomes policy. If costs determine prices and costs are
historically determined, then the way to stop any rise in prices is to stop the rise in costs.
These views became widely accepted by economists at large both as theory and as implications
for policy. It is hard now at this distance in time to recognize how widely they were accepted.
Let me just give you one quotation which could be multiplied many-fold, to give you the flavor
of the views at the end of World War II. Parenthetically, acceptance of these views continued
until more recently in Britain than in the United States, so it may be easier for you to recognize
the picture I have been painting than it would be now for people in the United States. I quote
from John H. Williams, who was a Professor of Economics at Harvard University, a principal
advisor to the Federal Reserve Bank of New York, and widely regarded as an anti-Keynesian. In
1945 he wrote: ‘I have long believed that the quantity of money by itself has a permissive rather
than a positive effect on prices and production’. And in the sentence I want to stress he wrote: ‘I
can see no prospect of a revival of general monetary control in the post-war period’. That was a
very sweeping statement, and one that obviously proved very far indeed from the mark.
The high point in the United States of the application of Keynesian ideas to economic policy
probably came with the new economists of the Kennedy administration. Their finest hour was
the tax cut of 1964 which was premised entirely on the principles that I have been describing.
Having sketched briefly the initial stage of the quantity theory, and the revolutionary stage of the
Keynesian theory, I come now to the monetarist counter-revolution.
III. The Counter-Revolution
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
6
As so often happens, just about the time that Keynes’s ideas were being triumphant in practice,
they were losing their hold on the minds of scholars in the academies. A number of factors
contributed to a change of attitude towards the Keynesian doctrine. One was the experience
immediately after World War II. On the basis of the Keynesian analysis, economists and others
expected the war to be followed by another great depression. With our present experience of over
two decades of inflation behind us it is hard to recognize that this was the sentiment of the times.
But alike in the United States, in Great Britain and in many other countries, the dominant view
was that, once World War II ended, once the pump-priming and government spending for
military purposes ended, there would be an enormous economic collapse because of the scarcity
of investment opportunities that had been given the blame for the Great Depression. Massive
unemployment and massive deflation were the bugaboos of the time. As you all know, that did
not happen. The problem after the war turned out to be inflation rather than deflation.
A second post-war experience that was important was the failure of cheap money policies. In
Britain, Chancellor Dalton tried to follow the Keynesian policy of keeping interest rates very
low. As you all know, he was unable to do so and had to give up. The same thing happened in
the United States. The Federal Reserve System followed a policy of pegging bond prices, trying
to keep interest rates down. It finally gave up in 1953 after the Treasury-Federal Reserve Accord
of 1951 laid the ground-work for setting interest rates free. In country after country, wherever the
cheap money policy was tried, it led to inflation and had to be abandoned. In no country was
inflation contained until orthodox monetary policy was employed. Germany was one example in
1948; Italy shortly after; Britain and the United States later yet.
Reconsideration of Great Depression
Another important element that contributed to a questioning of the Keynesian doctrine was a re-
examination of monetary history and particularly of the Great Depression. When the evidence
was examined in detail it turned out that bad monetary policy had to be given a very large share
of the blame. In the United States, there was a reduction in the quantity of money by a third from
1929 to 1933. This reduction in the quantity of money clearly made the depression much longer
and more severe than it otherwise would have been. Moreover, and equally important, it turned
out that the reduction in the quantity of money was not a consequence of the unwillingness of
horses to drink. It was not a consequence of being unable to push on a string. It was a direct
consequence of the policies followed by the Federal Reserve system.
From 1930 to 1933, a series of bank runs and bank failures were permitted to run their course
because the Federal Reserve failed to provide liquidity for the banking system, which was one of
the main functions the designers of the Federal Reserve System intended it to perform. Banks
failed because the public at large, fearful for the safety of their deposits, tried to convert their
deposits into currency. In a fractional reserve system, it is literally impossible for all depositors
to do that unless there is some source of additional currency. The Federal Reserve System was
established in 1913 in response to the banking panic of 1907 primarily to provide additional
liquidity at a time of pressure on banks. In 1930–33, the system failed to do so and it failed to do
so despite the fact that there were many people in the system who were calling upon it to do so
and who recognized that this was its correct function.
