[Note: Unfortunately, only the answers not the questions were fully recorded. Accordingly, the questions have not been reproduced accurately. Either their direction is suggested, or a hypothetical reconstruction attempted, partly from memory, partly from the answers. We ask the pardon and indulgence of the questioners.]

Prof. Friedman: That is a very complicated question and I won’t profess to answer it in full, but let me try to see if I can separate out some of the elements.

One part goes as follows. There are changes in the quantity of money on the side of supply. There are also changes in the demand for money. Surely, you will say, the sensible approach to monetary policy is to change the supply of money not at a steady rate but at a rate that adjusts for changes in the demand for money. For example, instead of increasing the quantity of money at 5 per cent per year every year, in a year in which the demand for money, whether through the more lengthy chain you have outlined or directly, goes tip by 5 per cent, we ought to increase the quantity of money by 10 per cent.

In analyzing that particular part of your point, it is important to distinguish between the demand for money in nominal terms and in real terms. The crucial distinction is that the holders of money determine what it will consist of as a fraction of a year’s income. The central bank cannot determine the real quantity of money. It only determines the nominal quantity. It determines the number of Israeli pounds that are outstanding. If holders of money want to hold half a year’s income in the form of money and if the central bank tries to push out more money than that, the holders of money will bid up total spending and in the process make the real quantity of money what they want it to be.

In principle, if we knew about autonomous changes in the real demand for money, it would be right to adjust the nominal supply to them. However, we don’t know about them. What we do know is something else. We know, from all our evidence, that the real demand for money has been much stabler historically than the nominal quantity of money supplied. My own conclusion is that we do best by assuming that the real demand for money is perfectly stable and hence changing the nominal supply at a steady rate rather than trying to make fine adjustment for changes in real demand. We don’t know what adjustment to make and once we start on that line we tend to be led into self-defeating adjustments for changes in the nominal rather than real demand.

The second part of your question is something else. It says that the quantity of money affects interest rates and other things which in turn may affect the GNP, which in turn may affect the quantity of money. That is perfectly correct. There is no inconsistency between saying that changes in the quantity of money affect income and saying that changes in income affect the quantity of money. Both can be simultaneously true and both are simultaneously true. What happens to money today determines what happens to income tomorrow, which determines what happens to money the day after. The clearest example is under a pure gold standard. When the U.S. increased the quantity of money in the late nineteenth century, say, this would tend to raise incomes and prices and thereby create a balance of payments deficit that would drive out gold, which in turn would force a decline in the quantity of money. It is perfectly correct that there is this reciprocal influence, but it doesn’t alter the prescription for policy because it doesn’t mean that you can never control the quantity of money. It means only that there are institutions under which you cannot and other institutions under which you can.

The third component of your question is much more complicated. What are the channels through which changes in money affect income? Your tendency to describe those channels as operating through interest rates is a manifestation of your Keynesian education! It is not a reflection on you or on Keynes. Keynes was a great man. His hypothesis was a first-rate hypothesis. One of the things that made it first-rate was that it was a hypothesis that had predictions that could be contradicted. It is the easiest thing in the world to construct a theory that no evidence can contradict, but such a theory is not useful. I am opposed to the Keynesian view not because I think it was the wrong kind of theory, but because its predictions have been contradicted, which suggests that it made the wrong simplifications.

One can describe the channels of influence as operating through the rate of interest, but to do so, one must adopt a much broader conception of rates of interest than is ordinarily adopted. Changes in the quantity of money may or may not in the first instance affect the rate of interest. The crucial distinction here is between what you might call the first-round effect and the ultimate effect of a change of the quantity of money. Let us go back to 1848 in the United States when the quantity of money was increased by the great discoveries of gold. The additional gold didn’t go into loanable funds in the first instance and so may have had no direct influence on the rate of interest at all. What happened was that people had gold nuggets in their pockets and went out and spent it on everything. They spent it on clothes, hats, shoes, and whatnot. On the other hand, if the quantity of money is increased, as it mostly is under current institutions, by central bank operations in the credit market, it will in the first instance affect rates of interest. But that is only the first effect. The more important effect is that all through the economy people will discover that they have higher cash balances than they desire and they will seek to spend them in all sorts of ways and not only on what we ordinarily call investments.

