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The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by the Bank’s
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2
THE MONETARIST CONTROVERSY
CONTENTS
Page
Presentation by Franco Modigliani . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 5
Discussion by Milton Friedman and Franco Modigliani
12
Floor Discussion
23
American Economic Assn. Presidential Address by Franco Modigliani
27
3
EDITORIAL NOTE
At the January 1977 meeting of its monthly Economic Seminar
series, the Federal Reserve Bank of San Francisco was honored
to present Prof. Franco Modigliani, Immediate Past President
of the American Economic Association. In his paper, Prof.
Modigliani developed some of the themes which he had first
covered last September in his AEA Presidential Address, "The
Monetarist Controversy - Or, Should We Forsake Stabilization
Policies?" The Bank was doubly fortunate to obtain, as seminar
discussant, Nobel Laureate Milton Friedman, who was serving
as Visiting Scholar at this institution during the winter term.
This supplement to the Bank's Economic Review contains Prof.
Modigliani's lecture, Prof. Friedman's reply, the discussion
between the two and a floor discussion - plus, as an appendix,
Prof. Modigliani's AEA Presidential Address. The seminar was
chaired by Dr. Michael W. Keran, Vice President and Director
of Research for the Federal Reserve Bank of San Francisco.
4
The Monetarist Controversy
Presentation by
Franco ModigHani
investment. In consumer behavior, his name is
associated with the life cycle hypothesis, which
helps to explain personal savings rates. He is
here with us today to talk about one of his
major areas of research interest: monetary
theory and policy. His interest in this topic
goes back to his Ph.D. dissertation published
in 1944, which I suspect all of us in this
room who were ever graduate students in
economics have had to read for macro theory
courses. Since that time, he has not only been
a leading figure in monetary theory, he has
also been an active participant in and an
advisor on monetary policy.
The Federal Reserve has had very close
working relationships with Professor Modigliani, particularly because of his role in designing the financial sector of the large econometric model that the Federal Reserve System
uses for its monetary policy simulations.
The topic of Professor Modigliani's paper
today is The Monetarist Controversy, subtitled
"Should We Forsake Stabilization Policies?"
Professor Modigliani: It is a pleasure to be
here today, to enjoy the invigorating air of the
Bay Area, and to enjoy invigorating intellectual exchanges with Professor Friedman. It is
indeed refreshing to realize how much we still
have to argue about. At MIT, everybody
agrees. The differences between us are so puny
that we can understand each other very quickly.
Mr. Keran has mentioned that my initial
work in economics, at least the initial significant work, was in the area of understanding
the relation between Keynes and the classics.
And apparently I am destined to end my
career by being concerned with the relation
between Mr. Keynes and Monetarism; and
that is really the subject of my conversation
today. I have been attracted back to this area
Michael Keran: On behalf of the Federal
Reserve Bank of San Francisco, I'd like to
welcome you all to our monthly seminar
series.
This month represents the beginning of the
fourth year of this series. The purpose of
these seminars is to bring together professionals in the Bay Area business and financial
community with active research workers who
are largely but not entirely from the academic
community, to talk about issues that are of
common concern in areas of public policy and
to which people bring different perspectives.
Today represents the high water mark in
our monthly seminar series because of the
distinguished character of both the discussion
leader, Franco Modigliani, and his discussant,
Milton Friedman.
We will start off with the discussion leader,
Professor Modigliani, spending 30 or 40 minutes laying out the issues. This will then be
followed by a comment by Professor Friedman on the issues. Then we will open it to
a general exchange of views from the audience.
Franco Modigliani is a professor of economics and finance at the Sloan School of Management at the Massachusetts Institute of
Technology, and is the immediate past president of the American Economic Association.
He was born in Rome, studied at the University of Rome, and received his Ph.D. from the
New School of Social Research in New York.
He has taught at the University of Illinois,
the Carnegie Institute of Technology, and
Northwestern University, before he came to
MIT in 1962.
Professor Modigliani is well known for his
research in a wide range of areas. In finance,
he has made state of the art contributions in
the area of cost of capital and the theory of
5
during the 1974 period, because it seemed to
me at that time that everybody who had any
common sense would agree on certain basic
rules of the game, including the fact that when
you get an outside price shock of the magnitude experienced in that year, you do need to
relax your money supply rules and allow for
a more rapid growth of the money supply.
I had a. hard time understanding why my
monetarist friends did not agree. I knew, of
course, that it would take quite a bit of
imagination, after having spent their life saying money supply must always grow at the
same rate, to make a change; but I thought
that, given the circumstances, they would.
Monetarists have changed in one very minute
way: they would now target a 5- or 6-percent
increase, while five years ago it would have
been somewhat less. Still they have a very
rigid formulation.
I began to spend time trying to understand
how intelligent people dealing with the same
world, and having presumably similar analytical tools, should come to such different conclusions. I have written a couple of papers
on this topic. One is my presidential address;
another is a paper that I prepared for the
Federal Reserve Bank of Boston, entitled
"Monetary Policy for the Coming Quarters:
The Conflicting Views." Since you have seen
my presidential address, I shall only summarize
some key issues that I think will be useful
for discussion.
I started out, under the inspiration of
Professor Friedman, to distinguish the sources
of differences: (1) differences in analysis;
(2) differences in empirical assessment of
parameters; and (3) differences in value judgments. The latter may get imported into our
policy prescription without carefully saying
"I'm advising you to do this because I think
you should have low unemployment." And
somebody else, who thinks low unemployment
is not as important, doesn't understand how
you arrived at your conclusions.
Well, let me first say that the conclusion
of my work is very clear: namely, that there
really are no significant differences of analysis
between able, intelligent, open-minded monetarists and non-monetarists. This is true despite
the fact that very frequently a monetarist
and a non-monetarist will start out approaching thl;lsame problem with somewhat different
models. What I maintain is that, in those cases,
if a monetarist wants to, he will be able to
recast his analysis into a non-monetarist language; and the non-monetarist, if he will try,
can recast his analysis into a monetarist
language. And that it will always turn out
that one is consistent with the other, except
possibly in the sense that one is a limiting
case of the other - for instance, a limiting
caSe in which a particular parameter is zero.
Assigning zero value to the parameter is a
particular value; so in this sense, there are
no major differences.
To give an illustration: When a monetarist
describes the relation between money M and
income Y, he'll start by writing Y = aM;
and the non-monetarist will start by writing
M = aY. The monetarist will think that his
equation is a statement about income, and the
non-monetarist will think that his equation is
the demand for money. Yet you can write the
equation either way, and you can also interpret it either way, if you are careful enough.
In particular, a non-monetarist should see and I have now learned to do that, so my
blood no longer rises when I sit down to read
the monetarist literature - that the proposition
Y = aM is perfectly consistent with the Keynesian framework under a number of conditions. The most trivial one is that "a" is
definitional; that is, there exists, at every
point of time, an "a" such that Y = aM.
So, if a monetarist writes in this sense, and
sometimes he does, there is nothing to get
your blood pressure up.
Secondly, you can write Y = aM in a more
general sense, as a reduced form of the Hicks
IS-LM curve, provided you are careful to note
that, in that case, "a" is either a function
of interest rates - or, if you don't want to
use interest rates, then "a" is a function of
output. Of course, recognizing that makes a
lot of difference, because then the derivative
6
of "Y" with respect to "M" does depend on
how the effect of "M" is distributed between
price P and output X. It makes a lot of
difference because then "a" is not a constant,
but depends on M in ways which the equation
Y = aM cannot account for.
Finally, suppose that, sticking to this last
case, you happen to believe that what I've
called the lIicksian mt:chanism is very powerful. Then to a good approximation "a" is a
constant - or, at any rate, is a random variable. Its value may move a little bit, but not
as a function of what you are doing. Even
if it does, it is a secondary effect; so, for
many purposes, you may want to take it as
a constant.
I maintain that, by the same token, a
monetarist should be willing to take the traditional two equations of the non-monetarist
Hicksian framework (which sometimes becomes two thousand equations), and see that
the Hicksian framework is consistent with
his model.
So it seems to me that the framework is
the same, and that the real issue has to do,
on the one hand, with assessment of the value
of the parameters; and, on the other hand,
on assessment of the crucial simplifications
that are appropriate at different times. With
respect to the latter, I think any intelligent
non-monetarist will agree that if you are dealing with the post-World War I German inflation (or I would even say with the British
or Italian inflation of this time), the Hicksian mechanism is a refinement that we can
forget about. However, I wish the monetarist
would understand that if you are dealing with
the Great Depression, then the constancy of
"a" is a luxury that you cannot use. It is
a convenient approximation which is no
longer useful. For that reason, when either a
monetarist or a non-monetarist deals with extreme situations, he should have no difficulty
coming to similar conclusions.
I have just been working on a paper dealing with the problem of the Italian inflation,
and I'm sure that Milton would be willing to
sign his name to it. I conclude that you can
only maintain a certain rate of inflation if
the money supply is growing at the appropriate rate. If you stop the money supply from
growing, you cannot for long have any significant inflation as etnployment. tends to shrink
to some critical level consistent with price
stability.
Note that Italy has a fairly stable Phillips
curve, because the economY is indexed 100
percent, and contracts are highly centralized.
In this context, expectations have no role.
Thus it turns out that you can keep employment above the critical level; but, because, at
the. higher level of employment prices that
firms charge are not consistent with the wage
demanded, you get a higher rate of inflation.
The larger the level of output the greater the
discrepancy between wages and prices, and the
higher the inflation. However, even this Phillips curve is unstable in the longer run, because it relies entirely on the lag in the escalator clause of wage adjustment behind
prices. So high employment is made possible
because the real wage is reduced through the
inflation. But workers must at some point
catch on, and must either agree to a lower
real wage, or must try to shorten the escalator lag - in which case, inflation would
grow; and so you do have an explosive inflation.
So you see that when we are dealing with
concrete problems, non-monetarists can come
to quite monetarist conclusions.
Then the question is: Where is the main
source of difference? Is it in empirical assessment? I have indicated that essentially, at
the start, there was a great difference of empirical assessments, with the monetarist thinking that the Hicksian mechanism is very
powerful, while the early Keynesians thought
it was rather powerless. I guess I've always
been between the two positions, although I
would say that I have moved toward the view
that the power of the Hicksian mechanism
is sizable, unless you get into a really deep
depression.
The assessments that come out of the MPS
model and many other models agree, at least
7
in terms of order of magnitude, that the
double mechanism, the Hicksian mechanism
and the price flexibility mechanism, put together, really does reduce considerably the
impact of outside disturbances.
Just to remind you of what happens in
terms of the MPS model, we find that if you
have an exogenous disturbance to demand, the
multiplier far from being a gigantic number
is reasonably small; it is not quite one, to
begin with; then it gets to a maximum of two,
and then stays there. But that assumes perfect price rigidity. Once you allow for the
fact that prices gradually respond to unemployment, then you do find that the maximum
impact is reached in about a year; it is not
much over one, and then it dies out. After
a couple of years, the net effect is zero.