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
7
It was widely asserted at the time that the decline in the quantity of money was a consequence of
the lack of willing borrowers. Perhaps the most decisive bit of evidence against that
interpretation is that many banks failed because of a decline in the price of government
securities. Indeed, it turned out that many banks that had made bad private loans came through
much better than banks that had been cautious and had bought large amounts of Treasury and
municipal securities for secondary liquidity. The reason was that there was a market for the
government securities and hence when bank examiners came around to check on the banks, they
had to mark down the price of the governments to the market value. However, there was no
market for bad loans, and therefore they were carried on the books at face value. As a result,
many careful, conservative banks failed.
The quantity of money fell by a third and roughly a third of all banks failed. This is itself a
fascinating story and one that I can only touch on. The important point for our purposes is that it
is crystal clear that at all times during the contraction, the Federal Reserve had it within its power
to prevent the decline in the quantity of money and to produce an increase. Monetary policy had
not been tried and found wanting. It had not been tried. Or, alternatively, it had been tried
perversely. It had been used to force an incredible deflation on the American economy and on
the rest of the world. If Keynes—and this is the main reason why I said what I did at the
beginning—if Keynes had known the facts about the Great Depression as we now know them, he
could not have interpreted that episode as he did.
Wider Evidence
Another scholarly element that contributed to a reaction against the Keynesian doctrine and to
the emergence of the new doctrine was extensive empirical analysis of the relation between the
quantity of money on the one hand, and income, prices and interest rates on the other. Perhaps
the simplest way for me to suggest why this was relevant is to recall that an essential element of
the Keynesian doctrine was the passivity of velocity. If money rose, velocity would decline.
Empirically, however, it turns out that the movements of velocity tend to reinforce those of
money instead of to offset them. When the quantity of money declined by a third from 1929 to
1933 in the United States, velocity declined also. When the quantity of money rises rapidly in
almost any country, velocity also rises rapidly. Far from velocity offsetting the movements of the
quantity of money, it reinforces them.
I cannot go into the whole body of scientific work that has been done. I can only say that there
has arisen an extensive literature concerned with exploring these relations which has
demonstrated very clearly the existence of a consistent relation between changes in the quantity
of money and changes in other economic magnitudes of a very different kind from that which
Keynes assumed to exist.
The final blow, at least in the United States, to the Keynesian orthodoxy was a number of
dramatic episodes in our recent domestic experience. These episodes centered around two key
issues. The first was whether the behavior of the quantity of money or rates of interest is a better
criterion to use in conducting monetary policy. You have had a curious combination in this area
of central bankers harking back to the real bills doctrine of the early 19th century on the one
hand, and Keynesians on the other, who alike agreed that the behavior of interest rates was the
relevant criterion for the conduct of monetary policy. By contrast, the new interpretation is that
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
8
interest rates are a misleading index of policy and that central bankers should look rather at the
quantity of money. The second key issue was the relative role of fiscal policy and of monetary
policy. By fiscal policy, I mean changes in government spending and taxing, holding the quantity
of money constant. By monetary policy, I mean changes in the quantity of money, holding
government spending and taxing constant.
Fiscal Versus Monetary Policy
The problem in discussing the relative roles of fiscal policy and monetary policy is primarily to
keep them separate, because in practice they operate jointly most of the time. Ordinarily if a
government raises its spending without raising taxes, that is if it incurs a deficit in order to be
expansionary, it will finance some of the deficit by printing money. Conversely if it runs a
surplus, it will use part of that surplus to retire money. But from an analytical point of view, and
from the point of view of getting at the issue that concerns the counter-revolution, it is important
to consider fiscal policy and monetary policy separately, to consider each operating by itself. The
Keynesians regarded as a clear implication of their position the proposition that fiscal policy by
itself is important in affecting the level of income, that a large deficit would have essentially the
same expansionary influence on the economy whether it was financed by borrowing from the
public or by printing money.
