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Money and Economic Development
yThe Horowitz Lectures of 1972
Milton Friedman

FIRST LECTURE: A Survey for the Evidence of Monetarism

Scholarly Work

The second body of evidence that produced a drastic change in the role assigned to money was the result of scholarly work in economic theory, monetary history, and statistical and econometric analysis.

In theory there was both negative work and positive work. Theoretical analysis raised doubts about some of the central propositions of Keynesian theory. One of the central propositions of that theory, one which had a great deal to do with gaining it adherents among non-economists, was the proposition that there was a flaw in the price system, that there was no reason to expect a freely working price system to have an equilibrium position corresponding to full employment of resources, that you could have an underemployment equilibrium. The theoretical work which raised grave doubts about that fundamental proposition is associated with the names of Gottfried Haberler, A. C. Pigou, James Tobin, and Don Patinkin.

On the positive side, there was theoretical work which produced a more sophisticated version of the quantity theory of money, and which led to an analysis on a much more subtle level of the relation between money on the one hand and income on the other.

A second strand of scholarly work was in monetary history. Here there is no doubt that the most important element was a reconsideration of what had happened during the great depression. Undoubtedly the major factor that produced the Keynesian revolution and its acceptance was the widespread belief that monetary policy had failed to prevent the great depression. Keynes himself was of course a great proponent of monetary policy before 1930. He was a quantity theorist and his book Monetary Reform, published in 1923, is an important, fundamental, and excellent work on the quantity theory of money. His Treatise on Money likewise greatly emphasized the role of monetary policy. But he was persuaded, and other scholars at the time were persuaded, that monetary policy had been tried in the great depression and found wanting, that both in Britain but particularly in the United States the central bank had tried easy money but its attempts failed to stimulate spending. This led to a widespread belief that monetary policy was like a string ‘‘you could pull on it, but you couldn’t push on it,’’ and similar aphorisms like “you can lead a horse to water but you can’t make him drink” became the small change of academic and popular discussion of the role of monetary policy.

When Anna Schwartz and I came to re-examine the experience of the Great Depression, we came to the conclusion that this view was tragically false—that far from the Great Depression being a testament to the impotence of monetary policy, it was quite the opposite—evidence of how potent monetary policy was, how important, how much harm it could do when it was wrong. We found that the quantity of money had declined by one third in the United States from 1929 to 1933 and that this decline could have been prevented at all times by policies readily available to the central bank. We concluded that if those policies had been followed, and if the decline in the quantity of money had been prevented, the Great Depression would certainly have been milder and almost as certainly would have been much shorter. This conclusion, I believe, is by now widely accepted by economists of all shades of opinion Keynesians as well as quantity theorists.

I am myself persuaded that if Keynes and others had known at the time what the facts were about the Great Depression, the whole course of development of their theoretical ideas and their policy recommendations would have been different.

Other work in the field of monetary history likewise demonstrated a clear and strong connection between changes in the quantity of money on the one hand and changes in economic activity on the other. These results were strongly reinforced by the third strand of scholarly work—statistical and econometric studies. All that I can do here is to list a few of them and outline their major results. One set of statistical studies were by Clark Warburton very early and by Anna Schwartz and myself later on, dealing with the cyclical behaviour of the quantity of money. We found that the quantity of money had a systematic cyclical behaviour: the rate of change of the quantity of money tends to rise during the early phases of an expansion, reaches its peak well before the peak in general business, then declines and reaches its trough well before the trough in general business. There thus tends to be a systematic relation between changes in the quantity of money on the one hand and changes in economic activity which has as one of its characteristic features that the rate of change of the quantity of money tends to move early in the business cycle.

These studies popularized and introduced the concept of a long and variable lag between changes in monetary growth on the one hand and changes in economic activity on the other. This again is by now a commonplace, but it has become a commonplace only as a result of these and related statistical studies.

Another set of important statistical studies were on the demand curve for money. These studies were carried out for many different countries and for many different periods. They were important because a major implicit element in the rejection of the role of money was the judgment that the demand for money was highly unstable; that the quantity of money that people wanted to keep, expressed in real terms or as a fraction of their income (velocity), was very unstable; that it had no systematic pattern. Hence, it was concluded, we need to find a much more stable relation. From this point of view, the essence of the Keynesian revolution was the substitution of a relation between consumption and income or the relation that you all know in the form of the multiplier, for the quantity theory relation as a stable and key relation that could be depended on. That is why studies on the demand function for money were so important. A whole series of them demonstrated that a relatively stable demand function for money did exist, if only allowance was made for a few important variables that affected the quantity of money people wanted to hold.

As I have already suggested, these studies dealt with the quantity of money, not in terms of pounds or dollars or marks but in terms of command over real resources, in perhaps the easiest version to comprehend, in terms of the number of weeks of income to which it was equivalent. The question is: why is it that people choose to hold an amount equal to something like four or five weeks of income in the form of currency, to something like three or four or five months of income in the form of currency plus deposits?

For countries which had experienced considerable inflation, the amount of money people wanted to hold in real terms turned out to be very importantly affected by the rate of change of prices, that is, by the extent of inflation. In periods of hyper inflation, as in Germany after World War I, the quantity of money people held was reduced to as little as the equivalent of two or three or four days’ income. In countries like Chile or Korea or Brazil, where inflation did not reach the hyper-inflation levels of 100 per cent a day reached in some periods of the German hyper-inflation, but did run at the levels of 25 to 50 per cent a year, a rate that as I understand it Israel is quickly trying to approach, real balances were not reduced to anything like the levels I have described for Germany. However, they were much lower than in countries with stable prices. More important, there was a fairly systematic functional relation between changes in the rate of inflation on the one hand and changes in real balances on the other.

For other countries, where the rate of inflation was fairly small, it had very little influence on the demand for money. In those countries the real quantity of money held tended to be fairly regularly and closely related to the level of real income on the one hand and to the level of interest rates on the other

The important result from all these studies is that they showed that a few key variables, like rate of inflation, level of real income, and interest rates, accounted for a large part of such changes as did occur in the real cash balances held by people.

A third statistical study that turned out to be important in changing opinions about the role of money was made by David Meiselman and myself some ten years ago. It compared the stability over time in the United States of the velocity of circulation of money on the one hand and the Keynesian multiplier on the other. This study, which was published by the Commission on Money and Credit, produced an enormous amount of controversy and, as those of you who are students of economics know, wasted many pages in the American Economic Review in replies, counter replies, counter-counter replies, and so on. The exact outcome of that controversy is irrelevant for the present purpose. The important point is that the effect of the controversy was to produce a drastic reconsideration of the extreme Keynesian position that money could be almost completely neglected and to lead even the most single-minded adherents of the Keynesian view to give much greater emphasis to the role of money.

Meiselman and I had concluded in our study that once account was taken of the changes in the quantity of money, nothing else was left. The velocity of money seemed very much more stable than the multiplier in almost all periods, except for a few years around the Great Depression. Our opponents questioned our conclusion but they ended up with the position that we were wrong not because we attributed importance to the quantity of money but because we attributed too little importance to autonomous expenditure. They said in effect, “You are extreme. You think only money matters. You are wrong. We admit that money does matter, but also. . . .” The part of the statement that money does matter was, I think, the major result of the controversy.

A fourth set of important statistical studies include the construction of a monetary model by the Federal Reserve Bank of St. Louis and a whole series of other studies done by that maverick institution. One virtue of decentralization is that there are many alternative channels of power. That is true in general, and in particular, one of the few virtues of the decentralized Federal Reserve System in the United States with its 12 Banks is that at least one of them saw the light. It is a fascinating phenomenon. Here is one of the less important of the Federal Reserve Banks, out in St. Louis, far from the financial centres, that has had more effect on monetary thinking and understanding than the rest of the Federal Reserve System put together. That is not merely a partisan remark but can be treated objectively. Go through any of the economic journals and count the number of footnote references to work done at the Federal Reserve Bank of St. Louis on the one hand and at the other 11 Federal Reserve Banks, plus the Federal Reserve Board on the other. I have not done that myself but I have every confidence that it will support the statement I have made.

Finally, a number of scholars returned to a theme Irving Fisher had introduced many years ago, and a theme that is very familiar to all of you here in Israel. That theme is the difference between real and nominal interest rates; the difference between an interest rate that is not adjusted for the rate of inflation and an interest rate that is; the difference between an interest rate of 18 per cent when prices are rising at 12 per cent a year, and a real interest rate of 6 per cent after allowing for that 12 per cent price rise. The studies made in the past few years on this theme have had great importance in driving home the lesson that what mattered about money was the quantity of money and not interest rates—that interest rates could be a highly deceptive indicator of monetary policy.


1. Nominal income is net national product; money is currency outside commercial banks plus all deposits (time and demand) of the public at commercial banks.
2. Each rate of change is computed as the slope of a least squares straight line between the natural logarithm of the variable (income or money) and time fitted to three successive phase averages.
3. This summary is adapted from Milton Friedman, The Counter-Revolution in Monetary Theory, Occasional Paper 33 (London: Institute of Economic Affairs, 1970), pp. 22-26.
4. See my "The Optimum Quantity of Money" in The Optimum Quantity of Money and Other Essays (Chicago: Aldine Publishing Co. 1969).
5. "Government Revenue from Inflation, "Journal of Political Economy, Vol. 79 (July/August, 1971), 846-856.

Reprinted from Money and Economic Development The Horowitz Lectures 1972 by Milton Friedman, copyright © 1973

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