On the other hand, the effect in terms of
money income must be appreciatively larger
if prices are responding. It is at this point
that there has been some difficulty with some
monetarists, because of what I call the St.
Louis quandary. According to the St. Louis
equation, which is estimated in terms of money
income, the fiscal effect would last two quarters and disappear after that. I have always
felt that result was inconsistent with any sensible monetarist point of view. I am pleased
to say that I've never heard Milton quite
endorse that result - particularly since he is
known to emphasize the fact that the responsiveness of prices is slow. In other words, with
his distribution of the change in income between output and prices, the price component
is sluggish. If that is the case, how could you
not get a fairly long diffused effect?
In my presidential address, I have mentioned
a number of tests which resolve the issue to
my satisfaction. I think the St. Louis results
are not inconsistent with what a non-monetarist
would expect, a priori. The apparent difference
is due, first of all, to the fact that the
St. Louis approach is unreliable. You can get
almost any answer, if you play around with
that equation. That's understandable, given
the many variables you are leaving out. The
St. Louis equation attempts to explain income
with just two variables, fiscal policy and
money, when in fact there are two thousand
other things that are whipping it around. So
to pretend that you can explain fiscal influences with simple short lags, and particularly
ignoring the distinction between real income
and money, is just to ask too much. You get
a very poor fit, and you get poor estimates estimates that are highly unreliable. i have
"shown this to be the case, by two approaches.
One, suggested by a student of mine, Dan
O'Neill, is an F test, which shows that the
difference between the St. Louis coefficient
and the coefficient which you estimate from a
model like the MPS is not significant, most of
the time, for most of the tests I have made.
Secondly, and perhaps more interestingly,
by showing that the fiscal multipliers estimated
from the MPS model are more reliable than
the St. Louis estimate. To this end I took
the St. Louis equation, estimated the coefficients of the fiscal variables through 1969
and extrapolated. I got worse results than if
I extrapolated a St. Louis equation in which
the fiscal coefficients were set equal to the
MPS coefficients, which have never changed
in time. I get a better fit outside the sample
period, which simply means that their estimate
is not very reliable. In other words, the St.
Louis coefficients give a closer fit during the
period of estimation, but when you extrapolate - they go to pieces.
The reason, by the way, why the extrapolation is so poor, is the following: When
you refit the St. Louis equation for a longer
and longer period, the estimates tend to get
closer and closer to those implied by the MPS
and other econometric models. Indeed, Ben
Friedman has just finished and submitted a
paper in which he shows that if you go
through 1976, and particularly if you go from
1960 to 1976, the coefficients of the government expenditure variable in the St. Louis
equation are essentially the dream of a nonmonetarist. They are essentially two, and they
never become negative. They start positive and
they always remain positive. This may actually
be too good to be true, because my own esti8
mate is that they ought to be not quite as
high as that; so even these are not very reliable. But what this evidence really shows is
the unreliability of a method whose coefficients keep changing as you move along.
But while there is by now relatively little
theoretical disagreement, I suspect that when
we apply our conclusions to the real world
perhaps each side tends to forget that he has
admitted his earlier faults of exaggerating in
one direction or another. For instance, I heard
Milton say again, just before this seminar,
that a tax cut which is not accompanied
by a change in money has "almost" no effect.
I think I know what "almost" means. It
means that in the first year it has an effect
of something like half. But that does not
sound to me like "almost" nothing. Or perhaps he is somehow disagreeing with what I
thought he agreed to in theory.
Of course, there are situations where Milton and I would agree that the fiscal effects
are almost zero; namely, a transient tax cut
which is stated to be transient, and which
everybody knows is transient. I think there is
strong reason to believe that it will produce
no effect; and I have been fascinated by
studying the evidence that comes out of the
latest experience we have had in 1975. That
is a fascinating experience; because that tax
rebate was as transient as you can get. In
one quarter we reduced taxes at the annual
rate of some $32 billion. The next quarter, we
raised taxes at the same annual rate. Will
people behave as if they had lost $30 billion
of income permanently in the first quarter,
and gained $30 billion the next quarter?
The evidence seems to me strikingly against it.
The amount of savings went up by $37 billion in the first quarter, and went down by
$24 billion the next quarter. A close examination of this episode led me to the conclusion
that people treated the rebate as a one-time
gift, and spent it as dribble. You don't see
much evidence of an effect either in the same
quarter or in the immediately following ones.
Let me indicate, since I mentioned this,
that of course I am now touching on one
point in which Milton and I see eye-to-eye,
and that is the theory of consumption. This
is an area in which our work complements
each other beautifully. It seems to me that
his work had a great impact beyond mine,
at the methodological level, by showing the
relationship between theory and tests, and how
you define under what conditions a theory
would be rejected. This has a lot of carryover to problems other than consumption.
On the other hand, my model doesn't have
much carry-over, because it is specific to the
life cycle. It is like Milton's permanent income
hypothesis; but life is finite. There are all kinds
of fascinating consequences that come out of
my approach which you could not conveniently derive from his model. And so it really
pushes in one direction - in that particular
direction I think quite far.
Let me now return to the question: If
there is no difference in analysis, how can
we disagree? Well, before we come to value
judgments, there is still a difference, an empirical difference, which Milton has stressed in
the past. And, by the way, I must give
credit to Milton for having said many times
that the differences are empirical. The empirical difference essentially is this: the monetarists' belief that, whatever the coefficients
are on the average, they are very unstable;
and that since you are dealing with a dynamic system you don't really have enough
knowledge to stabilize the economy.
Actually, at this level, Milton has in my
view made a grave mistake; he has tried to
establish as a logical proposition that you cannot stabilize the economy. I say that is a
mistake because as he has stressed, these are
not logical differences. You know his logical
argument - he stated in his presidential
address that the Phillips curve is vertical at
the natural rate of unemployment, and we
don't know exactly where that is located.
If we are anywhere on one side or the other
of the natural rate, we have a cumulative
process of either inflation or deflation. Therefore to try to stabilize unemployment can only
result in extreme instability.
9
I am very proud of my analogy, which
some of you may have seen in the footnote,
that says this sounds just like advising a man
in Minneapolis, who wants to go down to New
Orleans,along the following lines: "Look
here, there are two ways to go. I know you
are trying to go by car; but there is only
one waY to go that is sure. You should put
yourself in a tub and drift down the river.
Because we know that the Mississippi River
has a current, you can't fail to get there
eventually. Whereas, if you take the car, you
might make a wrong turn, and you might
end up in Alaska. You might catch pneumonia. You might never get there."
It seems to me that it is exactly the same
argument. Let me make it specific. There are
circumstances in which taking the tub down
the Mississippi is better than taking an automobile; suppose for instance, the automobile
is a wagon, and there are lots of Indians in
the way, whereas the Mississippi is secured by
your friendly troops. Well, in that case, I
would say the tub is a good idea.
Or let me take another example, which I
think is pertinent. Suppose you don't want to
go to New Orleans, but just wish to visit
somebody a few miles down river, and you
don't exactly know the road and haven't got
a map. In that case, you might find that it
is more reliable to take the tub. The moral:
a) you should not try to use stabilization policies for fine tuning; but b) it is a different
matter when you have a long trip; and I submit that our knowledge of the economy is
sufficient to make the situation far closer to
the automobile in a friendly country than to
Milton's wagon in Indian country.
In any event, what I am really saying is that
this is an empirical question. Of course, it
may be that if you have nothing but a constant money supply in the longest run you
may eventually get there; but it doesn't mean
that on the average you will not be far away
from target. That is just an empirical matter
of how well your stabilization works, and
how serious is the risk of major errors.
Now, I have tried to face the problem as
an empirical one, and I have tried, in my
paper, to provide a good deal of evidence
that suggests, on the one hand, that a constantmQney supply does not work wen; and,
on the other hand, that stabilization policies
have worked well. I'm sure there will be some
room for discussion on this point.
Idohave something to say about value
judgments. Just a few words. I think there
is no question but that value judgments
play a major role in the differences between
economists. And I think it is unfortunate, but
true, that value judgments end up by playing
a role in your assessment of parameters and
of the evidence we consider. And here, let me
remind you of one very important development of recent years: We have all learned
about Bayesian statistics and Bayesian inference rules. Now, in one sense, Bayesian statistics and inference is a very good approach
to problems; but it has its drawbacks. And
there is no question that Milton and I, looking at the same evidence, may reach different
conclusions as to what it means. Because, to
him, it is so clear that government intervention is bad that there cannot be an occasion
where it was good! Whereas, to me, government discretion can be good or bad. I'm quite
open-minded about that, and am -therefore
willing to take the point estimate. He will not
take the point estimate; it will have to be a
very biased estimate, before he will accept it.
It is very important to understand the
sources of differences; there is no question
that, in the advice we have been giving at
different times, we value differently the cost
of unemployment versus, let's say, the cost
of inflation. I must say that I, among nonmonetarists, am particularly sensitive to the
cost of inflation; and, in fact, the last part
of my paper deals precisely with the question
of how to respond to inflation when you think
it is costly. The literature on the cost of
inflation has been waylaid by trivia about the
little triangle due to the fact that, when interest rates rise, you economize on the use of
money. I think that is trivia since, with respect to most of the money (namely, demand
10
deposits). we could eliminate that loss immediately by just letting interest rates be paid on
it. Once you have done. that, the only .thing
left is currency; and that is a small quantity,
and we can probably invent ways of saving
on that. too - credit cards, and what not.
So I think that is really trivial.
The real costs of inflation are. I think,
related to unexpected changes. I believe that
steady inflation (and I think Milton would not
disagree with this) has almost zero cost. There
is to be sure a very small welfare triangle;
but it's pretty trivial; and almost any other
cost you can mention, I think even that can
be taken care of. If we lived in a world of
steady state inflation, I'm sure we could find
ways of making its cost pretty negligible. So
I think that what is really costly about inflation is unexpected deviations of inflation
from the anticipated steady state path. This is
the problem that I have tried to address. If
yOll findyo\.l.rselfoff the long-run target on
the Phillips curve, because of unexpected
events, such as the. oil crisis, or because of
errors in policy such as the Vietnam War and
the •way it \vas financed, how do you return
to the long-run path? That, I think, is a very
important problem; and I wish that rnorie~
tarists and non-monetarists could join forces
in the interesting task of estimating what are
the costs of being off the long-run path.
What are the costs of taking longer to get
there? Is it the change in the price level that
matters? Or is it the rate of inflation, per se?
I think these are fascinating questions, which
should provide a common ground for monetarists and non-monetarists alike.
Thank you.
11
The Monetarist Controversy
Discussion by Milton Friedman
and Franco Modigliani
that steady-state inflation has negligible costs.