The ‘monetarists’ rejected this proposition and maintained that fiscal policy by itself is largely
ineffective, that what matters is what happens to the quantity of money. Off-hand that seems like
an utterly silly idea. It seems absurd to say that if the government increases its expenditures
without increasing taxes, that may not by itself by expansionary. Such a policy obviously puts
income into the hands of the people to whom the government pays out its expenditures without
taking any extra funds out of the hands of the taxpayers. Is that not obviously expansionary or
inflationary? Up to that point, yes, but that is only half the story. We have to ask where the
government gets the extra funds it spends. If the government prints money to meet its bills, that
is monetary policy and we are trying to look at fiscal policy by itself. If the government gets the
funds by borrowing from the public, then those people who lend the funds to the government
have less to spend or to lend to others. The effect of the higher government expenditures may
simply be higher spending by government and those who receive government funds and lower
spending by those who lend to government or by those to whom lenders would have loaned the
money instead. To discover any net effect on total spending, one must go to a more sophisticated
level—to differences in the behavior of the two groups of people or to effects of government
borrowing on interest rates. There is no first-order effect.
Evidence from US ‘Experiments’
The critical first test on both these key issues came in the USA in 1966. There was fear of
developing inflation and in the spring of 1966 the Federal Reserve Board, belatedly, stepped very
hard on the brake. I say ‘stepped very hard’ because the record on the Federal Reserve over 50
years is that it has almost invariably acted too much too late. Almost always it has waited too
long before acting and then acted too strongly. In 1966, the result was a combination of a very
tight monetary policy, under which the quantity of money did not grow at all during the final
nine months of the year, and a very expansive fiscal policy. So you had a nice experiment.
Which was going to dominate? The tight money policy or the easy fiscal policy? The Keynesians
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
9
in general argued that the easy fiscal policy was going to dominate and therefore predicted
continued rapid expansion in 1967. The monetarists argued that monetary policy would
dominate, and so it turned out. There was a definite slowing down in the rate of growth of
economic activity in the first half of 1967, following the tight money policy of 1966. When, in
early 1967, the Federal Reserve reversed its policy and started to print money like mad, about six
or nine months later, after the usual lag, income recovered and a rapid expansion in economic
activity followed. Quite clearly, monetary policy had dominated fiscal policy in that encounter.
A still more dramatic example came in 1968 and from 1968 to the present. In the summer of
1968, under the influence of the Council of Economic Advisers and at the recommendation of
President Johnson, Congress enacted a surtax of 10 per cent on income. It was enacted in order
to fight the inflation which was then accelerating. The believers in the Keynesian view were so
persuaded of the potency of this weapon that they were afraid of ‘overkill’. They thought the tax
increase might be too much and might stop the economy in its tracks. They persuaded the
Federal Reserve system, or I should rather say that the Federal Reserve system was of the same
view. Unfortunately for the United States, but fortunately for scientific knowledge, the Federal
Reserve accordingly decided that it had best offset the overkill effects of fiscal policy by
expanding the quantity of money rapidly. Once again, we had a beautiful controlled experiment
with fiscal policy extremely tight and monetary policy extremely easy. Once again, there was a
contrast between two sets of predictions. The Keynesians or fiscalists argued that the surtax
would produce a sharp slow-down in the first half of 1969 at the latest while the monetarists
argued that the rapid growth in the quantity of money would more than offset the fiscal effects,
so that there would be a continued inflationary boom in the first half of 1969. Again, the
monetarists proved correct. Then, in December 1968, the Federal Reserve Board did move to
tighten money in the sense of slowing down the rate of growth of the quantity of money and that
was followed after the appropriate interval by a slow-down in the economy. This test, I may say,
is still in process, but up to now it again seems to be confirming the greater importance of the
monetary than of the fiscal effect.
‘This Is Where I Came In’
One swallow does not make a spring. My own belief in the greater importance of monetary
policy does not rest on these dramatic episodes. It rests on the experience of hundreds of years
and of many countries. These episodes of the past few years illustrate that effect; they do not
demonstrate it. Nonetheless, the public at large cannot be expected to follow the great masses of
statistics. One dramatic episode is far more potent in influencing public opinion than a pile of
well-digested, but less dramatic, episodes. The result in the USA at any rate has been a drastic
shift in opinion, both professional and lay.
This shift, so far as I can detect, has been greater in the United States than in the United
Kingdom. As a result, I have had in the UK the sensation that I am sure all of you have had in a
continuous cinema when you come to the point where you say, ‘Oh, this is where I came in’. The
debate about monetary effects in Britain is pursuing the identical course that it pursued in the
United States about five or so years ago. I am sure that the same thing must have happened in the
1930s. When the British economists wandered over to the farther shores among their less
cultivated American brethren, bringing to them the message of Keynes, they must have felt, as I
have felt coming to these shores in the opposite direction, that this was where they came in. I am
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
10
sure they then encountered the same objections that they had encountered in Britain five years
earlier. And so it is today. Criticism of the monetary doctrines in this country today is at the
naïve, unsophisticated level we encountered in the USA about five or more years ago.
Thanks to the very able and active group of economists in this country who are currently
working on the monetary statistics, and perhaps even more to the effect which the course of
events will have, I suspect that the developments in this country will continue to imitate those in
the United States. Not only in this area, but in other areas as well, I have had the experience of
initially being in a small minority and have had the opportunity to observe the scenario that
unfolds as an idea gains wider acceptance. There is a standard pattern. When anybody threatens
an orthodox position, the first reaction is to ignore the interloper. The less said about him the
better. But if he begins to win a hearing and gets annoying, the second reaction is to ridicule him,
make fun of him as an extremist, a foolish fellow who has these silly ideas. After that stage
passes the next, and the most important, stage is to put on his clothes. You adopt for your own
his views, and then attribute to him a caricature of those views saying, ‘He’s an extremist, one of
those fellows who says only money matters—everybody knows that sort. Of course money does
matter, but…’
IV. Key Propositions of Monetarism
Let me finally describe the state to which the counter-revolution has come by listing
systematically the central propositions of monetarism.
1. There is a consistent though not precise relation between the rate of growth of the quantity of
money and the rate of growth of nominal income. (By nominal income, I mean income measured
in pounds sterling or in dollars or in francs, not real income, income measured in real goods.)
That is, whether the amount of money in existence is growing by 3 per cent a year, 5 per cent a
year or 10 per cent a year will have a significant effect on how fast nominal income grows. If the
quantity of money grows rapidly, so will nominal income; and conversely.
2. This relation is not obvious to the naked eye largely because it takes time for changes in
monetary growth to affect income and how long it takes is itself variable. The rate of monetary
growth today is not very closely related to the rate of income growth today. Today’s income
growth depends on what has been happening to money in the past. What happens to money today
affects what is going to happen to income in the future.
3. On the average, a change in the rate of monetary growth produces a change in the rate of
growth of nominal income about six to nine months later. This is an average that does not hold in
every individual case. Sometimes the delay is longer, sometimes shorter. But I have been
astounded at how regularly an average delay of six to nine months is found under widely
different conditions. I have studied the data for Japan, for India, for Israel, for the United States.
Some of our students have studied it for Canada and for a number of South American countries.
Whichever country you take, you generally get a delay of around six to nine months. How clear-
cut the evidence for the delay is depends on how much variation there is in the quantity of
money. The Japanese data have been particularly valuable because the Bank of Japan was very
obliging for some 15 years from 1948 to 1963 and produced very wide movements in the rate of
change in the quantity of money. As a result, there is no ambiguity in dating when it reached the
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
11
top and when it reached the bottom. Unfortunately for science, in 1963 they discovered
monetarism and they started to increase the quantity of money at a fairly stable rate and now we
are not able to get much more information from the Japanese experience.
4. The changed rate of growth of nominal income typically shows up first in output and hardly at
all in prices. If the rate of monetary growth is reduced then about six to nine months later, the
rate of growth of nominal income and also of physical output will decline. However, the rate of
price rise will be affected very little. There will be downward pressure on prices only as a gap
emerges between actual and potential output.
5. On the average, the effect on prices comes about six to nine months after the effect on income
and output, so the total delay between a change in monetary growth and a change in the rate of
inflation averages something like 12–18 months. That is why it is a long road to hoe to stop an
inflation that has been allowed to start. It cannot be stopped overnight.
6. Even after allowance for the delay in the effect of monetary growth, the relation is far from
perfect. There’s many a slip ‘twixt the monetary change and the income change.
7. In the short run, which may be as much as five or ten years, monetary changes affect primarily
output. Over decades, on the other hand, the rate of monetary growth affects primarily prices.
What happens to output depends on real factors: the enterprise, ingenuity and industry of the
people; the extent of thrift; the structure of industry and government; the relations among
nations, and so on.
8. It follows from the propositions I have so far stated that inflation is always and everywhere a
monetary phenomenon in the sense that it is and can be produced only by a more rapid increase
in the quantity of money than in output. However, there are many different possible reasons for
monetary growth, including gold discoveries, financing of government spending, and financing
of private spending.
9. Government spending may or may not be inflationary. It clearly will be inflationary if it is
financed by creating money, that is, by printing currency or creating bank deposits. If it is
financed by taxes or by borrowing from the public, the main effect is that the government spends
the funds instead of the taxpayer or instead of the lender or instead of the person who would
otherwise have borrowed the funds. Fiscal policy is extremely important in determining what
fraction of total national income is spent by government and who bears the burden of that
expenditure. By itself, it is not important for inflation. (This is the proposition about fiscal and
monetary policy that I discussed earlier.)
10. One of the most difficult things to explain in simple fashion is the way in which a change in
the quantity of money affects income. Generally, the initial effect is not on income at all, but on
the prices of existing assets, bonds, equities, houses, and other physical capital. This effect, the
liquidity effect stressed by Keynes, is an effect on the balance-sheet, not on the income account.
An increased rate of monetary growth, whether produced through open-market operations or in
other ways, raises the amount of cash that people and businesses have relative to other assets.
The holders of the now excess cash will try to adjust their portfolios by buying other assets. But
one man’s spending is another man’s receipts. All the people together cannot change the amount
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
12
of cash all hold—only the monetary authorities can do that. However, as people attempt to
change their cash balances, the effect spreads from one asset to another. This tends to raise the
prices of assets and to reduce interest rates, which encourages spending to produce new assets
and also encourages spending on current services rather than on purchasing existing assets. That
is how the initial effect on balance-sheets gets translated into an effect on income and spending.
The difference in this area between the monetarists and the Keynesians is not on the nature of the
process, but on the range of assets considered. The Keynesians tend to concentrate on a narrow
range of marketable assets and recorded interest rates. The monetarists insist that a far wider
range of assets and of interest rates must be taken into account. They give importance to such
assets as durable and even semi-durable consumer goods, structures and other real property. As a
result, they regard the market interest rates stressed by the Keynesians as only a small part of the
total spectrum of rates that are relevant.
11. One important feature of this mechanism is that a change in monetary growth affects interest
rates in one direction at first but in the opposite direction later on. More rapid monetary growth
at first tends to lower interest rates. But later on, as it raises spending and stimulates price
inflation, it also produces a rise in the demand for loans which will tend to raise interest rates. In
addition, rising prices introduce a discrepancy between real and nominal interest rates. That is
why world-wide interest rates are highest in the countries that have had the most rapid rise in the
quantity of money and also in prices—countries like Brazil, Chile or Korea. In the opposite
direction, a slower rate of monetary growth at first raises interest rates but later on, as it reduces
spending and price inflation, lowers interest rates. That is why world-wide interest rates are
lowest in countries that have had the slowest rate of growth in the quantity of money—countries
like Switzerland and Germany.
This two-edged relation between money and interest rates explains why monetarists insist that
interest rates are a highly misleading guide to monetary policy. This is one respect in which the
monetarist doctrines have already had a significant effect on US policy. The Federal Reserve in
January 1970 shifted from primary reliance on ‘money market conditions’ (i.e., interest rates) as
a criterion of policy to primary reliance on ‘monetary aggregates’ (i.e., the quantity of money).
The relations between money and yields on assets (interest rates and stock market earnings-price
ratios) are even lower than between money and nominal income. Apparently, factors other than
monetary growth play an extremely important part. Needless to say, we do not know in detail
what they are, but that they are important we know from the many movements in interest rates
and stock market prices which cannot readily be connected with movements in the quantity of
money.
