[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
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
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
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.