You have raised a very complicated issue, and I have just touched on some of the points you raised.

Question: What monetary policy do you think the Nixon Administration could be expected to follow in 1972?

Prof. Friedman: Recent movements in the quantity of money consist of a very rapid explosion in the first seven months of 1971, zero rate of growth in the last five months of 1971, another explosion in the early months of 1972. When you ask what I expect the Nixon Administration to do about monetary policy, I must note that we have an independent Federal Reserve System. I agree with your smiles—throughout the world, in every country, whenever the independent central bank is different from the finance ministry, or its equivalent, it has almost invariably been the Finance Minister who has won. That is one of the reasons why I have never been in favour of an independent central bank! However, in the U.S. there is a real measure of independence especially over short periods, and policy during the coming months will depend primarily on the Fed’s attitudes and desires and only secondarily on the Administration’s.

A full analysis of recent and current monetary policy would be a subject for another evening. So I am not really going to give you an answer. If I had to guess, I would not be surprised to see a pattern for 1972 not dissimilar to that for 1971.

Question: Has there not been a reaction against monetary policy because the Nixon Administration’s monetary policies failed?

Prof. Friedman: It is a reaction against the bad use of monetary policy in the early years of the Administration. You must distinguish between the slogans, the descriptions that were given of the policy, and the actual policy followed. There was a great deal of talk—very good talk and the right kind of talk—about the adoption of a gradualist policy. But a gradualist policy was not in fact followed. You did not in fact have a period of two or three years of steady growth in the quantity of money that produced bad results which in turn led to a reaction. On the contrary, the actual course of monetary policy was that the Federal Reserve stepped too hard on the monetary brakes in 1969, and too hard on the accelerator in the first part of 1971, and too hard on the brake in late 1971. The year 1970 is the only year for which monetary policy conformed largely to the gradualist prescription. Except for that, in 1969, it went too far one way, in the early part of 1971, too far the other way, in the last part of 1971, again too far. So I believe it is not correct to say that there was a gradualist monetary policy which was disappointing.

Question: Was not the introduction of price and wage controls on August 15, 1971, made necessary by the failure of the gradualist policies?

Prof. Friedman: Let’s get the facts straight. First of all, the monetary policy was not in accordance with prescription, but in the second place it is very questionable whether things went wrong. I think things went very well. There is no way of stopping an inflation without causing a recession. No country has ever done it. The one great mistake which I thought at the time that the Nixon Administration made in 1969 was to overpromise, was to say that we are going to stop the inflation without a recession. Nobody knows how to do it. What happened in fact was that we had a recession in 1970 but it was the mildest recession in post-war history. It came to an end at the end of 1970. In 1971, we were having a recovery. At the same time the rate of inflation was tapering off. The rate of rise of the cost of living reached a peak in the United States of over 6 per cent per year in early 1970. By the middle of 1971, consumer prices were rising at 4 per cent per year—that was still too high but it was a decided improvement.

So the actual course of events was on the whole very good. However, anybody who is out of power has an understandable and desirable interest in showing how bad things are. And the American people were persuaded in the middle of 1971 against the face of the evidence, that we were in a state of crisis, that no progress is being made against unemployment and no progress is being made against inflation, neither of which was true in fact.

Question by Prof. M. Michaeli about the time lags for an economy which usually has an actual product not below potential product, which has a sort of continuous inflation but at a changing rate. He also added a comment about the charts.

Prof. Friedman: I am not sure all of you could hear the question so let me restate the question. The question was: I presented estimates that there was a lag of about six to nine months between the rate of change of money and the rate of change of output and a much longer lag between the rate of change of money and the rate of change of prices. Now, the evidence for that, says Prof. Michaeli, is mostly derived from the United States where there have been substantial fluctuations in the rate of growth of real output. Do the same conclusions hold for a country which has been in a state of perpetual full employment or roughly full employment. In such a country, says he, will you not find that there will be no lag, or no relationship with real output and that the effect on prices will show up much more rapidly?

First, the six to nine months lag is not derived solely from the United States. It holds just as well for Japan which is certainly a country which has been having a very high rate of real growth and which would fit his description. I believe that people are wrong in supposing that there is a rigid ceiling on output such that further increases in real output are impossible once you hit the ceiling. That isn’t the case. It is possible to have overemployment as well as underemployment; have fluctuations in the rate of overemployment as well as in the rate of underemployment. I know the facts for Japan, as it happens, much better than I do for Israel, and I know that in Japan the rates of growth of real output have varied from something like 11 or 12 per cent a year to 4 or 5 per cent a year. That is as wide a range as has been observed in the United States in the post-war period and the time lag is the same in Japan as in the United States.

So I doubt that there is any country that satisfies Prof. Michaeli’s description. In all the countries he is referring to, I believe that a closer examination of the movements of real output will reveal cycles if the rate of monetary growth has had cycles. Whenever monetary growth is highly variable, real output growth is highly variable; whenever monetary growth is stable, real output growth is stable.

The Israeli economy has shown considerable fluctuations in the rate of real output growth. If you continue to have wide fluctuations in the rate of monetary growth, you will continue to show considerable fluctuations in the rate of real output growth with a lag of about six to nine months between the two.

On the inflation side, that is a more complicated question, because it does seem clear that the lag is much shorter for countries that have experienced widely varying rates of inflation than for countries that have not. The evidence for countries like Chile or Argentina or Brazil or Korea, reveals a much shorter lag between rates of monetary growth and rates of price growth than for a country like the United States which has had little fluctuation in prices.

The comment that Prof. Michaeli made was that he judged from the charts that the relation between money and income had been relatively weaker in the 1950s, much tighter during the 1960s, much weaker during the 1970s so far. And he wondered whether there might be a relation between the changing correlation and the lack of importance attributed to monetarism in the 1950s, the growing importance in the 1960s, and his prediction of declining importance during the 1970s.

It is true that for a period in the 1960s there was an abnormally close relation between money and income. Indeed I have myself tended in the past few years to stress that one shouldn’t overstate the case for monetarism. In that sense I agree with him that there was a tendency at the end of the 1960s for the pendulum to swing too far, for people to put too much emphasis on the closeness of the relation between money and income. But I do not agree that there has been a breakdown in the statistical relation in the 1970s. It has continued to prevail in roughly the same form as it did before in the U.S., if you allow for particular disturbing events, particularly the GM strike which did produce a sharp divergence for a quarter or two, the U.S. threat of a steel strike and its aftermath, and the wage-price freeze.

Questioner commented that his impression was that the lag between monetary change and changes in prices was very short in Israel.

Prof. Friedman: That is perfectly consistent with my analysis, because Israel is a country in which the rate of inflation has varied very widely and has been relatively high. Therefore people are very sensitive to it. The crucial thing is what happens to people’s expectations. You know, people have a misconception about economic history. They think all of history is a history of inflation. That is not true. In both the United States and in Great Britain, prices in 1939 were no higher than they had been a century earlier. The U.S. price level today is higher than it was right after the Revolution, only because of what happened during and since World War II.

If now you have a country like the United States in which people have come to expect over a long period of time that the price level is not going to move very sharply one way or the other, it is understandable that they are slow to react. On the other hand, in a country which has had a different experience and in which people are accustomed to observing the rate of price inflation go up sharply or down sharply, expectations will adjust much more rapidly. All studies of hyper inflation show a very short lag in hyper inflations between rates in change in money and rate of change in inflation, much shorter than you get in the United States. I am interested in your remark for Israel.

Question asking for elaboration of reason for long lag in the U.S.

Prof. Friedman: I am saying that the reason why prices are slow to adjust in the United States is because two elements enter into price determination: relative price considerations and considerations about what is going to happen to the price level in general. In a country in which the price level in general has tended to be stable, people will react primarily to forces affecting the individual industry or product, and they will react by regarding an increase in demand as an increase in real demand and one which they should meet by expanding output. It is only gradually that they will realize that there hasn’t been an increase in real demand, that there has been an increase in nominal money demand, and that sooner or later this increase is going to be reflected in prices elsewhere. When they do come to this realization, they will start marking up their prices in accordance with what they expect to happen to prices in general. In a country in which people have experienced wide changes in prices in general, this process will go much faster.

Chairman: I want to thank Prof. Friedman for his very interesting lecture and good night.

NOTES: