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The Monetarist Controversy or, Should We
Forsake Stabilization Policies?
By F r a n c o M o d ig lia n i*
In recent years and especially since the onset
of the current depression, the economics profes­
sion and the lay public have heard a great deal
about the sharp conflict between “ monetarists
and Keynesians” or between “ monetarists and
fiscalists.” The difference between the two
“ schools” is generally held to center on whether
the money supply or fiscal variables are the
major determinants of aggregate economic ac­
tivity, and hence the most appropriate tool of
stabilization policies.
My central theme is that this view is quite far
from the truth, and that the issues involved are of
far greater practical import. There are in reality
no serious analytical disagreements between
leading monetarists and leading nonmonetarists.
Milton Friedman was once quoted as saying,
“ We are all Keynesians, now ,” and I am quite
prepared to reciprocate that “ we are all mone­
tarists” — if by monetarism is meant assigning to
the stock of money a major role in determining
output and prices. Indeed, the list of those who
have long been monetarists in this sense is quite
extensive, including among other John May­
nard Keynes as well as myself, as is attested by
my 1944 and 1963 articles.
In reality the distinguishing feature of the
monetarist school and the real issues of disagree­
ment with nonmonetarists is not monetarism, but
rather the role that should probably be assigned

to stabilization policies. Nonmonetarists accept
what I regard to be the fundamental practical
message of The General Theory: that a private
enterprise economy using an intangible money
needs to be stabilized, can be stabilized, and
therefore should be stabilized by appropriate
monetary and fiscal policies. Monetarists by
contrast take the view that there is no serious
need to stabilize the economy; that even if there
were a need, it could not be done, for stabiliza­
tion policies would be more likely to increase
than to decrease instability; and, at least some
monetarists would, I believe, go so far as to hold
that, even in the unlikely event that stabilization
policies could on balance prove beneficial, the
government should not be trusted with the neces­
sary power.
What has led me to address this controversy
is the recent spread of monetarism, both in a
simplistic, superficial form and in the form of
growing influence on the practical conduct of
economic policy, which influence, I shall argue
presently, has played at least some role in the
economic upheavals of the last three years.
In what follows then, I propose first to review
the main arguments bearing on the need for
stabilization policies, that is, on the likely extent
of instability in the absence of such policies, and
then to examine the issue of the supposed desta­
bilizing effect of pursuing stabilization policies.
My main concern will be with instability gener­
ated by the traditional type of disturbances— de­
mand shocks. But before I am through, I will
give some consideration to the difficult problems
raised by the newer type of disturbance— supply
shocks.

*PresidentiaI address delivered at the eighty*ninth meet­
ing of the American Economic A ssociation, Atlantic City,
New Jersey, September 17, 1976. The list of those to whom I
am indebted for contributing to shape the ideas expressed
above is much too large to be included in this footnote. I do
wish, however, to single out two lifetime collaborators to
whom my debt is especially large, Albert Ando and Charles
Holt. I also wish to express my thanks to Richard Cohn,
Rudiger D ornbusch, and Benjamin Friedm an for their
valuable criticism of earlier drafts, and to David Modest for
carrying out the sim u latio n s and o th er com putations
mentioned in the text.




I. The Keynesian Case for Stabilization Policies
A. The General Theory
Keynes’ novel conclusion about the need for
1

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THE AMERICAN ECONOMIC REVIEW

stabilization policies, as was brought out by the
early interpreters of The General Theory (for
example, John Hicks, the author, 1944), re­
sulted from the interaction of a basic contribu­
tion to traditional monetary theory— liquidity
preference— and an unorthodox hypothesis
about the working of the labor market— com­
plete downward rigidity of wages.
Because of liquidity preference, a change in
aggregate demand, which may be broadly de­
fined as any event that results in a change in the
market clearing or equilibrium rate of interest,
will produce a corresponding change in the real
demand for money or velocity of circulation, and
hence in the real stock of money needed at full
employment. As long as wages are perfectly
flexible, even with a constant nominal supply,
full employment could and would be maintained
by a change of wages and prices as needed to
produce the required change in the real money
supply— though even in this case, stability of the
price level would require a countercyclical mon­
etary policy. But, under the Keynesian wage
assumption the classical adjustment through
prices can occur only in the case of an increased
demand. In the case of a decline, instead, wage
rigidity prevents the necessary increase in the
real money supply and the concomitant required
fall in interest rates. Hence, if the nominal
money supply is constant, the initial equilibrium
must give way to a new stable one, characterized
by lower output and by an involuntary reduction
in employment, so labeled because it does not
result from a shift in notional demand and supply
schedules in terms of real wages, but only from
an insufficient real money supply. The nature of
this equilibrium is elegantly captured by the
Hicksian IS-LM paradigm, which to our gener­
ation of economists has become almost as fa­
miliar as the demand-supply paradigm was to
earlier ones.
This analysis implied that a fixed money sup­
ply far from insuring approximate stability of
prices and output, as held by the traditional
view, would result in a rather unstable economy,
alternating between periods of protracted unem­
ployment and stagnation, and bursts of inflation.




MARCH 1977

The extent of downward instability would de­
pend in part on the size of the exogenous shocks
to demand and in part on the strength of what
may be called the Hicksian mechanism. By this
I mean the extent to which a shift in IS, through
its interaction with LA/, results in some decline
in interest rates and thus in a change in income
which is smaller than the original shift. The sta­
bilizing power of this mechanism is controlled
by various parameters of the system. In par­
ticular, the economy will be more unstable
the greater the interest elasticity of demand for
money, and the smaller the interest responsive­
ness of aggregate demand. Finally, a large
multiplier is also destabilizing in that it implies
a larger shift in IS for a given shock.
However, the instability could be readily
counteracted by appropriate stabilization poli­
cies. Monetary policy could change the nominal
supply of money so as to accommodate the
change in real demand resulting from shocks in
aggregate demand. Fiscal policy, through ex­
penditure and taxes, could offset these shocks,
making full employment consistent with the
initial nominal money stock. In general, both
monetary and fiscal policies could be used in
combination. But because of a perceived uncer­
tainty in the response of demand to changes in
interest rates, and because changes in interest
rates through monetary policy could meet diffi­
culties and substantial delays related to expec­
tations (so-called liquidity traps), fiscal policy
was regarded as having some advantages.
B. The Early Keynesians
The early disciples o f the new Keynesian
gospel, still haunted by memories o f the Great
Depression, frequently tended to out do Keynes’
pessimism about potential instability. Concern
with liquidity traps fostered the view that the de­
mand for money was highly interest elastic;
failure to distinguish between the short* and
long-run marginal propensity to save led to over­
estimating the long-run saving rate, thereby
fostering concern with stagnation, and to under­
estimating the short-run propensity, thereby
exaggerating the short-run multiplier. Interest

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MODIGLIANI: MONETARIST CONTROVERSY

rates were supposed to affect, at best, the de­
mand for long-lived fixed investments, and the
interest elasticity was deemed to be low. Thus,
shocks were believed to produce a large re­
sponse. Finally, investment demand was seen as
capriciously controlled by “ animal s p irits /’
thus providing an important source of shocks.
All this justified calling for very active stabiliza­
tion policies. Furthermore, since the very
circumstances which produce a large response to
demand shocks also produce a large response to
fiscal and a small response to monetary actions,
there was a tendency to focus on fiscal policy as
the main tool to keep the economy at near full
employment.
C. The Phillips Curve
In the two decades following The General
Theory, there were a number of developments of
the Keynesian system including dynamization of
the model, the stress on taxes versus expendi­
tures and the balanced budget multiplier, and the
first attempts at estimating the critical param­
eters through econometric techniques and mod­
els. But for present purposes, the most important
one was the uncovering of a “ stable” statistical
relation between the rate of change of wages and
the rate of unemployment, which has since come
to be known as the Phillips curve. This relation,
and its generalization by Richard Lipsey to allow
for the effect of recent inflation, won wide acceptance even before an analytical underpinning
could be provided for it, in part because it could
account for the “ puzzling” experience of 1954
and 1958, when wages kept rising despite the
substantial rise in unemployment. It also served
to dispose of the rather sterile “ cost push” “ demand pull” controversy.
In the following years, a good deal of attention
went into developing theoretical foundations for
the Phillips curve, in particular along the lines of
search models (for example, Edmund Phelps et
al.). This approach served to shed a new light on
the nature of unemployment by tracing it in the
first place to labor turnover and search time
rather than to lack of jobs as such: in a sense
unemployment is all frictional— at least in de­




3

veloped countries. At the same time it clarified
how the availability of more jobs tends to reduce
unemployment by increasing vacancies and thus
reducing search time.
Acceptance of the Phillips curve relation
implied some significant changes in the Keynes­
ian framework which partly escaped notice until
the subsequent monetarists* attacks. Since the
rate of change of wages decreased smoothly with
the rate of unemployment, there was no longer a
unique Full Employment but rather a whole
family of possible equilibrium rates, each asso­
ciated with a different rate of inflation (and re­
q uiring, presum ably, a different long-run
growth of money). It also impaired the notion of
a stable underemployment equilibrium. A fall in
demand could still cause an initial rise in unem­
ployment but this rise, by reducing the growth of
wages, would eventually raise the real money
supply, tending to return unemployment to the
equilibrium rate consistent with the given longrun growth of money.
But at the practical level it did not lessen the
case for counteracting lasting demand distur­
bances through stabilization policies rather than
by relying on the slow process of wage adjust­
ment to do the job, at the cost of protractcd un­
employment and instability of prices. Indeed,
the realm of stabilization policies appeared to ex­
pand in the sense that the stabilization authority
had the power of choosing the unemployment
rate around which employment was to be sta­
bilized, though it then had to accept the asso­
ciated inflation. Finally, the dependence of wage
changes also on past inflation forced recognition
of a distinction between the short- and the longrun Phillips curve, the latter exhibiting the longrun equilibrium rate of inflation implied by a
maintained unemployment rate. The fact that the
long-run tradeoff between unemployment and
inflation was necessarily less favorable than the
short-run one, opened up new vistas of “ enjoyit-now, pay-later” policies, and even resulted in
an entertaining literature on the political busi­
ness cycle and how to stay in the saddle by riding
the Phillips curve (see for example, Ray Fair,
William Nordhaus).

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4

II. The Monetarists’ Attack
A. The Stabilizing Power o f the
Hicksian Mechanism
The monetarists’ attack on Keynesianism was
directed from the very beginning not at the
Keynesian framework as such, but at whether it
really implied a need for stabilization. It rested
on a radically different empirical assessment of
the value of the parameters controlling the sta­
bilizing power of the Hicksian mechanism and of
the magnitude and duration of response to
shocks, given a stable money supply. And this
different assessment in turn was felt to justify a
radical downgrading of the practical relevance
of the Keynesian framework as distinguished
from its analytical validity.
Liquidity preference was a fine contribution
to monetary theory but in practice the respon­
siveness of the demand for money, and hence of
velocity, to interest rates, far from being unman­
ageably large, was so small that according to a
well-known paper by Milton Friedman (1969),
it could not even be detected empirically. On the
other hand, the effect of interest rates on aggre­
gate demand was large and by no means limited
to the traditional fixed investments but quite
pervasive. The difficulty of detecting it empir­
ically resulted from focusing on a narrow range
of measured market rates and from the fact that
while the aggregate could be counted on to re­
spond, the response of individual components
might not be stable. Finally, Friedman’s cele­
brated contribution to the theory of the consump­
tion function (1957) (and my own work on the
life cycle hypothesis with Richard Brumberg and
others, reviewed by the author, 1975) implied a
very high short-run marginal propensity to save
in response to transient disturbances to income
and hence a small short-run multiplier.
All this justified the conclusion that (i) though
demand shocks might qualitatively work along
the lines described by Keynes, quantitatively the
Hicks mechanism is so strong that their impact
would be small and transient, provided the
stock of money was kept on a steady growth
path; (ii) fiscal policy actions, like other demand




MARCH 1977

shocks, would have minor and transitory effects
on demand, while changes in money would
produce large and permanent effects on money
income; and, therefore, (iii) the observed in­
stability of the economy, which was anyway
proving moderate as the postwar period un­
folded, was most likely the result of the unstable
growth of money, be it due to misguided en­
deavors to stabilize income or to the pursuit of
other targets, which were either irrelevant or, in
the case of balance of payments goals, should
have been made irrelevant by abandoning fixed
exchanges.
B. The Demise o f
Rigidity and the
Vertical Phillips Curve
But the most serious challenge came in
Friedman's 1968 Presidential Address, building
on ideas independently put forth also by Phelps
(1968). Its basic message was that, despite ap­
pearances, wages were in reality perfectly flex­
ible and there was accordingly no involuntary
unemployment. The evidence to the contrary,
including the Phillips curve, was but a statistical
illusion resulting from failure to differentiate be­
tween price changes and unexpected price
changes.
Friedman starts out by reviving the Keynesian
notion that, at any point of time, there exists a
unique full-employment rate which he labels the
“ natural rate." An unanticipated fall in demand
in Friedman's competitive world leads firms to
reduce prices and also output and employment
along the short-run marginal cost curve— unless
the nominal wage declines together with prices.
But workers, failing to judge correctly the cur­
rent and prospective fall in prices, misinterpret
the reduction of nominal wages as a cut in real
wages. Hence, assuming a positively sloped
supply function, they reduce the supply of labor.
As a result, the effective real wage rises to the
point where the resulting decline in the demand
for labor matches the reduced supply. T h u s, out­
put falls not because of the decline in demand,
but because of the entirely voluntary reduction in
the supply of labor, in response to erroneous
perceptions. Furthermore, the fall in employ*

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MODIGLIANI: MONETARIST CONTROVERSY

mcnt can only be temporary, as expectations
must soon catch up with the facts, at least in the
absence of new shocks. The very same mech­
anism works in the case of an increase in de­
mand, so that the responsiveness of wages and
prices is the same on either side of the natural
rate.
The upshot is that Friedman’s model also
implies a Phillips-type relation between infla­
tion, employment or unemployment, and past
inflation,— provided the latter variable is inter­
preted as a reasonable proxy for expected infla­
tion. But it turns the standard explanation on its
head: instead of (excess) employment causing
inflation, it is (the unexpected component of)
the rate o f in fla tio n th a t c a u se s e x c e ss
employment.
One very basic implication of Friedman’s
model is that the coefficient of price expectations
should be precisely unity. This specification
implies that whatever the shape of the short-run
Phillips curve— a shape determined by the rela­
tion between expected and actual price changes,
and by the elasticity of labor supply with respect
to the perceived real wage— the long-run curve
must be vertical.
Friedman’s novel twist provided a fresh prop
for the claim that stabilization policies are not
really needed, for, with wages flexible, except
possibly for transient distortions, the Hicksian
mechanism receives powerful reinforcement
from changes in the real money supply. Simi­
larly, the fact that full employment was a razor
edge provided new support for the claim that
stabilization policies were bound to prove de­
stabilizing.
C. The Macro Rational Expectations Revolution
But the death blow to the already badly bat­
tered Keynesian position was to come only
shortly thereafter by incorporating into Fried­
man's model the so-called rational expectation
hypothesis, or R E H . Put very roughly, this hy­
pothesis, originally due to John Muth, states that
rational economic agents will endeavor to form
expectations of relevant future variables by
making the most efficient use of all information



S

provided by past history/It is a fundamental and
fruitful contribution that has already found many
important applications, for example, in connec­
tion with speculative markets, and as a basis for
some thoughtful criticism by Robert Lucas
(1976) of certain features of econometric mod­
els. What 1 am concerned with here is only its
application to macro-economics, or MR EH,
associated with such authors as Lucas (1972),
Thomas Sargent (1976), and Sargent and Neil
Wallace (1976).
The basic ingredient of MREH is the postulate
that the workers of Friedman’s model hold ratio­
nal expectations, which turns out to have a num­
ber of remarkable implications: (i) errors of
price expectations, which are the only source of
departure from the natural stale, cannot be
avoided but they can only be short-lived and
random. In particular, there cannot be persistent
unemployment above the natural rate for this
would imply high serial correlation between the
successive errors of expectation, which is incon­
sistent with rational expectations; (ii) any at­
tempts to stabilize the economy by means of
stated monetary or fiscal rules arc bound to be
totally ineffective because their effect will be
fully discounted in rational expectations; (iii)
nor can the government successfully pursue ad
hoc measures to offset shocks. The private sec­
tor is already taking care of any anticipated
shock; therefore government policy could con­
ceivably help only if the government informa­
tion was better than that of the public, which is
impossible, by the very definition of rational
expectations. Under these conditions, ad hoc
stabilization policies are most likely to produce
instead further destabilizing shocks.
These arc clearly remarkable conclusions, and
a major rediscovery— for it had all been said 40
years ago by Keynes in a well-known passage of
The General Theory:
If, indeed, labour were always in a posi­
tion to take action (and were to do so),
whenever there was less than full employ­
ment, to reduce its money demands by
concerted action to whatever point was
required to make money so abundant rela­

THE AMERICAN ECONOMIC REVIEW

6

tively to the wage-unit that the rate of
interest would fall to a level compatible
with full employment, we should, in ef­
fect, have monetary management by the
Trade Unions, aimed at full employment,
instead of by the banking systems.
[p. 267]
The only novelty is that MREH replaces Keynes'
opening “ if” with a “ since.”
If one accepts this little amendment, the case
against stabilization policies is complete. The
economy is inherently pretty stable— except
possibly for the effect of government messing
around. And to the extent that there is a small
residual instability, it is beyond the power of
human beings, let alone the government, to
alleviate it.

III. How Valid Is the Monetarist Case?
A. The Monetarist Model o f Wage
Price Behavior
In setting out the counterattack it is convenient
to start with the monetarists* model of price and
wage behavior. Here one must distinguish be­
tween the model as such and a specific implica­
tion of that model, namely that the long-run
Phillips curve is vertical, or, in substance, that,
in the long run, money is neutral. That conclu­
sion, by now, does not meet serious objection
from n o n m o n etarists, at least as a first
approximation.
But the proposition that other things equal,
and given time enough, the economy will even­
tually adjust to any indefinitely maintained stock
of money, or nih derivative thereof, can be de­
rived from a variety of models and, in any event,
is of very little practical relevance, as I will argue
below. What is unacceptable, because incon­
sistent with both micro and macro evidence, is
the specific monetarist model set out above and
its implication that all unemployment is a volun­
tary , fleeting response to tran sito ry mis*
perceptions.
One may usefully begin with a criticism of the
Macro Rational Expectations model and why
Keynes’ “ if” should not be replaced by
“ since.” At the logical level, Benjamin Fried­




MARCH 1977

man has called attention to the omission from
MREH of an explicit learning model, and has
suggested that, as a result, it can only be inter­
preted as a description not of short-run but of
long-run equilibrium in which no agent would
wish to recontract. But then the implications of
MREH are clearly far from startling, and their
policy relevance is almost nil. At the institu­
tional level, Stanley Fischer has shown that the
mere recognition of long-term contracts is suf­
ficient to generate wage rigidity and a substantial
scope for stabilization policies. But the most
glaring flaw of MREH is its inconsistency with
the evidence: if it were valid, deviations of un­
employment from the natural rate would be
small and transitory— in which case The Gen­
eral Theory would not have been written and
neither would this paper. Sargent (1976) has
attempted to remedy this fatal flaw by hypothe­
sizing that the persistent and large fluctuations
in unemployment reflect merely corresponding
swings in the natural rate itself. In other words,
what happened to the United States in the 1930’s
was a severe attack of contagious laziness! I can
only say that, despite Sargent’s ingenuity,
neither I nor, I expect, most others at least of
the nonmonetarists’ persuasion are quite ready
yet to turn over the field of economic fluctua­
tions to the social psychologist!
Equally serious objections apply to Fried­
man’s modeling of the commodity market as a
perfectly competitive one— so that the real wage
rate is continuously equated to the short-run
marginal product of labor— and to his treatment
of labor as a homogenous commodity traded in
an auction market, so that, at the going wage,
there never is any excess demand by firms or
excess supply by workers. The inadequacies of
this model as a useful formalization of present
day Western economies are so num erous that
only a few of the major ones can be mentioned
here.
Friedman’s y'tcw o f unemployment as a vol­
untary reduction in labor supply could at best
provide an explanation of variations in labor
force— and then only under the questionable
assumption that the supply function has a sig-

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MODIGLIANI: MONETARIST CONTROVERSY

nifieantly positive slope— but cannot readily
account for changes in unemployment. Further­
more, it cannot be reconciled with the wellknown fact that rising unemployment is
accompanied by a fall, not by a rise in quits, nor
with the role played by temporary layoffs to
which Martin Feldstein has recently called
attention. A gain, his com petitive model of
the commodity market, accepted also in The
General Theory, implies that changes in real
wages, adjusted for long-run productivity trend,
should be significantly negatively correlated
with cyclical changes in employment and output
and with changes in money wages. But as early
as 1938, John Dunlop showed that this conclu­
sion was rejected by some eighty years of British
experience and his results have received some
support in more recent tests of Ronald Bodkin
for the United States and Canada. Similar tests
of my own, using quarterly data, provide strik­
ing confirmation that for the last two decades
from the end of the Korean War until 1973, the
association of trend adjusted real compensa­
tions of the private nonfarm sector with either
employment or the change in nominal compensation is prevailingly positive and very signifi­
cantly so.1
This evidence can, instead, be accounted for
by the oligopolistic pricing model— according
to which price is determined by long-run mini­
b u s , in a logarithmic regression of private nonfarm
hourly co m pensation deflated by the private nonfarm
deflator on output per m an-hour, tim e, and private nonfarm
employment, after correcting for first-order serial correla­
tion, the latter variable has a coefficient of . 17 and a /-ratio
of 5. Similar though less significant results were found for
manufacturing. If em ploym ent is replaced by the change in
nominal com pensation, its coefficient is .40 with a /-ratio o f
6.5. Finally, if the change in com pensation is replaced by
the change in price, despite the negative bias from error
of measurement of price, the coefficient of this variable is
only - . 0 9 with an entirely insignificant /*ratio of .7. The
period after 1973 has been omitted from the tests as irrelevant
for our purposes, since the inflation was driven primarily by
an exogenous price shock rather than by excess dem and. As a
result of the shock, prices, and to some extent wages, rose
rapidly while em ploym ent and real wages fell. T hus, the
addition of the last two years tends to increase spuriously the
positive association between real wages and em ployment,
and to decrease that between real wages and the change in
nominal wages or prices.




7

mum average cost up to a mark-up reflecting
entry-preventing considerations (see the author,
1958)— coupled with some lags in the adjust­
ment of prices to costs. This model implies that
firms respond to a change in demand by endeav­
oring to adjust output and employment* without
significant changes in prices relative to wages;
and the resulting changes in available jobs have
their initial impact not on wages but rather on
unemployment by way of layoffs and recalls and
through changes in the level of vacancies, and
hence on the length of average search time.
If, in the process, vacancies rise above a criti­
cal level, or “ natural rate,” firms will endeavor
to reduce them by outbidding each other, thereby
raising the rate of change of wages. Thus, as
long as jobs and vacancies remain above, and
unemployment remains below, some critical
level which might be labeled the “ noninfiationary rate” (sec the author and Lucas Papademos,
1975), wages and prices will tend to accelerate.
If, on the other hand, jobs full below, and unem­
ployment rises above, the noninflationary rate,
firms finding that vacancies arc less than optimal
— in the limit the unemployed queuing outside
the gate will fill them instantly— will have an
incentive to reduce their relative wage offer. But
in this case, in which too much labor is looking
for too few jobs, the trend toward a sustained
decline in the rate of growth of wages is likely
to be even weaker than the corresponding accel­
eration when too many jobs arc bidding for too
few people. The main reason is the nonhomo*
geneity of labor. By far the largest and more
valuable source of labor supply to a firm consists
of those already employed who are not readily
interchangeable with the unemployed and, in
contrast with them, are concerned with protec*
ting their earnings and not with reestablishing
full employment. For these reasons, and because
the first to quit are likely to be the best workers, a
reduction of the labor force can, within limits, be
accomplished more economically, not by re­
ducing wages to generate enough quits, but by
firing or, when possible, by layoffs which insure
access to a trained labor force when demand
recovers. More generally, the inducement to

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THE AMERICAS ECONOMIC REVIEW

reduce relative wages to eliminate the excess
supply is moderated by the effect that such a
reduction would have on quits and costly turn­
over, even when the resulting vacancies can be
readily filled from the ranks of the unemployed.
Equally relevant are the consequences in terms
of loss of morale and good will, in part for rea­
sons which have been elaborated by the literature
on implicit contracts (see Robert Gordon).
Thus, while there will be some tendency for the
rate of change of wages to fall, the more so the
larger the unemployment— at least in an eco­
nomy like the United States where there are no
overpowering centralized unions— that ten­
dency is severely damped.
And whether, given an unemployment rate
significantly and persistently above the noninflationary level, the rate of change of wages would,
eventually, tend to turn negative and decline
without bound or whether it would tend to an
asymptote is a question that I doubt the empirical
evidence will ever answer. The one experiment
we have had— the Great Depression— suggests
the answer is negative, and while I admit that,
for a variety of reasons, that evidence is mud­
died, I hope that we will never have the oppor­
tunity for a second, clean experiment.
In any event, what is really important for
practical purposes is not the long-run equilib­
rium relation as such, but the speed with which it
is approached. Both the model sketched out and
the empirical evidence suggest that the process
of acceleration or deceleration of wages when
unemployment differs from the noninflationarv
rate will have more nearly the character of a
crawl than of a gallop. It will suffice to recall in
this connection that there was excess demand
pressure in the United States at least from 1965
to m id-1970, and during that period the growth
of inflation was from some 1.5 to only about 5.5
percent per year. And the response to the excess
supply pressure from m id-1970 to early 1973,
and from late 1974 to date was equally sluggish.
B. The Power o f Self-Stabilizing Mechanisms:
The Evidence from Econometric Models
There remains to consider the monetarists’
initial criticism of Keynesianism, to wit, that
even without high wage flexibility, the system’s



MARCH 1977

response to demand shocks is small and short­
lived, thanks to the power of the Hicksian mech­
anism. Here it must be acknowledged that every
one of the m onetarists' criticisms of early,
simpleminded Keynesianism has proved in
considerable measure correct.
With regard to the interest elasticity of de­
mand for money, post-Keynesian developments
in the theory of money, and in particular, the
theoretical contributions of William Baumol,
James Tobin, Merton Miller, and Daniel Orr,
point to a modest value of around one-half to
one-third, and empirical studies (see for exam­
ple, Stephen Goldfeld) are largely consistent
with this prediction (at least until 1975!). Simi­
larly, the dependence of consumption on longrun, or life cycle, income and on wealth,
together w ith the high marginal tax rates of the
postwar period, especially the corporate tax,
and leakages through imports, lead to a rather
low estimate of the multiplier.
Last but not least, both theoretical and empir­
ical work, reflected in pan in econometric mod­
els. have largely vindicated the monetarist
contention that interest effects on demand are
pervasive and substantial. Thus, in the construc­
tion and estimation o f the MIT-Penn-Social
Science Research Council (MPS) econometric
model of the United States, we found evidence
of effects, at least modest, on nearly every com­
ponent of aggregate demand. One response to
money supply changes that is especially impor­
tant in the M PS. if somewhat controversial, is
via interest rates on the market value of all assets
and thus on consumption.
There is, therefore, substantial agreement that
in the United States the Hicksian mechanism is
fairly effective in limiting the effect of shocks,
and that the response of wages and prices to
excess demand or supply will also work gradu­
ally toward eliminating largely, if not totally,
any effect on employment. But in the view of
nonmonetarists, the evidence overwhelmingly
supports the conclusion that the interim response
is still of significant magnitude and of consider­
able duration, basically because the wheels of
the offsetting mechanism grind slowly. To be
sure, the first link of the mechanism, the rise in
short-term rates, gets promptly into play and

VOL. 67 NO. 2

MODIGLIANI; MONETARIST CONTROVERSY

heftily, given the low money demand elasticity;
but most expenditures depend on long-term
rates, which generally respond but gradually,
and the demand response is generally also grad­
ual. Furthermore, while this response is building
up, multiplier and accelerator mechanisms work
toward amplifying the shock. Finally, the clas­
sical mechanism— the change in real money
supply through prices— has an even longer lag
because of the sluggish response of wages to
excess demand.
These interferences are supported by simula­
tions with econometric models like the MPS.
Isolating, first, the working of the Hicksian
mechanism by holding prices constant, we find
that a 1 percent demand shock, say a rise in real
exports, produces an impact effect on aggregate
output which is barely more than 1 percent, rises
to a peak of only about 2 percent a year later, and
then declines slowly toward a level somewhat
over 1.5 percent.
Taking into account the wage price mech­
anism hardly changes the picture for the first
year because of its inertia. Thereafter, however,
it becomes increasingly effective so that a year
later the real response is back at the impact level,
and by the end of the third year the shock has
been fully offset (thereafter output oscillates
around zero in a damped fashion). Money in­
come, on the other hand, reaches a peak of over
2.5, and then only by the middle of the second
year. It declines thereafter, and tends eventually
to oscillate around a positive value because nor­
mally, a demand shock requires eventually a
change in interest rates and hence in velocity
and money income.
These results, which are broadly confirmed by
other econometric models, certainly do not sup­
port the view of a highly unstable economy in
which fiscal policy has powerful and everlasting
effects. But neither do they support the mone­
tarist view of a highly stable economy in which
shocks hardly make a ripple and the effects of
fiscal policy are puny and fast vanishing.
C. The Monetarist Evidence and the
St. Louis Quandary
Monetarists, however, have generally been
inclined to question this evidence. They coun­



9

tered at first with tests bearing on the stability of
velocity and the insignificance of the multiplier,
which, however, as indicated in my criticism
with Albert Ando (1965), must be regarded as
close to worthless. More recently, several au­
thors at the Federal Reserve Bank of St. Louis
(Leonall Andersen, Keith Carlson, Jerry Lee
Jordan) have suggested that instead of deriving
multipliers from the analytical or numerical
solution of an econometric model involving a
large number of equations, any one of which
may be questioned, they should be estimated
directly through “ reduced form” equations by
relating the change in income to current and
lagged changes in some appropriate measure of
the money supply and of fiscal impulses.
The results of the original test, using the
current and but four lagged values of M l and of
high Employment Federal Expenditure as mea­
sures of monetary and fiscal impulses, turned out
to be such as to fill a monetarist’s heart with joy.
The contribution of money, not only current but
also lagged, was large and the coefficients im­
plied a not unreasonable cffcct of the order of
magnitude of the velocity of circulation, though
somewhat higher. On the other hand, the esti­
mated coefficients of the fiscal variables seemed
to support fully the monetarists* claim that their
impact was both small and fleeting: the effect
peaked in but two quarters and was only around
one, and disappeared totally by the fourth quar­
ter following the change.
These results were immediately attacked on
the ground that the authors had used the wrong
measure of monetary and fiscal actions, and it
was shown that the outcome was somewhat
sensitive to alternative measures; however, the
basic nature of the results did not change, at least
qualitatively. In particular, the outcome does not
differ materially, at least for the original period
up to 1969, if one replaces high employment out­
lays with a variable that might be deemed more
suitable, like government expenditure on goods
and services, plus exports.
These results must be acknowledged as dis­
turbing for non monetarists, for there is little
question that movements in government pur­
chases and exports are a major source of demand
disturbances; if econometric model estimates of

10

THE AMERICAN ECONOMIC REVIEW

the response to demand disturbances are roughly
valid, how can they be so grossly inconsistent
with the reduced form estimates?
Attempts at reconciling the two have taken
several directions, which are reviewed in an
article coauthored with Ando (1976)* Our main
conclusion, based on simulation techniques, is
that when income is subject to substantial shocks
from many sources other than monetary and
fiscal, so that these variables account for only a
moderate portion of the variations in income (in
the United States, it has been of the order of onehalf to two-thirds), then the St. Louis reduced
form method yields highly unstable and unreli­
able estimates of the true structure of the system
generating the data.
The crucial role of unreliability and instability
has since been confirmed in more recent work of
Daniel O ’Neill in his forthcoming thesis. He
shows in the first place that different methods
of estimation yield widely different estimates*
including many which clearly overstate the
expenditure and understate the money multi­
pliers. He further points out that, given the
unreliability of the estimates resulting from
multicollinearity and large residual variance,
the relevant question to ask is not whether
these estimates differ from those obtained by
structural estimation, but whether the difference
is statistically significant; that is, larger than
could be reasonably accounted for by sampling
fluctuations.
I have carried out this standard statistical test
using as true response coefficients those gener­
ated by the MPS model quoted earlier.2 I find
that, at least when the test is based on the largest
possible sample— the entire post-Korean period
up to the last two very disturbed years— the
difference is totally insignificant when estima­
tion is in level form (F is less than one) and is
still not significant at the 5 percent level, when in
2For the purpose of the test, coefficients were scaled
down by one-third to allow for certain major biases in
measured government expenditure for present purposes
(mainly the treatment of military procurement on a delivery
rather than work progress basis, and the inclusion of direct
military expenditure abroad).




MARCH 1977

first differences.
This test resolves the puzzle by showing that
there really is no puzzle: the two alternative esti­
mates of the expenditure multipliers are not
inconsistent, given the margin of error of the
estimates. It implies that one should accept
whichever of the two estimates is produced by a
more reliable and stable method, and is generally
more sensible. To me, those criteria call, with­
out question, for adopting the econometric
model estimates. But should there be still some
lingering doubt about this choice, I am happy to
be able to report the results of one final test
which I believe should dispose of the reduced
form estimates— at least for a while. Suppose
the St. Louis estimates of the expenditure multi­
plier are closer to G od’s truth than the estimates
derived through econometric models. Then it
should be the case that if one uses their coeffi­
cients to forecast income beyond the period of
fit, these forecasts should be appreciably better
than those obtained from a forecasting equation
in which the coefficients of the expenditure vari­
able are set equal to those obtained from eco­
nometric models.
I have carried out this test, comparing a re­
duced form equation fitted to the period origi­
nally used at St. Louis, terminating in 1969 (but
reestimated with the lastest revised data) with an
equation in which the coefficients of government
expenditure plus exports were constrained to be
those estimated from the M PS, used in the above
F-test. The results are clear cut: the errors using
the reduced form coefficient are not smaller but
on the average substantially larger than those
using MPS multipliers. For the first four years,
terminating at the end of 1973, the St. Louis
equation produces errors which are distinctly
larger in eight quarters, and smaller in but three,
and its squared error is one-third larger. For the
last two years of turm oil, both equations perform
miserably, though even here the MPS coeffi*
cients perform just a bit better. I have repeated
this test with equations estimated through the
first half of the postwar period, and the results
are, if anything, even more one-sided.
The moral of the story is pretty clear. First,

VOL. 67 NO. 2

MODIGUANI: MONETARIST CONTROVERSY

rcduced form equations relying on just two exog­
enous variables are very unreliable for the pur­
pose of estim ating structure, nor arc they
particularly accurate for forecasting, though per
dollar of research expenditure they are surpris­
ingly good. Second, if the St. Louis people want
to go on using this method and wish to secure the
best possible forecast, then they should ask the
MPS or any other large econometric model what
coefficients they should use for government
expenditure, rather than trying to estimate them
by their unreliable method.
From the theory and evidence reviewed, we
must then conclude that opting for a constant rate
of growth of the nominal money supply can
result in a stable economy only in the absence of
significant exogenous shocks. But obviously the
economy has been and will continue to be ex­
posed to many significant shocks, coming from
such things as war and peace, and other large
changes in government expenditure, foreign
trade, agriculture, technological progress, popu­
lation shifts, and what not. The clearest evidence
on the importance of such shocks is provided by
our postwar record with its six recessions.

IV. The Record of Stabilization Policies:
Stabilizing or Destabilizing
A. Was Postwar Instability D ue to Unstable
Money Growth?
At this point, of course, monetarists will ob­
ject that, over the postwar period, we have not
had a constant money growth policy and will hint
that the observed instability can largely be traced
to the instability of money. The only way of
meeting this objection squarely would be, of
course, to rerun history with a good computer
capable of calculating 3 percent at the helm of
the Fed.
A more feasible, if less conclusive approach
might be to look for some extended periods in
which the money supply grew fairly smoothly
and see how the econom y fared. Combing
through our post-Korean War history, I have
been able to find just two stretches of several
years in which the growth o f the money stock
was relatively stable, whether one chooses to




II

measure stability in terms of percentage devia­
tions from a constant growth or of dispersion of
four-quarter changes. It may surprise some that
one such stretch occurred quite recently and
consists of the period of nearly four years begin­
ning in the first quarter of 1971 (see the author
and Papademos, 1976). During this period, the
average growth was quite large, some 7 percent,
but it was relatively smooth, generally well
within the 6 to 8 percent band. The average
deviation from the mean is about .75 percent.
The other such period lasted from the beginning
of 1953 to the first half of 1957, again a stretch
of roughly four years. In sharp contrast to the
most recent period, the average growth here is
quite modest, only about 2 percent; but again,
most four-quarter changes fell well within a
band of two percentage points, and the average
deviation is again .7. By contrast, during the
remaining 13-year stretch from m id-1957 to the
end of 1970, the variability of money growth
was roughly twice as large if measured by the
average deviation of four quarter changes, and
some five times larger if measured by the per­
centage deviation of the money stock from a
constant growth trend.
How did the economy fare in the two periods
of relatively stable money growth? It is common
knowledge that the period from 1971 to 1974, or
from 1972 to 1975 if we want to allow a one-year
lag for money to do its trick, was distinctly the
most unstable in our recent history, marked by
sharp fluctuations in output and wild gyrations
of the rate of change of prices. As a result, the
average deviation of the four-quarter changes in
output was 3.3 percent, more than twice as large
as in the period of less stable money growth. But
the first stretch was also marked by well above
average instability, with the contraction of 1954,
the sharp recovery of 1955, and the new contrac­
tion in 1958, the sharpest in postwar history
except for the present one. The variability of out­
put is again 50 percent larger than in the middle
period.
To be sure, in the recent episode serious exog­
enous shocks played a major role in the develop­
ment of prices and possibly output, although the

THE AMERICAS ECONOMIC REVIEW

12

same is not so readily apparent for the period
1953 to 1958. But, in any event, such extenu­
ating circumstances are quite irrelevant to my
point; for I am not suggesting that the stability of
money was the major cause of economic insta­
bility— or at any rate, not yet! All I am arguing is
that (i) there is no basis for the monetarists’ sug­
gestion that our postwar instability can be traced
to monetary instability— our most unstable
periods have coincided with periods of relative
monetary stability; and (ii) stability of the
money supply is not enough to give us a stable
economy, precisely because there are exogenous
disturbances.
Finally, let me mention that I have actually
made an attempt at rerunning history' to see
whether a stable money supply would stabilize
the economy, though in a way that I readily
acknowledge is much inferior to the real thing,
namely through a simulation with the MPS. The
experiment, carried out in cooperation with
Papademos, covered the relatively quiet period
from the beginning of 1959 to the introduction of
price-wage controls in the middle of 1971. If
one eliminates all major sources of shocks, for
example, by smoothing federal government
expenditures, we found, as did Otto Eckstein in
an earlier experiment, that a stable money
growth of 3 percent per year does stabilize the
economy, as expected. But when we allowed for
all the historical shocks, the result was that with
a constant money growth the economy was far
from stable— in fact, it was distinctly less stable
than actual experience, by a factor of 50 percent.
B. The Overall Effectiveness o f Postwar
Stabilization Policies
But even granted that a smooth money supply
will not produce a very stable world and that
there is therefore room for stabilization policies,
monetarists will still argue that we should none*
theless eschew such policies. They claim, first,
that allowing for unpredictabiy variable lags and
unforseeable future shocks, we do not know
enough to successfully design stabilization
policies, and second, that the government would
surely be incapable of choosing the appropriate




MARCH 1977

policies or be politically willing to provide
timely enforcement. Thus, in practice, stabili­
zation policies will result in destabilizing the
economy much of the time.
This view is supported by two arguments, one
logical and one empirical. The logical argument
is the one developed in Friedman’s Presidential
Address (1968). An attempt at stabilizing the
economy at full employment is bound to be de­
stabilizing because the full employment or
natural rate is not known with certainty and is
subject to shifts in time; and if we aim for the
incorrect rate, the result must perforce be explo­
sive inflation or deflation. By contrast, with a
constant money supply policy, the economy will
automatically hunt for, and eventually discover,
that shifty natural rate, wherever it may be
hiding.
This argument, I submit, is nothing but a
debating ploy. It rests on the preposterous as­
sumption that the only alternative to a constant
money growth is the pursuit of a very precise
unemployment target which will be adhered to
indefinitely no matter what, and that if the target
is off in the second decimal place, galloping
inflation is around the corner. In reality, all that
is necessary to pursue stabilization policies is a
rough target range that includes the warranted
rate, itself a range and not a razor edge; and, of
course, responsible supporters of stabilization
policies have long been aware of the fact that the
target range needs to be adjusted in time on the
basis of forsceable shifts in the warranted range,
as well as in the light of emerging evidence that
the cuiTcnt target is not consistent with price
stability. It is precisely for this reason that I, as
well as many other nonmonetarists, would side
with monetarists in strenuous opposition to
recent p ro p o sa ls for a target unem p lo y m en t rate
rigidly fixed by statute (although there is nothing
wrong with Congress committing itself and the
country' to work toward the eventual achieve­
ment of some target unemployment rate through
structural changes rather than aggregate demand
policies).
Clearly, even the continuous updating o
targets cannot guarantee that errors can be

VOL. 67 NO. 2

MODtGUANI; MONETARIST CONTROVERSY

avoided altogether or even that they will be
promptly recognized; and while errors persist,
they will result in some inflationary (or defla­
tionary) pressures. But the growing inflation to
which Friedman refers is, to repeat, a crawl not a
gallop. One may usefully recall in this connec­
tion the experience of 1965-70 referred to ear­
lier, with the further remark that the existence of
excess employment was quite generally recog­
nized at the time, and failure to eliminate it
resulted overwhelmingly from political consid­
erations and not from a wrong diagnosis.3
There remains then only the empirical issue:
have stabilization policies worked in the past and
will they work in the future? Monetarists think
the answer is negative and suggest, as we have
seen, that misguided attempts at stabilization,
especially through monetary policies, are re­
sponsible for much of the observed instability.
The main piece of evidence in support of this
contention is the Great Depression, an episode
well documented through the painstaking work
of Friedman and Anna Schwartz, although still
the object of dispute (see, for example, Peter
Temin). But in any event, that episode while it
may attest to the power of money, is irrelevant
for present purposes since the contraction of the
money supply was certainly not part of a com­
prehensive stabilization program in the postKeynesian sense.
When we come to the relevant postwar period,
the problem of establishing the success or failure
of stabilization policies is an extremely taxing
one. Many attempts have been made at devel­
oping precise objective tests, but in my view,
none of these is of much value, even though I am
guilty of having contributed to them in one of my
3Friedman\s logical argum ent against stabilization pol­
icies and in favor of a constant money growth rule is, I
subm it, much like arguing to a man from St. Paul wishing to
go to New Orleans on important business that he would be a
fool to drive and should instead get him self a tub and drift
down the Mississippi: that way he can be pretty sure that the
current will eventually get him to his destination; whereas, if
he drives, he might m ake a wrong turn and, before he notices
he w ill be going further and further away from his destination
and pretty soon he may end up in Alaska, where he will
surely catch pneum onia and he may never get to New
Orleans!




13

worst papers (1964). Even the most ingenious
test, that suggested by Victor Argy. and relying
on a comparison of the variability of income with
that of the velocity of circulation, turns out to
be valid only under highly unrealistic restrictive
assumptions.
Dennis Starleaf and Richard Floyd have pro­
posed testing the effectiveness of stabilization by
comparing the stability of money growth with
that of income growth, much as I have done
above for the United States, except that they
apply their test to a cross section of industrial­
ized countries. They found that for a sample of
13 countries, the association was distinctly
positive. But this test is again of little value. For
while a negative association fora given country,
such as suggested by my U.S. test, docs provide
some weak indication that monetary activism
helped rather than hindered, the finding of a
positive association across countries proves
absolutely nothing. It can be readily shown, in
fact, that, to the extent that differential variabil­
ity of income reflects differences in the character
of the shocks— a most likely circumstance for
their sam ple— successful stabilization also
implies a positive correlation between the vari­
ability of income and that of money.
But though the search for unambiguous quan­
titative tests has so far yielded a meager crop,
there exists a different kind of evidence in favor
of Keynesian stabilization policies which is
impressive, even if hard to quantify. To quote
one of the founding fathers of business cycle
analysis, Arthur Burns, writing in 1959, “ Since
1937 we have had five recessions, the longest of
which lasted only 13 months. There is no parallel
for such a sequence of mild— or such a sequence
of brief— contractions, at least during the past
hundred years in our country” (p. 2). By
now we can add to that list the recessions of
1961 and 1970.
There is, furthermore, evidence that very
similar conclusions hold for other industrialized
countries which have made use of stabilization
policies; at any rate that was the prevailing view
among participants to an international confer­
ence held in 1967 on the subject, “ Is the busi­

THE AMERICAS ECONOMIC REVIEW

14

ness cycle obsolete?" (see Martin Bronfenbrenner, editor). No one seemed to question the
greater postwar stability of all Western econ­
omies— nor is this surprising when one recalls
that around that time business cycle specialists
felt so threatened by the new-found stability that
they were arguing for redefining business cycles
as fluctuations in the rate o f growth rather than
in the level of output.
It was recognized that the reduced severity of
fluctuations might in part reflect structural
changes in the economy and the effect of stron­
ger built-in stabilizers, inspired, of course, by
the Keynesian analysis. Furthermore, the greater
stability in the United States, and in other indus­
trialized countries, are obviously not indepen­
dent events. Still, at least as of the time of that
conference, there seemed to be little question
and some evidence that part of the credit for the
greater stability should go to the conscious and
on balance, successful endeavor at stabilizing
the economy.

V. The Case of Supply Shocks and the
1974-76 Episode
A. Was the 1974 Depression Due to Errors o f
Commission or Omission?
In pointing out our relative postwar stability
and the qualified success of stabilization poli­
cies, I have carefully defined the postwar period
as ending somewhere in 1973. What has hap­
pened since that has so tarnished the reputation
of economists? In facing this problem, the first
question that needs to be raised is whether the
recent combination of unprecedented rates of
inflation as well as unemployment must be
traced to crimes of commission or omission. Did
our monetary and fiscal stabilization policies
misfire, or did we instead fail to use them?
We may begin by establishing one point that
has been blurred by monetarists' blanket indict­
ments of recent monetary policy: the virulent
explosion that raised the four-quarter rate of
inflation from about 4 percent in 1972 to 6.5
percent by the third quarter of 1973, to 1 L5
percent in 1974 with a peak quarterly rate of
13.5, can in no way be traced to an excessive, or




MARCH 1977

to a disorderly, growth of the money supply. As
already mentioned, the average rate of money
growth from the beginning of 1970 to the second
half of 1974 was close to 7 percent. To be sure,
this was a high rate and could be expected sooner
or later to generate an undesirably high inflation
— but how high? Under any reasonable assump­
tion one cannot arrive at a figure much above 6
percent. This might explain what happened up to
the fall of 1973, but not from the third quarter
of 1973 to the end of 1974, which is the really
troublesome period. Similarly, as was indicated
above, the growth of money was reasonably
smooth over this period, smoother than at any
other time in the postwar period, staying within
a 2 percent band. Hence, the debacle of 1974
can just not be traced to an erratic behavior of
money resulting from a misguided attempt at
stabilization.
Should one then conclude that the catastrophe
resulted from too slavish an adherence to a stable
growth rate, forsaking the opportunity to use
monetary policy to stabilize the economy? In
one sense, the answer to this question must in
my view be in the affirmative. There is ample
ground for holding that the rapid contraction that
set in toward the end of 1974, on the heels of a
slow decline in the previous three quarters, and
which drove unemployment to its 9 percent
peak, was largely the result of the astronomic
rise in interest rates around the middle of the
year. That rise in turn was the unavoidable result
of the Fed’s stubborn refusal to accom m odate,
to an adequate extent, the exogenous inflation­
ary shock due to oil, by letting the money supply
grow th exceed the 6 percent rate announced at
the beginning of the year. And this despite re­
peated warnings about that unavoidable result
(see, for example, the author 1974).
Monetarists have suggested that the sharp
recession was not the result of too slow a mone­
tary growth throughout the year, but instead of
the deceleration that took place in the last half of
1974, and early 1975. But this explanation just
does not stand up to the facts. The fall in the
quarterly growth of money in the third and fourth
quarters was puny, especially on the basis o

VOL. 65 NO. 2

MODIGUANI; MONETARIST CONTROVERSY

revised figures now available: from 5.7 percent
in the second to 4.3 and 4 .1 — hardly much
larger than the error of estimate for quarterly
rates! To be sure, in the first quarter of 1975 the
growth fell to .6 percent. But, by then, the vio­
lent contraction was well on its way— between
September 1974 and February 1975, industrial
production fell at an annual rate of 25 percent.
Furthermore, by the next quarter, monetary
growth had resumed heftily. There is thus no
way the monetarist proposition can square with
these facts unless their long and variable lags
arc so variable that they sometimes turn into
substantial leads. But even then, by anybody's
model, a one-quarter dip in the growth of money
could not have had a perceptible effect.
B. What Macro Stabilization Policies
Can Accomplish, and How
But recognizing that the adherence to a stable
money growth path through much of 1974 bears
a major responsibility for the sharp contraction
does not per se establish that the policy was
mistaken. The reason is that the shock that hit
the system in 1973-74 was not the usual type of
demand shock which we have gradually learned
to cope with, more or less adequately. It was,
instead, a supply or price shock, coming from
a cumulation of causes, largely external. This
poses an altogether different stabilization prob­
lem, In particular, in the case of demand shocks,
there exists in principle an ideal policy which
avoids all social costs, namely to offset com­
pletely the shock thus, at the same time, stabi­
lizing employment and the price level. There
may be disagreement as to whether this target
can be achieved and how, but not about the
target itself.
But in the case of supply shocks, there is no
miracle cure— there is no macro policy which
can both maintain a stable price level and keep
employment at its natural rate. To maintain
stable prices in the face of the exogenous price
shock, say a rise in import prices, would require
a fall in all domestic output prices; but we know
of no macro policy by which domestic prices can
be made to fall except by creating enough slack,




IS

thus putting downward pressure on wages. And
the amount of slack would have to be substantial
in view of the sluggishness of wages in the face
of unemployment. If we do not offset the exoge­
nous shock completely, then the initial burst,
even if activated by an entirely transient rise in
some prices, such as a once and for all deteriora­
tion in the terms of trade, will give rise to further
increases, as nominal wages rise in a vain at­
tempt at preserving real wages; this secondary
reaction too can only be cut short by creating
slack. In short, once a price shock hits, there is
no way of returning to the initial equilibrium
except after a painful period of both above equi­
librium unemployment and inflation.
There are, of course, in principle, policies
other than aggregate demand management to
which we might turn, and which arc enticing
in view of the unpleasant alternatives offered by
demand management. But so far such policies,
at least those of the wage-price control variety,
have proved disappointing. The design of better
alternatives is probably the greatest challenge
presently confronting those interested in stabili­
zation. However, these policies fall outside my
present concern. Within the realm of aggregate
demand management, the only choice open to
society is the cruel one between alternative fea­
sible paths of inflation and associated paths of
unemployment, and the best the macroecono­
mist can offer is policies designed to approxi­
mate the chosen path.
In light of the above, we may ask: is it con­
ceivable that a constant rate of growth of the
money supply will provide a satisfactory re­
sponse to price shocks in the sense of giving
rise to an unemployment-inflation path to which
the country would object least?
C. The Monetarist Prescription: Or, Constant
Money Growth Once More
The monetarists are inclined to answer this
question affirmatively, if not in terms of the
country’s preferences, at least in terms of the
preferences they think it should have. This is
evidenced by their staunch support of a continu­
ation of the 6 percent or so rate of growth through

THE AMERICAN ECONOMIC REVIEW

16

1974, 1975, and 1976.
Their reasoning seems to go along the follow­
ing lines. The natural rate hypothesis implies
that the rate of inflation can change only when
employment deviates from the natural rate. Now
suppose we start from the natural rate and some
corresponding steady rate of inflation, which
without loss of generality can be assumed as
zero. Let there be an exogenous shock which
initially lifts the rate of inflation, say, to 10 per­
cent. If the Central Bank, by accommodating
this price rise, keeps employment at the natural
rate, the new rate of 10 percent will also be main­
tained and will in fact continue forever, as long
as the money supply accommodates it. The only
way to eliminate inflation is to increase unem­
ployment enough, above the natural rate and for
a long enough time, so that the cumulated re­
duction of inflation takes us back to zero. There
will of course be many possible unemployment
paths that will accomplish this. So the next
question is: Which is the least undesirable?
The monetarist answer seems to be— and
here I confess that attribution becomes difficult
— that it does not make much difference be­
cause, to a first approximation, the cumulated
amount of unemployment needed to unwind
inflation is independent of the path. If we take
more unemployment early, we need to take less
later, and conversely. But then it follows imme­
diately that the specific path of unemployment
that would be generated by a constant money
growth is, if not better, at least as good as any
other. Corollary: a constant growth of money is
a satisfactory answer to supply shocks just as it
is to demand shocks— as well as, one may sus­
pect, to any other conceivable illness, indisposi­
tion, or disorder.
D. Why Constant Money Growth Cannot
Be the Answer
This reasoning is admirably simple and ele­
gant, but it suffers from several flaws. The first
one is a confusion between the price level and
its rate of change. With an unchanged constant
growth of the nominal money stock, the system
will settle back into equilibrium not when the




MARCH 1977

rate of inflation is back to zero but only when,
in addition, the price level itself is back to its
initial level. This means that when inflation has
finally returned back to the desired original rate,
unemployment cannot also be back to the origi­
nal level but will instead remain above it as long
as is necessary to generate enough deflation to
offset the earlier cumulated inflation. 1doubt that
this solution would find many supporters and for
a good reason; it amounts to requiring that none
of the burden of the price shock should fall on
the holder of long-term money fixed contracts—
such as debts— and that all other sectors of soci­
ety should shoulder entirely whatever cost is
necessary to insure this result. But if, as seems
to be fairly universally agreed, the social target
is instead to return the system to the original rate
of inflation— zero in our example— then the
growth of the money supply cannot be kept con­
stant. Between the time the shock hits and the
time inflation has returned to the long-run level,
there must be an additional increase in money
supply by as much as the price level or by the
cumulant of inflation over the path.
A second problem with the monetarists' argu­
ment is that it implies a rather special preference
function that depends only on cumulated unem­
ployment. And. last but not least, it requires the
heroic assumption that the Phillips curve be not
only vertical in the long run but also linear in the
short run, an assumption that does not seem
consistent with empirically estimated curves.
Dropping this last assumption has the effect that,
for any given social preference, there will be in
general a unique optimal path. Clearly, for this
path to be precisely that generated by a constant
money growth, would require a m i r a c l e — or
some sleight of the invisible hand!
Actually, there are grounds for holding that
the unemployment path generated by a constant
money growth, even if temporarily raised to take
care of the first flaw, could not possibly be close
to an optimal. This conclusion is based on an
analysis of optimal paths, relying on the type of
linear welfare function that appears to underlie
the monetarists' argument, and which is also a
straightforward generalization of Okun’s fa*

VOL. 67 AO. 2

MODIGLIANI: MONETARIST CONTROVERSY

mous “ economic discomfort index.” That index
(which according to Michael Lovell appears to
have some empirical support) is the sum of un­
employment and inflation. The index used in my
analysis is a weighted average of the cumulated
unemployment and cumulated inflation over the
path. The weights express the relative social
concern for inflation versus unemployment.
Using this index, it has been shown in a forth­
coming thesis of Papademos that, in general, the
optimum policy calls for raising unemployment
at once to a certain critical level and keeping it
there until inflation has substantially abated. The
critical level depends on the nature of the Phillips
curve and the relative weights, but does not
depend significantly on the initial shock— as
long as it is appreciable. To provide an idea of
the order of magnitudes involved, if one relies on
the estimate of the Phillips curve reported in
my joint paper with Papademos (1975), which
is fairly close to vertical and uses O kun’s
weights, one finds that (i) at the present time, the
noninflationary rate of unemployment corres­
ponding to a 2 percent rate of inflation can be
estimated at 5.6 percent, and (ii) the optimal re­
sponse to a large exogenous price shock consists
in increasing unemployment from 5.6 to only
about 7 percent. That level is to be maintained
until inflation falls somewhat below 4 percent;
it should then be reduced slowly until inflation
gets to 2.5 (which is estimated to take a couple of
years), and rapidly thereafter. If, on the other
hand, society were to rate inflation twice as
costly as unemployment, the initial unemploy­
ment rate becomes just over 8 percent, though
the path to final equilibrium is then shorter.
These results seem intuitively sensible and quan­
titatively reasonable, providing further justifica­
tion for the assumed welfare function, with its
appealing property of summarizing preferences
into a single readily understandable number.
One important implication of the nature of the
optimum path described above is that a constant
money growth could not possibly be optimal
while inflation is being squeezed out of the sys­
tem, regardless of the relative weights attached
to unemployment and inflation. It would tend




17

to be prevailingly too small for some initial
period and too large thereafter.
One must thus conclude that the case for a
constant money growth is no more tenable in the
case of supply shocks than it is in the case of
demand shocks.
VI, Conclusion
To summarize, the monetarists have made a
valid and most valuable contribution in estab­
lishing that our economy is far less unstable than
the early Keynesians pictured it and in rehabil­
itating the role of money as a determinant of
aggregate demand. They arc wrong, however,
in going as far as asserting that the economy is
sufficiently shockproof that stabilization poli­
cies are not needed. They have also made an
important contribution in pointing out that such
policies might in fact prove destabilizing. This
criticism has had a salutary effect on reassessing
what stabilization policies can and should do,
and on trimming down fine-tuning ambitions.
But their contention that postwar fluctuations
resulted from an unstable money growth or that
stabilization policies decreased rather than in­
creased stability just docs not stand up to an
impartial examination of the postwar record of
the United States and other industrialized coun­
tries. Up to 1974, these policies have helped to
keep the economy reasonable stable by historical
standards, even though one can certainly point
to some occasional failures.
The serious deterioration in economic stabil­
ity since 1973 must be attributed in the first place
to the novel nature of the shocks that hit us,
namely, supply shocks. Even the best possible
aggregate demand management cannot offset
such shocks without a lot of unemployment
together with a lot of inflation. But, in addition,
demand management was far from the best. This
failure must be attributed in good measure to the
fact that we had little experience or even an
adequate conceptual framework to deal with
such shocks; but at least from my reading of
the record, it was also the result of failure to
use stabilization policies, including too slavish
adherence to the monetarists’ constant money

THE AMERICAS ECONOMIC REVIEW

18

growth presciption.
We must, therefore, categorically reject the
monetarist appeal to turn back the clock forty
years by discarding the basic message of The
General Theory. We should instead concentrate
our efforts in an endeavor to make stabilization
policies even more effective in the future than
they have been in the past.
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