If you could have inflation at a steady rate,
it would not be worth paying much in the
form of adjustment costs to move back to a
different rate. The fundamental cost, as Franco said, arises from unexpected deviations of
inflation from a steady rate. The major reason for favoring zero inflation is that I believe
it is almost impossible to have a political
set-up which will be consistent with steadystate inflation, unless that steady state is zero,
or close to it.
Now, let me go back to Franco's presidential address - both to express agreement and
disagreement with it. I may say that I've always
thought that Franco, insofar as you use these
terms, has always been a monetarist, in very
important ways. His famous 1944 paper certainly qualifies as a major element in the
so-called monetarist structure. But I must say
that in the presidential address he displays a
quality that I had never attributed to him:
a capacity for understatement. I am referring to his comment, where he is trying to
show how little difference there was, theoretically, between the monetarist and nonmonetarist view (or the Keynesian and the
classical theory), that "fiscal policy was regarded as having some advantages - according
to the gospel of the General Theory." Or, on
the next page, that "there was a tendency
(among the early Keynesians) to focus on fiscal policy as the main tool to keep the
economy at near full employment" (underlining
mine). I suggest that if you examine the writings of the people involved in the dispute in
the 1950's or early 1960's, the difference was
far greater than that. But that is just quibbling.
Michael Keran: The challenge has been
made, and the discussant is prepared to respond.
Professor Milton Friedman, among his other
notable accomplishments, of which I am sure
you are all aware, is the Visiting Scholar at
our Bank.
We are honored to have him with us, and
to have him respond to Professor Modigliani.
Professor Friedman: I certainly agree fully
with Franco Modigliani's basic proposition,
that the differences that separate so-called
monetarists - a term which I try to avoid
using myself, because I don't like it - from
non-monetarists are entirely empirical rather
than theoretical; and I am delighted to have
Franco agree with me on this point. I believe
that the differences are empirical not merely
with respect to our judgments about the size
of parameters, but also with respect to our
judgment of the way in which policy is
formed, operates and develops.
That is not a difference in value judgments.
I disagree with Franco on that. I doubt
very much that there is any significant difference between him and me, for example,
on the value judgments we attach to unemployment and inflation. If there be any difference
in value judgments in this respect, 1 would
say that perhaps it is in the discount rate
which we use in judging future events relative
to current events. Perhaps there is a difference
in time perspective.
I have been impressed in the past, that
the most consistent difference that I could
discern between people who tend to favor
fine tuning, and people like myself who tend
to favor rules, is in the discount rate that
they use - a short versus a long perspective.
I agree, also, with Franco's final point:
12
I can well understand that, while Franco is
delighted to agree so fully as he does, he
finds it somewhat unseemly to agree completely. Since there is nothing to disagree with
on the theoretical level, he does what we all
do when we try to differentiate our products;
namely, to set up straw men. In his address,
Franco sets up four straw men that I might
refer to briefly.
The first one is that he attributes to me the
view that "wages (are) in reality perfectly flexible," and that the world is "competitive";
and he refers to my "modeling of the commodity market as a perfectly competitive one."
I offer a challenge to Franco. I shall pay him
a quarter for any statement he can find in any
of my published works, in which I make those
explicit assumptions. To illustrate the basis
for my confidence, let me quote from my
presidential address in 1967, in which I said,
when describing the natural rate: "Many of
the market characteristics that determine its
level are man-made and policy-made. In the
United States, for example, legal minimum
wage rates, the Walsh-Healey and DavisBacon Acts, and the strength of labor unions
all make the natural rate of unemployment
higher than it would otherwise be." That is
hardly a statement that is consistent with my
assuming perfectly competitive labor markets,
or homogeneous labor, or any of the rest.
The second straw man is his assertion that
I assume that "expectations must soon catch
up with the facts" that what we are dealing
with is a "fleeting response to transitory misperceptions." Again, I quote from my earlier
paper, "How long •.. is 'temporary' ....
for unemployment? ... I can, at most,
venture a personal judgment based on some
examination of the historical evidence, that
the initial effects of a higher and unanticipated rate of inflation last for something like
two to five years; this initial effect then
begins to be reversed, and that a full adjustment to the rate of inflation takes about as
long for employment as for interest rates,
say, a couple of decades." It is hardly
accurate to characterize that statement and
that. explicit discussion of the time period as
assuming a very rapid, instantaneous and
immediate response. In those two respects,
again, I think these are differences that do
not exist, and that Franco is closer to me,
or I am closer to him, than he suggests.
The third straw man, which he emphasized
in his verbal statements, is an argument which
he described as my attempt to demonstrate
logically that monetary policy must be inherently unstable. If that is the interpretation
that can be placed on my words, then I
expressed myself very poorly. That wasn't
the purpose for which I was making the
argument. The essence of my argument in that
paper was that the monetary authorities had
a monetary instrument with which they could
ultimately control only monetary variables,
such as the price level and nominal income;
that it is not possible to use monetary instruments to achieve a real target, whether that
real target be the real interest rate or real
output or unemployment rate. It was not my
purpose to argue that you had dynamic instability in monetary policy in the sense that,
if you changed the real target, you were
necessarily at a razor's edge in which you
were driven one way or the other. The purpose
of that argument - and I think it is a valid
purpose - was to suggest that monetary
policy is an appropriate and proper tool
directed at achieving price stability or a desired
rate of price change, but is not an appropriate tool for achieving a particular target
rate of unemployment. And I think that
argument still holds.
The fourth straw man - and here, in a
way, I join Franco in attacking what he
attacks - is the discussion in his paper
about the theory of rational expectations. I'm
sure Franco will be pleased to know that in
the past several years, in our Workshop on
Money and Banking at the University of
Chicago, my major problem has been battling
with the proponents of Box-Jenkins on the
one hand, and rational expectations on the
other. (FRANCO: It's the same at MIT.)
They are both marvelous ideas and good
13
that mean that those expectations were not
rational? Not at all. What it meant was
that every single year there was one chance in
four that the peso was going to go down 50
percent; and that meant that it was appropriate
for the future price to be 12Y2 percent below
the current price. And that continued for 4 or
5 years.
The fact that those errors continued year
after year was no evidence that the expectations were irrational. It was only evidence
that you were dealing with a phenomenon
extending through time. I do not believe that
rational expectations imply, in any way, that
there cannot be significant deviations of
expectations from experience for lengthy periods.
But now we get to where we really disagree,
and that is on the policy level. Franco
referred, in his verbal talk, and has discussed
in much more detail in his paper, the evidence
which {)ersuades him that monetary policy
should have been different than it was in the
period after 1974, and that a stable rate of
monetary growth is not an appropriate way
to conduct monetary policy. And I must say
theories; but you know there is a tendency
to carry them much too far and convert them
into fads. So I agree with Franco on that
subject. Indeed, if he had had a chance to
read the later version of some of the material
about the natural rate hypothesis, in chapter
12 of my price theory book, he would have
discovered that I make some of the same
comments about rational expectations that he
does. He quotes some users of the theory of
rational expectations as asserting that errors
can only be short-lived and random; that they
must be serially uncorrelated. That is not a
valid implication of rational expectations, in
my opinion. That is a misinterpretation of
the theory of rational expectations.
Let me give you a simple example from
recent history. For about five years, the
futures price of the Mexican peso was decidedly below the current price. And every year,
while the Mexican government maintained
the price of the peso at 8¢ a peso, the people
operating in the futures market made an error
in the same direction. Anybody who sold the
peso short was bound to lose money. Did
Year over Year Quarterly
Percent
Percent Change
8
8
7
7
6
5
4
3
2
1
0
1968
14
1972
1976
some of this evidence absolutely baffles me.
He says that he has looked back over the
past and found that two periods of stable
monetary growth, but highly unstable economic
activity, were the periods from 1953 to 1957,
and 1971 to 1975. He said he formed that
judgment on the basis of four quarter changes
in the rates of monetary growth. Well, I have
prepared some charts, of which we have distributed some copies; and I believe that if you
look at Ml on your graph, you will find
it hard to believe that 1953 to 1957, and 1971
to 1975, are periods of especially stable monetary growth. If you will look at the M2
graph (and I may say, as you know, that I
have always tended to have much more
confidence in M2 than in Ml), and if you
again check the same periods, from 1953-57
and from 1971-75, they are hardly periods of
the most stable monetary growth. I would
say that the period which shows the most
stable rates of monetary growth, in the sense
of deviations from the long upward trend
throughout there, is the period from 1961
through 1965 or 1966. If we take that period
(1961 to 1965-66), that is the period of relatively stable economic development.
Modigliani: Is that 1961-65 a stable period?
Do you realize that Ml went from 1Yz percent
up to 7 percent?
Friedman: Of course; but they were proceeding along a steady path.
Modigliani: But what's the difference? You
are talking about the second derivative now.
Friedman: Of course I am.
Modigliani: Ah, the second derivative counts.
Well, that's a new theory.
Friedman: Excuse me, it is not a new
theory. We both agree that what matters is
the difference between anticipations and realizations. And what we are talking about are
the deviations from anticipated rates of growth.
Modigliani: And you mean, in this period
everybody anticipated that there would be
acceleration, acceleration, acceleration?
Friedman: This is off the track; because
whether you take it about a trend or whether
you take it in absolute terms, in no way are
the years from 1953-57 or 1971-74 periods
that have a lower standard deviation than the
M2
Year over Year Quarterly
Percent
Percent Change
12
12
11
11
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
2
2
1
1
0
1968
1952
15
1972
1976
0
period from 1962-65 or 1966. Absolute or
otherwise.
Modigliani: This is just a factual question;
so let's not argue until we have performed the
computation. I
Friedman: I just want you to do one more
thing. Take personal income, which, both in
my opinion and Franco's, is a variable that is
predominantly moved by the money supply,
and ask whether there is a significant differ-
ence in the relationship between the movement
ofpersonal income and the movement of M2
in the later part of the period and in the
earHer parLTheone.strikingdifference isa
much deeper recession in 1954 than yoU would
have expected from the monetary change.
That is a significant difference.
I have. always interpreted that difference
(and Anna Schwartz and I did this in our
Monetary History).as. a reflection of the dropping of the bond support program by the
Fed. That didn't really become effective until
1953, when, in one fell swoop, it demonetized a large volume of assets, namely governmentbonds. As a consequence, the effective
money supply dropped much more sharply
in 1953, than the reported money supply.
That is the main discrepancy that I can find
in these pictures between the movements in
personal income and money. I calculated separate regressions for the earlier and later
periods, and again I cannot find any significant
difference in the regressions for the two
periods.
With respect to the relationship between
moving standard deviations of money and
I. Modigliani note (added in galley): The average absolute
deviation of the four-quarter change in M j is found to
be .89 for the period 1962-6~ and .9~ if one adds 1966,
as compared with .72 and .74 respectively for "relatively stable" periods used in my analysis, 1953 to
1957.2 and 1971 to 1974.2. I must add that in the
process of checking Prof. Friedman's conjecture I have
discovered that there exists another spell in which M j
was roughly as stable as in the two periods I have
singled out, namely the period from the beginning of 1961
to the middle of 1964, for which the average absolute
deviation is .72.
Friedman note (added in galley): This is playing games
by picking periods. For 1963.3 through 1966, the same
length as Franco's second period, the average absolute
deviation is .55. For M2 , it is .89 for 1971 to 1974.2
and .72 for 1962 to 1965. And I suspect none of these
differences is statistically significant in the light of sampling fluctuations. In any event, little can be learned from
such brief periods in analyzing a phenomenon which
operates with a long distributed lag.
Per:sonal
Income
Year over Year Quarterly
Percent Change
Percent
12
12
11
11
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
f
2
0
0
1952
1960
1964
16
1968
1972
1976
income, I do not know whether Franco referred, in his Boston Fed paper, to the calculations of that kind that Anna Schwartz and
I made in our paper in the Review of
Economics and Statistics in 1963. We made
such calculations for a very long period. They
show a high positive correlation between the
instability of money, on the one hand, and
the instability of income, on the other.
Now I come to the next major point that
Franco raises about the alleged incompatibility
of the monetary movement with the economic
movement. He argues that you cannot possibly
explain the large price rise up to 1974 as
reflecting monetary growth. I don't have the
exact words here, but I think that is the
essence of Franco's contention.
Well, I made a little calculation. We both
agree that the price controls introduced in
197I altered the time pattern of recorded
price change. We would both agree that the
"true" inflation in 1972 and early 1973 was
larger than is shown by the numbers, and that
the "true" inflation in 1973 and 1974 was
less than is shown by the numbers, because of
the effects of first imposing controls and then
removing them. Consequently, I took the
whole period from the third quarter of 197 I,
which was the quarter when price controls
were imposed (on August 15), to the fourth
quarter of 1974 (the peak of the rate of price
inflation). On average, consumer prices over
that period rose at a rate of 7.5 percent
per year.
In order to see whether monetary growth
can account for this, I have to allow for
the fact that there is, on the average, a 2-year
lag between changes in nominal money and
changes in prices. So I took the rate of
change of M2 from the third quarter of 1969
to the fourth quarter of 1972 - that is, I
pushed it back two years. The average rate
of change over that period was 9.2 percent;
Le., 1.7 percentage points higher than the rate
of inflation. On the average for a long period
that difference is about 3 percent. On the
average over a long period M2 will grow
at about 3 percent more than prices, to allow
for real output growth. This time it is 1.7.
I believe there are two major factors which
contribute to the residual discrepancy of 1.3
percentage points between I. 7 and 3.0. I have
no doubt that the oil crisis in late 1973
and early 1974, by making this country
poorer, raised the price level. I have variously
estimated that as having been about I Yz percent. Spread that over the three years, and you
have about Yz a percentage point, per year.
The rest of the 1.3-percentage point discrepancy is obviously consonant with our theory.
We have always argued that if you shift
from one rate of monetary growth to a higher
rate, adjustment to that higher rate will
involve an increase in velocity, since the higher
rate of inflation makes the holding of cash
balances more costly and, as a result, it will
lead people to try to reduce their cash balances.
That shift in velocity is a once-for-all effect.
What this implies is that about .8 percent
per year over a three-year period, or 2.4
percent in all, was the extent to which the
quantity of money demanded fell as a result
of the higher interest rates and the higher
rates of inflation.
Let me interject that I may be carrying a
good thing too far. There is, of course, a good
deal of fluff in the relation between monetary
change and subsequent price change. My only
point is to demonstrate that there is nothing
about the price rise from 1971 to 1974 which
is not entirely consistent with earlier changes
in the quantity of money.
Now we come to the final question of
whether you should accommodate, as Franco
put it. And here it is hard for me to know
how to discuss that issue in brief compass.
My major difference of opinion with Franco
is in two respects: First, with his assumption
that he knows how to accommodate (or that
1 do, for that matter, or that anybody does);
and second, with the assumption that if in
fact you adopt a policy of accommodation,
Franco Modigliani will be twisting the dials.
I have increasingly (and this is a subject
on which I must say I've changed my views
over the years) become impressed with the
17
monetary growth in 1973; but there was a
much sharper slowdown in 1974. The charts
which show annual changes do not bring out
these points very clearly. It comes out much
more sharply in quarter-to-quarter changes.
At the time, I was arguing, along with Franco,
against the slowdown in mid-1974. We agreed
at that time, not precisely on what the right
policy was, but what the right direction of
policy was.
I have long been in favor, as you know,
of reducing the rate of monetary growth of
M2 to somewhere in the neighborhood of
3 to 5 percent; but I have always been in
favor of doing it gradually - precisely for
the kinds of reasons that Franco quite properly presents. What happened was that this was
not done gradually; it was done very violently.
I have no doubt that it reinforced the adverse
effect on the economy of the oil crisis, and
of the disturbances of that time.
But now, let's go back. Early in 1973,
M2 was going up at roughly 10 percent.
Would it have been desirable to continue at
10 percent? Would it have been desirable to
accommodate to the oil developments by
going to 13, 14 or 15 percent? Or where?
Franco tells us that what was desirable was
to increase the money supply enough to get
the unemployment rate up to 7 percent. Well,
now, I believe that's a terrible prescription.
It is a terrible prescription because I do not
believe that there is a very close relationship
between the unemployment rate and what you
do with the monetary growth. In addition,
I believe that the unemployment rate is a
very undesirable, unreliable criterion of policy.
I am persuaded that the ups and downs in
recent years have been affected at least as
much by changes in the Unemployment
Insurance Act, as they have been by the acts
of monetary policy. The very sharp rise in
unemployment in early 1975, from January to
March or April, owed at least as much to
the fact that in January of 1975 a new
arrangement for unemployment insurance came
into effect which doubled the benefit period
and widened eligibility, as it did to what
need for a positive science of politics, of
political science. All of us - Franco, myself,
and all the rest of us - have tended to
follow the attitude: Well, now, what we need
to do is to figure out the right thing. If
only we can tell them what the right thing
to do is, then there's no reason why able,
well-meaning, well-intentioned people should
not carry out those ideas. But then we discover, over and over again, that well-intentioned, able people have passed laws, or have
established institutions - and 10 and behold,
they don't work the way able, well-intentioned
people expected or believed they would work.
And it isn't an accident that that happens.
It happens for very systematic, explicit reasons.
Suppose, for a moment, I were to buy all
of Franco's arguments. Needless to say, I
don't; but suppose I did. I may say I do
agree with him completely, at one point, when
he says that it would be a miracle if a steady
rate of monetary growth would achieve precisely the pattern of inflation and unemployment that he plots. But I believe it would
be an even greater miracle that Franco would
be in a position to push those dials. That
is because, once you adopt a policy of
accommodating to changes, there will be all
sorts of changes that he and I know should
not be accommodated, with respect to which
there will be enormous pressure to accommodate. And he and I will not be able to
control that. I have increasingly moved to the
position that the real argument for a steady
rate of monetary growth is at least as much
political as it is economic; that it is a way
of having a constitutional provision to set
monetary policy which is not open to this
kind of political objection.
But let me return to the question of whether
Franco, or I, knows how to accommodate.
He takes the obvious example - 1974. What
happened in 1974 was not that the Fed did
not accommodate; what happened was that
the Fed stepped hard on the brakes, toward
the middle of 1974. It is true that the Fed
had stepped somewhat on the brakes earlier
in 1973, and there was a slow-down in
18
was happening to monetary policy.
Let me go beyond the 1974 period. I sat
at the Federal Reserve Board with Franco in
the summer of 1975, and I remember very
well his arguing, at that time, for something
over a 10-percent rate of growth in MI'
Would that have been desirable? I don't
believe he would think so now. And I didn't
think so then; so at least we are in agreernent
on that - if not at the same time!
My point is that maybe he was right on
that particular occasion in 1974; but is there
any reason to believe that he or I, or anybody
else, can be completely right, year after year,
under these circumstances? I don't believe so.
And I believe that if you adopt a policy and this is where I say the political assumptions come in - if you adopt a policy
which assigns to individuals the discretionary
power to fine-tune, or to gross-tune (I don't
care) - but the discretionary power to move
things like the rate of growth of the money
supply or, for that matter, taxes; then political forces are going to come into play, to
see that that power is used for purposes
other than those which either Franco or I
would approve.
Michael Keran: Professor Modigliani has a
couple of comments, before we open this to
general discussion.
Modigliani: I would like to react to just a
few points, to set the discussion on its right
path. First of all, I would like to say that
I would disagree completely that the differences between Milton and me, in the evaluation
of unemployment and inflation, have anything
to do with discounting. As a matter of fact,
in the work I'm doing now with Lucas
Papademos, we use zero discounting. The whole
point of the paper is to take into account
all future consequences of an action now. You
get some very fascinating results when you
take into account all future consequences of
an action. For example, even if the Phillips
curve is not vertical, the long run, not the
short Phillips curve is relevant for policy
purposes.
Secondly, he has made a few points that
I think are minor, and I want to leave them
out; but I do want to plead guilty to two
points. Let me make the minor first, and the
major next. About rational expectations, I do
agree now that I was wrong in saying that
rational expectations implies non-serially correlated errors. On the other hand, it is also
true that once you allow for serial correlation
then generally you also allow for some policy
influences, in many cases. One source of serial
correlation is long-term contracts; and this is
consistent with rational expectations. As soon
as you have long-term contracts, you do have
room for policy. So, in effect, you can't
have things both ways: if you insist there is
no room for policy, then you must really
rely, to a large extent, on non-serially correlated error.
Now I come to the more serious difference:
namely, that I have presented a picture of
Milton believing in fast adjustments and in
perfect markets. I must confess that here I
was confronted with a contradiction between
what his words said, at various places, and
what conclusions he was drawing from them.
I looked at the conclusions, not at the fine
words. Now it seems to me that if indeed
it takes five years to dispose of unemployment,
then it is hard to believe thata policy-maker
can be so stupid that one would believe he
cannot do something to improve the situation.
It seems to me that if you believe the effect
of disturbances is fleeting, then you open the
room for policy actions even for the fairly
stupid policy-maker. I'm not talking about the
mean policy-maker; that's a separate issue, to
which I want to come later - but stupid,
plain stupid. This explains why I attribute to
him perfect markets -- not perfect labor
markets, but perfect commodity markets;
because when I try to understand the model
that is behind his conclusions, and make it
so that the conclusions really follow from it,
then I have to go back to marginal cost
pricing, and to the sort of situation where
workers withdraw from the labor force because
they are misled about real wages. And I believe
that is the essence of Milton's model, and I
19
think it does require those kinds of assumptions to lead to his conclusions.
Now, being fleeting is different from being
perfect, because it has to do with how quickly
expectations are corrected. But it seems to me
that there are many things I do not understand
about Milton's view if he tells me those
markets do not adjust quickly, because Albert
Ando and I have concluded that monetarism
is the non-monetarist world in which lags
disappear. Because indeed, if lags disappear,
then you do get back to a classical world.
All that the classics say is correct. The price
mechanism does it all. So, if there are long
lags, then I cannot understand why we should
disagree about the effect of taxes, or about
the effect of many other things.
Now, just a word about the evidence. Money
first, and then personal income. I have drawn
the period on Milton's MI chart which I
have used in my paper, and for which I
said the money supply was "generally" within
one percent of the average. Well, please
compute it, and you will see that in the
period to which I referred as "stable," the
money supply hit a peak of just over 8
and a trough of just below 6.
I've used 3 Yz years - from the beginning of
1971 to the middle of 1974. Then, when I
used output, I used the same period shifted
by one year; so I go from 1972 to the middle
of 1975. So for those 3 Yz years, the money
supply is indeed quite stable, compared with
any other period. I defy you to find any
other period in which, for a period of that
length, you get that low level of variation 2.
Sure, there is a little peak; but again, are we
really worried about the fact that for one
quarter the annual growth of the money
supply was 8 instead of 7? It seemed to me
that you should make it clear, now, whether
you really believe in this mechanical view of
the money mechanism. After we have agreed
about how things work, at the theoretical
level, now, all of a sudden, we get these
point estimates. It takes two years; a twoyear lag and exactly point input, point output.
TwO years later, boom! I must confess that
I lose touch with Milton the scholar, when he
comes out with this kind of evidence.
Friedman: You're shifting back from your
understatement, to your overstatement. I don't
have to believe in a precise point lag to
say, as a rough estimate, let's look what
happens. If we allow for a two-year lag, of
course it's a distributed lag.
Modigliani: If you talk about a couple of
quarters, point input, point output may be
all right; but with a two-year lag, you just
can't do that. You've got to show me what
kind of lag you have. I mean, you have to
run a regression over a long time, and show
me what happens.
Friedman: Well, you go ahead and make
that regression for as long a period as you
want; but, allowing for averaging out the
period from 1971 to 1975, you will find that
price reacts to money during that period in
the same way as it does in other periods.
Modigliani: Similarly, you will find the
same thing to be true for the period I have
referred to in 1953-57; and I think you will
agree that this period was stable. In contrast,
1961-65 was an unstable period. The money
stock was growing faster and faster; so that
certainly is not a period of stable growth.
Now, as for the question of personal income
which he shows in his charts, the answer is very
simple. In the period 1972-75 there was great
instability, which is disguised when you plot
money income. Prices were rising like mad.
Then the whole problem was that the Federal
Reserve wasn't providing enough money, and
so, naturally, money income didn't change in
the face of prices rising by 12 percent. So if,
instead of taking money income, you take
real income - which is what I measured you will see the great instability. And I'm
surprised that we need to discuss it, because
you've all lived it. So do you believe everything was rosy and stable between 1972 and
1975? If you believe it, then I think you'd
better go back to school.
Friedman: But one of the things, Franco,
that I thought you and I agreed on, and that
2. Friedman note (added in galley): As noted above,
1963.3 through 1966 is such a period.
20
I have written on extensively, is that we know
much more about the nexus between money
and money income, or nominal income, than
we do about the forces that cause the division
between prices and output.
Modigliani: This happens to be a point
of complete disagreement. I believe we know
equally much about both issues. I think our
knowledge of the price mechanism is uncertain
at the fringe. For example, if you forever
keep unemployment one quarter percent below
what it should be, will inflation explode? or would it stabilize? Those things we don't
know. But we do know that wages respond
to unemployment, and past inflation, with fair
regularity - with the coefficient of past
inflation not very far from one. There is an
extensive literature that explains why that
would be the case. This is perhaps the difference between a monetarist and a non-monetarist, in the sense that, if you start from LM
and IS, a non-monetarist will stress real
output and will derive money output as a
result. Monetarists, instead, tend to go directly
to money income - and I think that is
misleading. Although in many cases it would
be all right, 1973-74 is not one of those
periods.
Now, let me finally say that, in this question
of looking at inflation as a function of past
growth of money, I think there are many
things wrong with what Milton said, but I
can't immediately tell you what the answers
would be. You want to stop in the middle
of 1974, because that's the period I'm talking
about. The explosion of prices was an explosion, because the rate of inflation of say the
CPI went up from something like 7 to something like 13 from the second quarter of
'73 to the first of '74. And if anybody believes
that an explosion of prices of this sort can
be accounted for by these wiggles in the
money supply, well, he can believe anything.
I don't know just why you chose a twoyear lag. Maybe, if I were to choose three
years, I might get another answer. But I think
that anybody who looks at the evidence must
conclude that what happened in 1974 is pri-
marily an explosion of prices, due to the
impact of food and oil; and the price controls
had been eliminated before this.
Furthermore, all the evidence I've seen
suggests that the price controls and wage
cOLtrols (and here I believe I agree with
Milton) had a very small impact. In fact, the
evidence suggests that controls had no effect
whatever on wages, and other evidence (some
from Bob Gordon, for instance) suggests that
it had a small effect on prices, and that it
washed out fairly quickly.
Now, I think we come back to the fundamental point. Milton says it is not a question
of values. Well, I don't know how you cut
this pie. You say that having trust in one's
government is a matter of value, or is a matter
of technique, or is a matter of empirical
estimates. I do not know. I have personally
no reason to believe that the United States
government (if you were talking about Italy,
it might be a different thing) is not able to
attract able people who are interested in the
common welfare and can do a good job.
And I believe that if you look at the quality
of the people that have, shall we say,
manned the Council of Economic Advisers,
I think that suggests the good quality of the
advice that is available to the President. If
the President wants to use bad advice, I can't
really imagine that he will be deterred by some
rule that says the money supply should grow
at a constant rate; he'll find some way of
getting around that. In the final analysis,
one has to use one's political activity to make
sure that public servants are doing the common
good - that their actions are in the public
interest.
I complain that the Federal Reserve does
not tell us its target. Why do I complain?
Because I have no way of telling if it is doing
a good job or not. That's why I want them to
tell us what their targets are - and not
necessarily money targets. I don't care about
money targets. They can do anything with
money, as long as they tell us what their real
targets are - and as long as they take the
blame when they do not hit the real targets.
21
selves of such a sensible rule for compensating
our servants?
Modigliani: Well, I think that would be a
good idea; and, of course, when I look at
Our record, it seems. to me that·. I •. can·. see
some errors; and most of those were errors
not of the advice, but of not following the
advice.
I find relatively few cases of wrong advice;
but there are some. I do admit that I
would have been wrong in 1968. In 1968, I
underestimated the power of inflation - and
a number of us did; but I think that is probably the only case where I would really
acknowledge that I would possibly have given
wrong advice, and that would have been only
for a short while - by the way, I think
quite short - because I did catch on.
Michael Keran: I think this would be a
good place to widen the debate and ask for
questions. Who would like to raise the first
question?
Now, that seems to me to be the fundamental
issue.
Do you want to deprive yourself of an
important tool to make our life better, because
th~re is sornedanger that,. in fact, the. p~ople
who are using the tool will be thieves, or
inefficient, or under pressures? I cannot
imagine the Council really being under pressure
of .any .special interest. I. think· they would
have an interest in the country; and I am quite
willing to say that they should be paid a wage
which is escalated on real national income.
It could go up one point for each one-point
rise in real income, and then go down three
points each time the inflation goes up. So,
you see, I have a very one-sided bias against
inflation.
Friedman: Franco, I agree that they should;
but tell me, what chance do you think there
is that such a method of payment would
ever be adopted? And why not? It is such a
sensible method; why should we deprive our-
22
The Monetarist Controversy
Floor Discussion
Q: I would like to address a question as
follows: Suppose that from 1946 to 1976,
the actual and the expected rate of monetary growth coincided at 5 percent. (M2)
Everyone knew that the money supply was
going to grow at 5 percent, and they
expected it, and so on. Let me ask each
of you: Would the standard deviation of
the following variables be greater, or less,
than it actually has been - unemployment,
real income, and prices.
F: Less, for all three.
M: Well, I have indicated my answer. My
answer is that, if we had had everything
else the same, including the Korean war
and the Vietnam war, then the answer is
"More." Distinctly more; especially if
you assume constant fiscal policy.
Q: But all we have been talking about is
monetary policy.
F: The assumption is that you would have
had the same set of tax rates, that you
would have had the same set of expenditure
programs, and that you would have resorted more to borrowing from the market, as
opposed to printing money on the average,
over that period.
M: Could I make an additional point? I
actually have done a simulation of this
with a model, and that is exactly what
happened: you do get more variability. It
all depends on what other things you
adjust. If you eliminate all kinds of sources
of variation if you smooth fiscal
policy F: No, no; don't do that.
M: If you don't do that, then you get more
variation.
F: Well, yes; but that shows what's wrong
with the model. Because this is the really
important insight of the rational expecta-
tions approach, in my OpInIOn. However
good a model may be, such as Franco
describes, for a world in which you do not
have agreement between the actual and
anticipated rate of money change, that
model - the equations of that model would have been different in a world
where you do.
M: Now, let me answer this, because I think
it is fundamental. The exact answer is
that in my view - not only the model's
view, since sometimes I disagree with the
model; we fight, and I say you're stupid,
you know that isn't right - but it is my
view that the expected rate of money growth,
when you're talking about 5 percent, is of
absolutely no consequence. Nobody paid
any attention until Milton told them that
they should look it up. Nobody would
ever dream of looking at the money supply;
and they don't dream of doing it in other
countries, except after Milton goes there.
Obviously, if you told me that you announce
a 20-percent rate of growth of money,
well, then, people who are moderately
smart will react to this. But if you are
saying that the money supply is behaving
reasonably, then what is expected or unexpected makes absolutely no difference to
anyone.
Who looks at the money supply? What
merchant, what industry, looks at the
money supply?
F: Nobody. Who cares whether they look at
it?
M: Okay; but then what does the expected
money supply matter? If I don't look at
it, how can I expect it?
Q: It seems to me that there is one difference
between the monetarists and the nonmonetarists, which in a way is a value
23
judgment - but perhaps not in the usual
sense of the term. And that is: that the
monetarists are more averse to risks than
non-monetarists. That monetarism is playing a minimum risk role, while nonmonetarists like Franco are willing to take
risks.
want to end inflation, you want unemployment to be hard. And if you want to
make it easy, then don't use it to end
inflation, so that we have in the end the
wOrst of all worlds, in which we essentially
end up by wasting resources. By making it
easy to be unemployed, we didn't accomplish what we wanted to accomplish.
One other thing which bears on the effectiveness of stabilization policy: Before the
Sec.ond World War, unemployment fluctuated more than it did after the war.
F: Of course, that's true. But again, that is
really evidence in favor of stable monetary growth; because, before World War II,
you had of course the most extraordinary
instability in monetary growth, with the
quantity of money declining by a third,
from 1929 to 1933.
M: No, no, no - leaving out the Great
Depression.
F: But the money supply was more variable
before 1929, than it was after World War
II.
M: Which means that the stabilization policy
has stabilized the money supply, and that
is great! It is true, by the way; and it is
exactly what you would expect.
F: Now, be careful. You're going to go back
on your initial statement that we agree
in theory; because I -believe that is a
statement which it will be very hard to
defend on monetarist theory - or on any
theory.
M: The statement is: If I can use fiscal
policy, and it has an effect, then I can
stabilize the economy with less variation
in the money supply.
Q: I think my question follows the statement
M: I hesitate to accept this proposition,
because one of the reasons that makes me
very opposed to the money supply is that
I can conceive of situations where you
would get tragedies; and 1974 was one of
them. In another context, stubbornly insisting on stable money growth is wrong
when we have just observed a great decline
in the demand for money.
F: Oh, no, we haven't.
M: That is another discussion that we can go
into later.
F: Currently?
M: Yes; over the last two years. Not M2,
butMJ.
F: Neither one. There is only a breakdown
in the bad demand functions that people
fit.
M: Well, what stability means is, of course,
one's judgment; but from any point I've
seen, M2 is quite stable, so we agree on
that. But Ml is quite unstable. In a situation
like this, if you continue on the stable
money supply, you could get bad effects.
That, by the way, applies equally - and I
didn't make this point before, but let me
make it now - when I said that I used
unemployment as a target and said it
should have been 7 percent, obviously
using one target is a convenient simplification. You may have to use something a
little more complex than that, in any
policy decisions.
Secondly, the unemployment rate target
was not very good after 1975, because the
policy of that Administration was to create
a lot of unemployment and then make it
easy to be unemployed (doubling the period
during which people would be eligible for
unemployment insurance). A completely
nonsensical, contradictory policy. If you
you have just made. In the past, monetary and fiscal policies, at times, have
been found to be at cross purposes with
each other. Suppose we do accept Professor
Friedman's proposition that the rate of
growth of money supply would be made
a part of the Constitution, and is known in
advance to be 4 percent, or 5 percent you can argue about the numbers. Then it
24
follows that all the economic policy and
the stabilization programs would be
addressed by fiscal policy; and, in fact,
money supply then would become a known
constant. What objection would you have?
You would have less to work with, in
terms of variability of money supply. But
you would have more discretion in doing
what you want to do with the budget, or
the taxes, to stabilize the economy.
Do you think it will yield finer tuning
than we have had in the past?
M: I think the answer to that is very similar
to saying that if you are very careful and
distribute the weight properly, you can
drive a car with three wheels. Does it
follow. however, that I should advise you
to do it?
It is exactly the same story. You are
removing one useful tool which permits a
blend. For instance, if there is a decline
in money demand (as might happen, for
instance, if we start paying interest on
demand deposits), in those circumstances,
if I am forced by your 4-percent rule,
I'll find myself having to cut off all
investment, possibly; or, alternatively, having to cut off consumption.
If for some reason the demand for money
rises, I have to respond by policy which
forces me to reduce investment and increase
consumption. And why should I do that?
Why should I cut myself off? Exactly
like the guy on three wheels.
Q: Is this the same story that used to be
used to justify foreign exchange intervention? The central bank knows better how
to equate the demand and supply for foreign exchange, and therefore they have to
intervene and offset the unwarranted
gyrations in the private sector. If you are
willing to argue that it takes the central
bank to stabilize the demand for money
in the monetary sector, you should argue
for fixed exchange rates.
M: First of all, I do argue for managed
exchange rates; but that's a different story.
I can't understand the twisting of certain
things. Look, suppose the demand for
money declines by 10 percent; how do you
think the private economy adjusts? How
does it adjust?
The demand for money shifts, so that, at
a given interest rate and given income, the
demand for money is 10 percent less.
Q: In the short run, the interest rate is up.
M: And what else?
Q: Interest rates would adjust, in the short run.
M: In a short while, prices would rise 10
percent.
Q: They would?
M: There is no other adjustment.
Q: All the redundant money would be converted into commodities instead of bonds?
M: Given the circumstances, it is clear what
must happen in a short time is a rise
in the price level.
F: Well, let's not say in a short time; but
sooner or later.
M: In short order, in short order. Do you
like that?
F: Excuse me
both of you; but I think
we are begging the real question. You
are begging the fundamental question of
how do you know there has been a decline
in money demand, and thus whether
you're going to do the right thing?
M: I abolish interest on demand deposits. Okay?
F: First of all, as you know, that is one of
the reasons I've never wanted to use MI.
I want to use M2.
Let's go back for a moment, because
you made a statement earlier that I think
is not right, and you won't want to stick
with it. I would warn all of you that,
whenever anybody resorts to analogies,
there is something wrong with the logic.
If you've got a good logical argument,
you don't need a three-wheeled car.
You will agree with the following proposition: that a policy of discretionary
movement in an instrument can lead to
worse results than stability in it, if there
is enough lack of correlation between the
actions taken and the actions that should
be taken, even though, on the average,
25
working better. In principle, anything can
happen. And the actual question is: Are
these coordinated so that in fact they don't
work independently of each other? In
other words, does it happen that when the
Federal Reserve decides that you need an
expansion, the fiscal policy authority also
decides to have an expansion, and we have
a positive correlated error, when it wasn't
needed. If they are coordinated, this is
highly unlikely to occur. The other point,
of course, is that this is precisely why the
targets need to be coordinated; that is
precisely why I am against the independence
of the Federal Reserve, if defined as
independence of targets. I am completely
for independence of the Federal Reserve,
if understood as independence of tools.
Given the target, given the fiscal policy
which is now fairly clearly stated by the
Congressional and Administrative policy,
through the budget process - given those
targets, the Federal Reserve ought to have
the same target, not a different one; or
disagree with the target, if it wants to,
and have it changed. But once the target
is there, it ought to work for the same
target.
Michael Keran: There's an old Jewish proverb which says that "When scholars disagree,
the public and the truth will both benefit."
I think this has been an excellent example of
that. I, for one, will look upon this as one
of the most enlightening seminars I have
attended. I hope you feel the same. And I
want to thank our very distinguished speaker
and discussant for a fascinating afternoon.
Thank you very much.
those actions are in the right direction.
Therefore, to get your three-wheeled car
analogy really going, you have to demonstrate that we know enough to be able to
take those discretionary actions which, on
the whole, are stabilizing, as opposed to
the errors which are destabilizing. The
basic empirical judgment on this score
which leads us to stable monetary growth
is the belief that we do not know enough
to do that. And that is true, even if you
leave aside for a moment the political
constraints. If you know there is a 10percent decline in the quantity of money,
you can offset it - of course! But what
you really have to demonstrate is that,
over time, you will in fact know enough
about such changes and will be able to
identify them soon enough, so that you
can make adjustments which, on the average, will do more good than harm.
I have observed over a long period of
time that whenever anything goes wrong
with monetary policy, the favorite excuse
of the monetary authorities is that there
has been an exogenous shift in the demand
for money. But that is only an excuse.
They don't know it in advance. If they
did, they wouldn't have to bring in that
excuse after the event. So what evidence
do you really offer that we know enough
so that we know how to handle that
fourth wheel to be more stable, rather than
less stable?
M: Well, this would get us pretty much
astray; but let me just give an indication.
First of all, I agree with you that, in
principle, fewer instruments could be
26
The Monetarist Controversy
Or, Shou Id We Forsake Stabi lization Pol icies?
American Economic Association Presidential Address
by Franco Modigliani*
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 stabilization 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 necessary 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 destabilizing effect of pursuing stabilization policies. My main concern
will be with instability generated by the traditional type of disturbances - demand shocks.
But before I am through, I will give some
consideration to the difficult problems raised
by the newer type of disturbance - supply
shocks.
In recent years and especially since the onset of the current depression, the economics
profession 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 activity, 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 non-Monetarists. Milton Friedman was
once quoted as saying, "We are all Keynesians, now," and I am quite prepared to
reciprocate that "we are all Monetarists" 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 others
John Maynard 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 disagreement with non-Monetarists 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
* Presidential Address delivered at the eighty-ninth meeting of the American Economic Association, At/antic City,
New Jersey. Reprinted by permission from the American Economic Review, March /977.
27
I. The Keynesian Case for Stabilization Policies
A. The General Theory
Keynes' novel conclusion about the need for
stabilization policies, as was brought out by
the early interpreters of the General Theory
(e.g., John R. Hicks; Modigliani, 1944),
resulted from the interaction of a basic contribution to traditional monetary theory liquidity preference - and an unorthodox
hypothesis about the working of the labor
market - complete downward rigidity of
wages.
Because of liquidity preference, a change in
aggregate demand, which may be broadly
defined 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 monetary 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 ne~essary 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 anew, stable one
characterized by lower output and by an involuntary reduction in employment, so labelled
because it does not result from a shift in
nominal 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 generation of economists has become almost as
familiar as the demand-supply paradigm was
to earlier ones.
This analysis implied that a fixed money
supply 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 unemployment and stagnation, and
bursts of inflation. The extent of downward
instability would depend 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 LM, results in some decline in
interest rates and thus in a change in income
which is smaller than the original shift. The
stabilizing power of this mechanism is controlled by various parameters of the system.
In particular, the economy will be more unstable the greater the interest elasticity of
demand for money, and the smaller the interest responsiveness 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 policies. 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 expenditure 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 uncertainty in the response of
demand to changes in interest rates, and because changes in interest rates through monetary policy could meet difficulties and substantial delays related to expectations (socalled liquidity traps), fiscal policy was regarded as having some advantages.
28
B. The Early Keynesians
The early disciples of the new Keynesian
gospel, still haunted by memories of the Great
Depression, frequently tended to outdo Keynes'
pessimism about potential instability. Concern
with liquidity traps fostered the view that the
demand for money was highly interest elastic;
failure to distinguish between the short- and
long-run marginal propensity to save led to
overestimating the long-run saving rate, thereby
fostering concern with stagnation, and to
underestimating the short-run propensity,
thereby exaggerating the short-run multiplier.
Interest rates were supposed to affect, at
best, the demand for long-lived fixed investments, and the interest elasticity was deemed
to be low. Thus, shocks were believed to produce a large response. Finally, investment
demand was seen as capriciously controlled by
"animal spirits," thus providing an important
source of shocks. All this justified calling for
very active stabilization 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.
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 (e.g. Edmund
Phelps et ai, 1970). 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 developed 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
Keynesian 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 associated with a different
rate of inflation (and requiring, presumably,
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 unemployment 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 long run growth of money.
But at the practical level it did not lessen
the case for counteracting lasting demand
disturbances through stabilization policies
rather than by relying on the slow process
of wage adjustment to do the job, at the
cost of protracted unemployment and instability of price. Indeed, the realm of stabilization policies appeared to expand in the
sense that the stabilization authority had the
power of choosing the unemployment rate
around which employment was to be stabilized,
though it then had to accept the associated
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 expenditures and the balanced budget
multiplier, and the first attempts at estimating
the critical parameters through econometric
techniques and models. 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 G.
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
29
inflation. Finally, the dependence of wage
changes also on past inflation forced recognition of a distinction between the shortand the long-run Phillips curve, the latter
exhibiting the long-run 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 "enjoy-it-now,
pay-later" policies, and even resulted in an
entertaining literature on the political business
cycle and how to stay in the saddle by
riding the Phillips curve (see, e.g. Ray Fair,
William Nordhaus).
II. The Monetarists' Attack
A. The Stabilizing Power of 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 stabilizing 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 feIt 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 responsiveness of the demand for money, and
hence of velocity, to interest rates, far from
being unmanageably 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 aggregate demand was large
and by no means limited to the traditional
fixed investments but quite pervasive. The
difficulty of detecting it empirically resulted
from focusing on a narrow range of measured
market rates and from the fact that while
the aggregate could be counted on to respond,
the response of individual components might
not be stable. Finally, Friedman's celebrated
contribution to the theory of the consumption
function (1957) (and my own work on the life
cycle hypothesis with Brumberg and others,
reviewed in Modigliani, 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 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 instability of the
economy, which was anyway proving moderate
as the postwar period unfolded, was most
likely the result of the unstable growth of
money, be it due to misguided endeavors 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 of Wage 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 appearances, wages were in reality
perfectly flexible 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 between, price changes
and unexpected price changes.
30
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
current 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. Thus, output
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 employment can only be temporary, as
expectations must soon catch up with the
facts, at least in the absence of new shocks.
The very same mechanism works in the case
of an increase in demand, 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 inflation, employment or unemployment, and past
inflation - provided the latter variable is
interpreted as a reasonable proxy for expected
inflation. But it turns the standard explanation on its head: instead of (excess) employment causing inflation, it is (the unexpected
component of) the nite of inflation that causes
excess 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 relation 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. Similarly, the fact that Full Employment was a razor edge provided new support
for the claim that stabilization policies were
bound to prove destabilizing.
C. The Macro Rational Expectations
Revolution
But the death blow to the already badly
battered Keynesian position was to come only
shortly thereafter by incorporating into
Friedman's model the so-called rational expectation hypothesis, or REH. Put very roughly,
this hypothesis, 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 provided by past history.
It is a fundamental and fruitful contribution
that has already found many important applications, e.g., in connection with speculative
markets, and as a basis for some thoughtful
criticism by Robert Lucas (1976) of certain
features of econometric models. What I am
concerned with here is only its application to
macro-economics, or MREH, 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 rational expectations, which turns out to
have a number of remarkable implications:
i) errors of price expectations, which are the
only source of departure from the natural
rate, 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 inconsistent with rational
expectations; ii) any attempts to stabilize the
economy by means of stated monetary or
fiscal rules are bound to be totally ineffective because their effect will be fully dis31
counted in rational expectations; iii) nor can
the government successfully pursue ad hoc
measures to offset shocks. The private sector
is already taking care of any anticipated
shock; therefore government policy could conceivably help only if the government information 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 are clearly remarkable conclusions,
and a major rediscovery - for it had all
been said 40 years ago by Keynes in a wellknown passage of the General Theory:
"If, indeed, labour were always in a
position to take action (and were to do so),
whenever there was less than full employment,
to reduce its money demands by concerted
action to whatever point was required to make
money so abundant relatively to the wageunit that the rate of interest would fall to
a level compatible with full employment, we
should, in effect, have monetary management
by the Trade Unions, aimed at full employment, instead of by the banking system." [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 of 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 between the model as such and a
specific implication of that model, namely
that the long-run Phillips curve is vertical,
or, in substance, that, in the long run, money
is neutral. That conclusion, by now, does
not meet serious objection from non-Monetarists, at least as a first approximation.
But the proposition that other things equal,
and given time enough, the economy will
eventually adjust to any indefinitely maintained stock of money, or nth derivative
thereof, can be derived from a variety of
models and, in any event, is of very little
practical relevance, as I will argue below.
What is unacceptable, because inconsistent
with both micro and macro evidence, is the
specific Monetarist model set out above and
its implication that all unemployment is a
voluntary, fleeting response to transitory misperceptions.
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 Friedman has called attention to
the omission from MREH of an explicit
learning model, and has suggested that, as
a result, it can only be interpreted 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 nill. At the
institutional level, Stanley Fischer has shown
that the mere recognition of long term
contracts is sufficient 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
unemPloyment from the natural rate would be
small and transitory - in which case the
General Theory would not have been written
and neither would this paper. Sargent (1976)
has attempted to remedy this fatal flaw by
hypothesizing that the persistent and large
fluctuations in unemployment reflect merely
corresponding swings in the natural rate
itself. In other words, what happened to the
32
u.s. 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 nonMonetarist persuasion,. are quite ready yet. to
turn over the field of economic fluctuations
to the social psychologist!
Equally serious objections apply to Friedman's modeling of the commodity market as
a perfectly competitive one - so that the real
wage rate is continuously equated to the shortrun 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 numerous that only a few of
the major ones can be mentioned here.
Friedman's view of unemployment as a voluntary 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
significantly positive slope - but cannot
readily account for changes in unemployment.
Furthermore, cannot be reconciled with the
well known fact that rising unemployment is
accompanied .by a faB, not by a rise in
quits, nor with the role played by temporary
lay-offs to which Feldstein has recently called
attention. Again, his competitive 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 T. Dunlop showed
that this conclusion 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 U.S.
and Canada. Similar tests of my own, using
quarterly data, provide striking. confirmation
that for the last two decades from the end
of the Korean war until 1973, the association
of trend adjusted re<:l.l compensations of the
private nonfarm sector with either employment .or the change in nominal compensation
is prevailingly positive and very significantly
so.l
This evidence can, instead, be accounted
for by theoligopolistic pricing model according to which .price is determined by
long-run. minimum average . cost ·upto ·a
mark-up reflecting entry preventingconsiderations(cf. Modigliani, 1958). - coupled with
some lags in the adjustment of prices to
costs. This model implies that firms respond
to a change in <demand by endeavoring 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 lay-offs
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
critical 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 "non-inflationary rate" (Modigliani and Lucas Papademos, 1975), wages and
prices will tend to accelerate. If, on the other
hand, jobs fall below, and unemployment rises
above, the non-inflationary rate, firms finding
that vacancies are 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 acceleration when too many
jobs are bidding for too few people. The main
reason is the non-homogeneity 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 inter33
non-inflationary 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 U.S.
at least from 1965 to mid 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 ·lllid 1970 to early 1973, or from late
1974 to date was equally sluggish.
B. The Power of 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
response to demand shocks is small and short
lived, thanks to the power of the Hicksian
mechanism. Here it must be acknowledged
that everyone of the Monetarists' criticisms
of early, simple-minded Keynesianism has
proved in considerable measure correct.
With regard to the interest elasticity of
demand 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 (e.g., Stephen M. Goldfeld) are largely
consistent with this prediction (at least until
1975!). Similarly, the dependence of consumption on long run, or life cycle, income and
on wealth, together with 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
empirical work, reflected in part in econometric models, have largely vindicated the
Monetarist contention that interest effects on
demand are pervasive and substantial. Thus,
in the construction and estimation of the MITPenn-Social Science Research Council (MPS)
econometric model of the U.S., we found
evidence of effects, at least modest, on nearly
every component of aggregate demand. One
changeable with the unemployed, and in
contrast with them, are concerned with protecting 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 reducing wages to generate enough quits, but by firing or, when
possible, by lay-offs which insure access to a
trained labor force when demand recovers.
More generally, the inducement to reduce
relative wages to eliminate the excess supply
is moderated by the effect that such a reduction would have on quits and costly turnover,
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 reasons which have been elaborated
by the literature on implicit contracts (cf.
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 economy
like the U.S. where there are no overpowering
centralized unions - that tendency 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 muddied, I hope that
we will never have the opportunity for a
second, dean experiment.
In any event, what is really important for
practical purposes is not the long-run equilibrium 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
34
year the shock has been fully offset (thereafter output oscillates around zero in a damped
fashion). Money income,· on the other hand,
reaches a peak of over two-and-one-half,and
thenouly by the middle of the second year.
It declines thereafter, and tends eventually
to oscillate around a positive value because
normally· 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
support the view of a highly unstable economy
in which fiscal policy has powerful and everlasting effects. But neither do they support the
Monetarist 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 countered 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 authors at the Federal Reserve Bank of
St. Louis (Leonall C. Andersen, Keith M.
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, anyone 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}and
of high-employment federal expenditure as
measures 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 implied a not un-
response to money supply changes that is
especially important in the MPS, 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 U.S., the Hicksianmechanism 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
gradually toward .eliminating largely, if not
totally, any effect on employment. But in the
view of non-Monetarists, the evidence overwhelmingly supports the conclusion that the
interim response is still of significant magnitude and of considerable 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 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 gradual.
Furthermore, while this response is building
up, multiplier and accelerator mechanisms
work toward amplifying the shock. Finally,
the classical 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 inferences are supported by simulations with econometric models like the MPS.
Isolating, first, the working of the Hicksian
mechanism by holding prices constant, we
find that a one-percent demand shock, say
a rise in real exports, produces an impact
effect on aggregate output which is barely
more than one percent, rises to a peak of
only about two percent a year later, and then
declines slowly toward a level somewhat
over one-and-one-half percent.
Taking into account the wage-price mechanism 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
35
reasonable effect of the order of magnitude
of the velocity of circulation, though somewhat
higher. On the other hand, the estimated
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 quarter 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 outlays with
a variable that might be deemed more suitable,
like government expenditure on goods and
services, plus exports.
These results must be acknowledged as
disturbing for non-Monetarists, for there is
little question that movements in government
purchases and exports are a major source of
demand disturbances; if econometric model
estimates of 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 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 U.S., it has been of the order of
one-half to two-thirds), then the St. Louis
reduced form method yields highly unstable
and unreliable 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 a forthcoming MIT
thesis. He shows, in the first place, that
different methods of estimation yield widely
different .estimates, including many which
4:learly overstate the expenditure, and understate the money multipliers. 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
generated 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 estimation is in level form
(F is less than one) and is still not significant
at the five-percent level, when in first
differences.
This test resolves the puzzle by showing
that there really is no puzzle: the two alternative estimates 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, without 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
estim.ates - at least for a while. Suppose
the 81. Louis estimates of the expenditure
multiplier are closer to God's truth than the
estimates derived through econometric models.
Then it should be the case that if one uses
their coefficients 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 variable are set equal to
36
just two exogenous variables are very unreliable for. the purpose of estimating structure,
nor are they Particularly accurate for fore~
casting, though per dollar of research expenditure tbeyare surprisingly 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,
ratber than.trying to estimate them by their
unreliable method.
From the theory and evidence reviewed, we
must tben 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 exposed to many significant
shocks, coming from such things as war and
peace, and other large changes in government
expenditure, foreign trade, agriculture, technological progress, population shifts and what
not. The clearest evidence on the importance
of such shocks is provided by our postwar
record with its six recessions.
those obtainedJrom econometric models.
I have carried· out this test, comparing a
reduced form equation fitted to the period
originally used at St. Louis, terminating in
1969 {but reestimated •with •. the ·.Iatest. revised
data) with an equation in which thecoefficients of government expenditure plus exports were constrained to be those estimated
from .the· MPS,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
turmoil, both equations perform miserably,
though even here the MPS coefficients 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, reduced form equations relying on
IV. Tile Record of Stabilization Policies: Stabilizing or Destabilizing
to measure stability in terms of percentage
deviations 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 beginning in the first quarter
of 1971 (cf. Modigliani and Papademos,
1976). During this period, the average growth
was quite large, some seven percent, but
it was relatively smooth, generally well
within the six-to eight-percent band. The
average deviation from the mean is about .75
percent. The other such period lasted. from
theheginning 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 two percent; but again, most fourquarter changes fell well within a band of
A. Was Postwar Instability Due to Unstable
Money Growth?
At this point, of course, Monetarists will
object 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 three
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 economy fared. Combing
through our post Korean war history, I have
been able to find just two stretches of several
years in which the growth of the money
stock was· relatively stable, whether one chooses
37
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, e.g., by smoothing Federal
government expenditures, we found, as did
Otto Eckstein in an earlier experiment, that a
stable money growth of three 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 of 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 nonetheless eschew such policies. They claim, first, that allowing for unpredictably 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 policies
or be politically willing to provide timely
enforcement. Thus, in practice, stabilization
policies wi!l 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 destabilizing 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 explosive inflation or
deflation. By contrast, with a constant money
supply policy, the economy will automatically
two percentage points, and the average deviation is again .7. By contrast, during the
remaining 13-year stretch from mid-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 percentage 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 contraction of 1958, the
sharpest in postwar history except for the
present one. The variability of output is again
50 percent larger than in the middle period.
To be sure, in the recent episode serious
exogenous shocks played a major role in the
development of prices and possibly output,
although the same is not so readily apparent
for the period 1953 to 1958. But, in any
event, such extenuating circumstances are
quite irrelevant to my point; for I am not
suggesting that the stability of money was the
major cause of economic instability - or at
any rate, not yet!! All I am arguing is that
i) there is no basis for the Monetarists'
suggestion 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
38
ists think the answer is negative and suggest,
as we have seen, that misguided attempts· at
stabilization, especially through monetary
policies, are responsible for much of the
observed instability. The mainpieceofevidence in support of this contention is· the
GreatDepression, an episode well documented
through the painstaking work of Friedman
and Anna Schwartz, .although still the object
of dispute (see, e.g. 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
comprehensive stabilization program in the
post Keynesian sense.
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
assumption 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 forseeable shifts in the warranted
range, as well as in the light of emerging
evidence that the current target is not consistent
with price stability. It is precisely for this
reason that I, as weB as many other nonMonetarists, would side with Monetarists in
strenuous opposition to recent proposals for a
target unemployment rate rigidly fixed by
statute (although there is nothing wrong with
Congress committing itself and the country
to work toward the eventual achievement of
some target unemployment rate through
structural changes rather than aggregate
demand policies).
Clearly, even the continuous updating of
targets cannot guarantee that errors can be
avoided altogether or even that they will be
promptly recognized; and while errors persist,
they will result in some inflationary (or
deflationary) pressures. But the growing inflation to which Friedman refers is, to repeat,
a crawl not a gallop. One may usefully
recall in this connection the experience of
1965-70 referred to earlier, with the further
remark that the existence of excess employment was quite generally recognized at the
time,and failure to eliminate it resulted overwhelmingly from political considerations 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? Monetar-
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 developing 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 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
proposed 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 U.S., except that
they apply their test to a cross section of
industrialized 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
for a given country, such as suggested by my
U.S. test, does 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 variability of income
reflects differences in the character of the
39
shocks - a most likely circumstance for their
sample - successful stabilization also implies
a positive correlation between the variability
of income and that of money.
But though the search for unambiguous
quantitative 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." [po 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 inter-
national conference held in 1967 on the subject,
"Is the business cycle obsolete?" (see Martin
Bronfenbrenner, editor). No one seemed to
question the greater postwar stability of all
W~stern •economies 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 of growth rather than in the level
of output.
!twas recognized that the reduced severity
of fluctuations might in part reflect structural
changes in the economy and the effect of
stronger built-in stabilizers, inspired, of course,
by the Keynesian analysis. Furthermore, the
greater stability in the U.S., and in other
industrialized countries, are obviously not independent 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
of Commission or Omission?
In pointing out our relative postwar stability
and the qualified success of stabilization policies, I have carefully defined the postwar
period as ending somewhere in 1973. What
has happened 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
indictments of recent monetary policy: the
virulent explosion that raised the four-quarter
rate of inflation from about 4 percent in
1972 to 6Y2 by the third quarter of 1973,
to n Y2 in 1974, with a peak quarterly rate
of 13 Y2, can in no way be traced to an excessive' or 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 assumption
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 il1dicated above, the growth of money was
reasonably smooth over this period, smoother
than at any other time in the postwar period,
staying within a two-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 catas40
trophe 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 accommodate, to an adequate extent, the exogenous
inflationary shock due to oil, by letting the
money supply growth exceed the 6-percent
rate announced at the beginning of the year.
And this despite repeated warnings about that
unavoidable result (e.g., Modigliani, 1974).
Monetarists have suggested that the sharp
recession was not the result of too slow a
monetary 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 of 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 the growth fell to
.6 percent. But, by then, the violent 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 are
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
41
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 riot 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 problem. In particular, in the case of demand shocks, there
exists, in principle, an ideal policy which avoids
all social costs, namely to offset completely
the shock thus, at the same time, stabilizing
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, 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 exogenous shock completely, then the
initial burst, even if activated by an entirely
transient rise in some prices, such as a once
and •for all deterioration in the terms of
trade, will give rise to further increases, as
nominal wages rise in a vain attempt 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
equilibrium employment and inflation.
There are, of course, in principle, policies
other than aggregate demand management to
which we might turn, and which are 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 stabilization. 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 feasible paths of inflation and associated paths of unemployment,
and the best the macroeconomist can offer
is policies designed to approximate the chosen
path.
In light of the above, we may ask: is it
conceivable that a constant rate of growth
of the money supply will provide a satisfactory
response 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
continuation of the six-percent or so rate of
growth through 1974, 1975 and 1976.
Their reasoning seems to go along the
following 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 percent. If
the Central Bank, by accommodating this
price rise, keeps employment at the natural
rate, the new rate of 10 percent will also
be maintained and will in fact continue forever, as long as the money supply accommodates it. The only way to eliminate inflation
is to increase unemployment enough, above
the natural rate and for a long enough time,
so that the cumulated reduction 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
because, 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 immediately 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 suspect, to
any other conceivable illness, indisposition or
disorder.
D. Why Constant Money Growth Cannot
Be the Answer
This reasoning is admirably simple and
elegant, 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 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 original level but will instead remain above
it as long as is necessary to generate enough
deflation to offset the earlier cumulated inflation. I doubt 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
society should shoulder entirely whatever cost
is necessary to insure this result. But if, as
seems to be fairly universally agreed, the social
42
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 constant. Between tne
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'
argument is that· it implies a rather special
preference function that depends only on
cumulated unemployment. 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
miracle - or some sleight of the invisible
hand!
Actually, there is ground 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 famous
"economic discomfort index." That index
(which according to Michael Lovell appears
to have some empirical support) is the sum
of unemployment 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
forthcoming 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. C\.irye 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 a joint paper with Papademos (1975),
which is fairly close to vertical, and uses
Okun's weights, one finds that i) at the present
time, the non-inflationary rate of unemployment corresponding to a 2-percent rate of
inflation can be estimated at 5.6 percent, and
ii) the optimal response 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 2Y2
(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 unemployment
rate becomes just over 8, though the path to
final equilibrium is then shorter. These results
seem intuitively sensible and quantitatively
reasonable, providing further justification 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 system, regardless of the relative
weights attached to unemployment and inflation. It would tend 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.
43
VI. Conclusion
To summarize, the Monetarists have made
a valid and most valuable contribution in
establishing that our economy is far less
unstable than the early Keynesians pictured
it and in rehabilitating the role of money
as a determinant of aggregate demand. They
are wrong, however, in going as far as
asserting that the economy is sufficiently
shock-proof that stabilization policies 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 increased stability just does not stand up
to an impartial examination of the postwar
record of the U.S. and other industrialized
countries. Up to 1974, these policies have
helped to keep the economy reasonably stable
by historical standards, even though one can
certainly point to some occasional failures.
The serious deterioration in economic stability 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 growth
prescription.
We must, therefore, categorically reject the
Monetarist appeal to turn back the clock 40
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.
Footnotes
IThus, in a logarithmic regression of private nonfarm
hourly compensation deflated by the private nonfarm
deflatM on output per man-hour, time, and private nonfarm employment, after correcting for first-order serial
correlation, the latter variable has a coefficient of .17
and a I-ratio of 5. Similar though less significant results
were found for manufacturing. If employment is replaced
by the change in nominal compensation, its coefficient
is .40 with a I-ratio of 6.5. Finally, if the change in
compensation is replaced by the change in price, despite
the negative bias from error of measurement of price,
the coefficient of this variable is only -.09 with an
entirely insignificant I-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 demand. As
a result of the shock, prices, and to some extent wages,
rose rapidly while employment and real wages fell.
Thus, the addition of the last two years tends to increase
spuriously the positive association between real wages and
employment, and to decrease that between real wages
and the change in nominal wages or prices.
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).
3Friedman's logical argument against stabilization policies and in favor of a constant money growth rule is,
I submit, 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 himself 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 make a wrong turn and, before he
notices he will be going further and further away from
his destination and pretty soon he may end up in
Alaska, where he will surely catch pneumonia and he
may never get to New Orleans!
44
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