V. Concluding Cautions
These propositions clearly imply both that monetary policy is important and that the important
feature of monetary policy is its effect on the quantity of money rather than on bank credit or
total credit or interest rates. They also imply that wide swings in the rate of change of the
quantity of money are destabilizing and should be avoided. But beyond this, differing
implications are drawn.
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
13
Some monetarists conclude that deliberate changes in the rate of monetary growth by the
authorities can be useful to offset other forces making for instability, provided they are gradual
and take into account the lags involved. They favor fine tuning, using changes in the quantity of
money as the instrument of policy. Other monetarists, including myself, conclude that our
present understanding of the relation between money, prices and output is so meager, that there
is so much leeway in these relations, that such discretionary changes do more harm than good.
We believe that an automatic policy under which the quantity of money would grow at a steady
rate—month-in, month-out, year-in, year-out—would provide a stable monetary framework for
economic growth without itself being a source of instability and disturbance.
One of the most widespread misunderstandings of the monetarist position is the belief that this
prescription of a stable rate of growth in the quantity of money derives from our confidence in a
rigid connection between monetary change and economic change. The situation is quite the
opposite. If I really believed in a precise, rigid, mechanical connection between money and
income, if also I thought that I knew what it was and if I thought that the central bank shared that
knowledge with me, which is an even larger ‘if’, I would then say that we should use the
knowledge to offset other forces making for instability. However, I do not believe any of these
‘ifs’ to be true. On the average, there is a close relation between changes in the quantity of
money and the subsequent course of national income. But economic policy must deal with the
individual case, not the average. In any one case, there is much slippage. It is precisely this
leeway, this looseness in the relation, this lack of a mechanical one-to-one correspondence
between changes in money and in income that is the primary reason why I have long favored for
the USA a quasi-automatic monetary policy under which the quantity of money would grow at a
steady rate of 4 or 5 per cent per year, month-in, month-out. (The desirable rate of growth will
differ from country to country depending on the trends in output and money-holding
propensities.)
There is a great deal of evidence from the past of attempts by monetary authorities to do better.
The verdict is very clear. The attempts by monetary authorities to do better have done far more
harm than good. The actions by the monetary authorities have been an important source of
instability. As I have already indicated, the actions of the US monetary authorities were
responsible for the 1929–33 catastrophe. They were responsible equally for the recent
acceleration of inflation in the USA. That is why I have been and remain strongly opposed to
discretionary monetary policy—at least until such time as we demonstrably know enough to
limit discretion by more sophisticated rules than the steady-rate-of-growth rule I have suggested.
That is why I have come to stress the danger of assigning too much weight to monetary policy.
Just as I believe that Keynes’s disciples went further than he himself would have gone, so I think
there is a danger that people who find that a few good predictions have been made by using
monetary aggregates will try to carry that relationship further than it can go. Three years ago I
wrote:
We are in danger of assigning to monetary policy a larger role than it can perform, in
danger of asking it to accomplish tasks that it cannot achieve and, as a result, in danger of
preventing it from making the contribution that it is capable of making.
3
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.
14
A steady rate of monetary growth at a moderate level can provide a framework under which a
country can have little inflation and much growth. It will not produce perfect stability; it will not
produce heaven on earth; but it can make an important contribution to a stable economic society.
_____________________________________________________________________________
Notes
* The First Wincott Lecture, delivered at the Senate House, University of London, 16 September 1970.
1
I chose this title because I used it about a dozen years ago for a talk at the London School of Economics. At that
time, I was predicting. Now, I am reporting.
2
Macmillan, 1923.
3
Milton Friedman, "The Role of Monetary Policy," Presidential Address to the American Economic Association, 29
December 1967; American Economic Review, March 1968 (reprinted in The Optimum Quantity of Money and Other
Essays, Aldine, Chicago, 1969, pp. 95-110 – quotation from p. 99).
______________________________________________________________________________
Reprinted in: (1) Milton Friedman, Monetarist Economics, pp. 1-20. Oxford: Basil Blackwell
Ltd, 1991. (2) Milton Friedman and Charles A. E. Goodhart, Money, Inflation and the
Constitutional Position of the Central Bank, pp. 64-90. London: Institute of Economic Affairs,
2003.
4/12/13
From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm.