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Money and Economic Development
The Horowitz Lectures of 1972
Milton Friedman

SECOND LECTURE: Monetary Policy in Developing Countries

Development Without Inflation

These considerations make it worth contemplating the possibility of refraining from using inflation as a method of taxation. So I want to talk a little about what is, in the present state of opinion in most of the world, an extremely hypothetical possibility, namely, the possibility that a government will deliberately refrain from inflation and will try to develop without inflation.

Though this is highly unrealistic, contemplating it serves a useful intellectual purpose by providing a standard with which we can compare current practice. It thereby will give us a greater degree of perspective.

The surest way to refrain from using inflation as a deliberate method of taxation is to unify the country’s currency with the currency of some other country or countries. In this case, the country in question would not have a monetary policy of its own. It would, as it were, tie its monetary policy to the kite of the monetary policy of another country, preferably a more developed, larger and relatively stable country.

Hong Kong is an obvious example. It has no central bank, no independent monetary policy. It has a currency closely linked to the British pound sterling. Through a Currency Board, printing of paper currency requires the deposit of British currency in stated ratio. The quantity of deposits is then indirectly controlled by the banks by the necessity for banks to keep deposits convertible into currency.

This system which I’ve described for Hong Kong was essentially also the system used by the United States in the nineteenth century after the U.S. return to gold in 1879. Though technically the currency was linked to gold, it could equally well be described as unified with the British pound sterling. The U.S. had no central bank, it had no independent monetary policy. The quantity of money in the United States had to be whatever sum was necessary in order to keep U.S. prices in line with world prices. The policy I’ve described is also the one that was used by Japan in the period from the Meiji Restoration to World War I.

A system of this kind—a unified currency—must be sharply distinguished from a system that superficially looks the same, but is basically very different, namely, a national currency subject to national control, but linked to other countries by pegged exchange rates. For example, different states in the United States, like Illinois and New York, have a truly unified currency. Both use the same dollar. There is no central bank in Illinois, there is no central bank in New York that can interfere with the flow of funds between them. If Illinois residents buy more from New York residents than New York residents buy from Illinois, and if Illinois residents finance their balance of payments deficit by drawing down their cash balances, then, so far as this goes—neglecting all other transactions—the quantity of money goes up in New York and it goes down in Illinois. And nobody can interfere with that process, because the only way in which the citizens of Illinois can pay for their excess purchases is by transferring the money. And the number of dollars by which the quantity of money increases in New York will be dollar for dollar equal to the number by which it decreases in Illinois.

Though Hong Kong and the United Kingdom use currencies with different names, essentially the same thing is true. They too have a unified currency with a fixed rate of exchange between them.

That kind of a unified currency is very different from national currencies linked by a pegged rate, say the U.S. dollar and the Israeli pound. There is a fixed rate of exchange—4.18 pounds to the dollar—but there are also central banks in the United States and Israel that can, and do, interfere with the flow of funds.

If U.S. residents convert dollars into Israeli pounds, to finance an excess of purchases in Israel, or to make payments to or investments in Israel, the Federal Reserve System can prevent that conversion from leading to a reduction in the U.S. monetary stock, and the Bank of Israel can prevent it from leading to an increase in the Israeli monetary stock—they can “sterilise” the deficit or surplus in the jargon that has developed. Of course, they may not do so. In the past six or nine months, as I understand it, this process has led to a very rapid increase in the quantity of money in Israel because the Bank of Israel did not in fact sterilise the inflow of foreign exchange. But it could have done so, and I doubt very much that the U.S. Federal Reserve System refrained from sterlising the outflow.

As a result, the rate of exchange between Israel and the United States is a pegged not a free market price, and is subject to substantial change from time to time. A unified currency has a truly fixed exchange rate. National currencies linked by pegged rates have jumping exchange rates. When a pegged exchange rate changes, it changes by a jump, as yours jumped a few months ago.

Technically speaking, a nation could refrain from using inflation as a method of taxation without going so far as to unify its currency with other currencies. A nation that succeeded in developing and that kept its prices constant, or in line with the price level in one or more major countries, would require a larger money stock to match its growing output. If it unified its currency with other currencies, whether through an intermediary like gold or directly, the increase in the quantity of money would have to come through a surplus in the balance of payments (defined to include all interest-bearing loans but not literal money).

Instead of doing this, the country could use a national currency and increase that national currency by the requisite amount, i.e., it could use a printing press or the central bank’s bookkeeper’s pen. The amount of increase in the national currency would have to be just sufficient to avoid a balance of payments surplus without departing greatly from the assumed path of prices. The national money would simply replace the inflow of foreign money.

While such a process is technically possible, under present conditions it is highly unlikely to be followed for very long. Even if the central bank itself tried to follow such an austere, self-denying policy, political pressures are almost sure, sooner or later, to lead to irresistible demands to go further, either to stabilise the economy or to provide the government with funds.

The experience of Thailand provides a recent clear example. For many years Thailand followed the policy I have described. It had a national money, and it increased the national money just enough to keep prices in line with world prices. It had a “hard” currency. But the government in power finally realized that printing money was a fine source of revenue. An excellent Governor and Deputy-Governor of the Bank of Thailand were kicked out or kicked upstairs. The Deputy-Governor, who happened to be a very able woman, is now at the International Monetary Fund or at the World Bank, I’ve for-gotten which. New people were brought into the bank, and the bank is now departing from its former austere policy and behaving like most other central banks, which means that it is inflating the currency.

I conclude that the only effective way to refrain from using inflation as a method of taxation is to avoid having a central bank. Once a central bank is established, the die is likely to have been cast for inflation. I hasten to add that this does not imply any judgment about the vices or virtues of central bankers, only about the pressures on the central bank that are almost certain to develop.

While the use of a unified currency is today out of fashion, it has many advantages for development, as its successful use in the past, and even at present, indicates. Indeed, I suspect that the great bulk, although not all, of the success stories of development have occurred with such a monetary policy, or rather an absence of monetary policy.

Perhaps the greatest advantage of a unified currency is that it is the most effective way to maximize the freedom of individuals to engage in whatever transactions they wish. In addition, while the major countries are capable of policies that seem unwise to many of their residents and to professional economists, yet they are likely to have far stabler and less erratic policies than the smaller, newer, less-established developing countries.

As many of you know, I have myself been a strong critic of monetary policy in the United States. Yet, the inflation of the post-war period in the United States has been far less severe than the inflation in most developing countries. We have had inflation, but at the maximum, our inflation, and then only for a brief time, was in the neighborhood of 6 per cent. For most of the period it has been much lower than that. We should do still better but the standards you use must vary depending on the alternatives considered.

If it’s true that the larger country is likely to have a more stable monetary policy than the smaller one, then a unified currency is likely to reduce the possibility of unwise governmental policy.

Finally, a unified currency assures a maximum degree of integration of the country in question with the greater world.

However great these advantages may be, the brute fact is that few countries are willing to accept the discipline of a unified currency and to refrain from the expensive luxury of establishing a central bank. So I turn to the question of the desirable monetary policy, given that a central bank exists, and that money creation is going to be used as a method of government finance.


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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