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Money and Economic Development
The Horowitz Lectures of 1972
Milton Friedman

SECOND LECTURE: Monetary Policy in Developing Countries


Chairman: Are there any questions from the audience not having to do with hints at how to evade....

Question whether a “trotting” peg as in Brazil would not be a way to limit the harm done by “evil” government.

Answer: Let me say first, that I don’t think governments are evil. Not at all. Governments do a great deal of harm, which is a very different thing. The people who run governments are generally decent people who are trying to do their best, but they have an impossible assignment. I don’t for a moment in any way want to impugn the personal character or personal motives of any of the people involved.

The Brazilian system is certainly an improvement over a system in which you keep the exchange rate pegged for long stretches of time. But I do not believe that there is any incompatibility between the existence of a government and of a central bank on the one hand, and freely floating exchange rates on the other. You don’t have to have the Brazilian system. The Brazilian system seems to me better than no attempt to change the exchange rate, but less good than an exchange rate that changes more rapidly. I have never been in Brazil but I have been in Korea for one day, which makes me an expert, and Korea also had a system very similar to Brazil’s. They justified it on the grounds that their commercial and financial markets were so poorly developed that they couldn’t expect an effective market rate to prevail. That’s not true for Israel.

Canada is a good example of a highly developed country that has a central bank, that has a government, and that for most of the last twenty years has had a freely floating exchange rate. So there’s no reason why Israel could not have one. Indeed, you do have a freely floating exchange rate. What are you kidding yourselves about? The only question is whether you have it in the open or whether you have it under the table. Surely it’s better to have it in the open!

Question expressing disagreement with the statement in the lecture that something like a 15 or 20 per cent annual rate of monetary growth would be consistent with stable prices on the grounds that velocity had not been declining in Israel.

Answer: I haven’t studied the detailed data for Israel in this period, so it may well be that my number is wrong. I didn’t mean to state that number as a definitive judgment on the appropriate rate of monetary growth for price stability. Let me take a different example for a moment.

I have looked in much greater detail into the data for Japan. Japan is a country that at the moment is on roughly the same economic level per capita as Israel. Like Israel it has been having a very rapid development for the past 10 to 15 years. For Japan, I have a good deal of confidence that a number like 20 per cent is right, because it is perfectly clear that during the period when they had relatively stable prices, velocity was declining fairly sharply.

It may be that that is not the case for Israel, and before a policy is adopted, one should of course examine the evidence carefully. However, there remains the question of whether the period you are speaking of is not a period in which the rate of inflation accelerated. If it was, the relatively stable velocity may conceal a tendency for velocity at stable prices to decline. You may be right—as I say, I haven’t studied those data and I don’t really want to offer any firm judgment.

Question on same general issue.

Prof. Friedman: Mr. Horowitz was saying that the actual rate of monetary growth in Israel has been considerably less than the 15 to 20 per cent mentioned for much of the period when you did have inflation. That would certainly suggest that my figure may well be an over-estimate. There’s a further problem of making sure that you define your money supply correctly. It’s a shame that so much of the ingenuity of the Jewish people in Israel has gone into devising the most complicated banking regulations in the world. As I understand it, the reserve requirements against deposits, the kind of interest rates that can be paid and so on, have much of the time been very elaborate and subject to frequent change. As a result, it is not clear that the usual monetary stock figures have a consistent meaning. In many ways, it may well be better for Israel to look at what happens to currency alone, rather than at currency plus deposits, whose precise meaning changes very rapidly over time.

Chairman: I have a question. I’d like to proceed with that comment—I wish the tape were off. To correct the last point you made—I think it is not correct that Israel really has a fluctuating exchange rate. It is common knowledge, although it may not be true, that the Bank of Israel frequently pegs the rate on Lilienblum Street, so that’s not necessarily a completely free rate.

Prof. Friedman: I wasn’t referring to Lilienblum Street at all. I was referring to my understanding that the standard life history of an exchange episode in Israel is that you have a devaluation, that the devaluation is accompanied by a liberalising of exchange controls and the narrowing of the multiple exchange rates, then inflation proceeds and the currency becomes over-valued, and then, in a perfectly legal manner, the multiple exchange rate system expands and special provisions are made for various groups. If I were therefore to calculate not the exchange rate that is posted on the board as the official rate but the average of the exchange rates at which dollars are in fact converted into pounds, I would find that that was a fluctuating rate.

You people in the audience know Israel far better than I do. Is what I have said an inaccurate description?

Chairman: My question was a different one. To me it wasn’t 100 per cent clear why a unified currency with a major developing country was a first step and a flexible rate a second step. The precise reason for the preference of the first over the second was not completely obvious to me. Let me state that there might, in the context of your presentation, be an argument in reverse—that is that government has more freedom under a flexible rate to use inflation as a tax, which for a country like Israel, or for an under-developed country in general, might be considered part of an advantage—you might not agree.

Prof. Friedman: Let me put aside for a moment the special problem of defence for Israel. If we postpone that and consider the problem of development, then my judgment from observing developing countries is that the less power the government has to tax the better. Government taxation tends to slow down development because it goes into the wrong kinds of programs.

The great advantage of a unified currency is that it limits the possibility of governmental intervention. The reason why I regard a floating rate as second best for such a country is because it leaves a much larger scope for governmental intervention.

In Israel, you have the special problem of defence. For that problem, it’s obvious that you have to have a very high rate of taxation. Nonetheless, it seems to me healthier for the society, both politically and economically, to face up to that problem explicitly, to have taxation be open and aboveboard, to have taxes be those that are legislated by the Knesset, rather than to have taxes imposed implicitly without legislative enactment by the rate of money creation. So even in that case I would say you should have a unified currency as the best solution, with a floating rate as a second-best solution and a pegged rate as very much worse than either.

I may say, in talking to many people around Israel about a floating rate, I have been impressed with one argument that is repeatedly offered as an argument against a floating rate yet that seems to be an argument for a floating rate. The argument that always comes up is the following. Israel, it is said, is a nation besieged. From time to time there will be great uncertainties. There might be a war. The outbreak of fears of a war would lead everybody to try to take his capital out of the country. That would be terrible. We must, it is concluded, have exchange control and a pegged rate to prevent such a development.

Let’s stop and consider that a bit more carefully. Suppose there is a rumour that there’s going to be a war and as a result widespread fear of war. Nobody can take his capital out in a physical sense. Nobody can pick up a factory that is in Israel and transport it across the border. Nobody can pick up a house and take it out. Hence, when you say that some people are trying to get capital out, you mean that some people in Israel are trying to sell pounds for dollars. How can they do it? They can do it only if they can find other people, in Israel or outside, who will accept pounds and sell them dollars. The way in which they try to persuade other people to sell them dollars is by offering a high price for the dollar. As an extreme assumption, the price of the dollar might go from 4 to 20 pounds a dollar.

Let us assume—because if we don’t, the whole issue is irrelevant—that either war does not occur or that Israel, as in the Six Day War, wins the war. When that happens, the exchange rate will return to roughly its earlier level.

Now I want you to ask yourself, who lost and who gained in this hypothetical episode? The people who sold their pounds for dollars—and hence lost—are people who had little faith in Israel. The people who bought the pounds for dollars—and hence gained—are people who had much faith in Israel. So this is an episode in which those people who have little faith in Israel lose, and those people who have much faith in Israel, gain. What is wrong with that? Why should you have an elaborate structure of exchange controls involving major economic inefficiencies and a major interference with human freedom, to prevent such an outcome?

Note that the episode I’ve described is a temporary phenomenon. The rate’s going to shoot up and it’s going to come down again. What Israel needs to bolster its strength and its ability to meet the threat of war is not a fixed exchange rate but a stock of foreign exchange. It is eminently sensible and desirable that for defence purposes the government should hold, as it now does, a substantial stock of dollars in order to be able to assure itself that it can buy munitions and other supplies outside the country in such an emergency.

So far as prices within the country are concerned, they will not be affected by the hypothetical episode I have described because those prices can only be affected as quantities are affected. What we are talking about is a situation of a temporary nature in which the price of a dollar is terms of pounds is driven up. Of course, in practise it would in fact not go up anything like the amount I envisaged because what would actually happen is that as the price of the dollar went up people would get discouraged and desist from trying to convert pounds to dollars.

I took an extreme case to show that even then flexible rates are a good thing and not a bad thing. In order for prices internally to be affected, you must have a high exchange rate persist for a long time. How can that be? If the pound price of the dollar goes up for a couple of weeks and then down again, it isn’t going to affect prices internally.

Comment that the abnormally high exchange rate would raise prices of imported goods.

Prof. Friedman: It is desirable that you should pay more for foreign goods under those circumstances, because under those circumstances it is essential that you reserve your foreign exchange for urgent purposes. There’s nothing wrong with that. Domestic prices cannot go up under those circumstances unless the government spends much more money.

Question whether I favour a multiple exchange rate system.

Prof. Friedman: Not at all. I favour a completely free exchange rate with a single rate.

Question about effect of the high exchange rate lasting for a long time.

Prof. Friedman: Of course, it will then have effects on the prices of foreign goods, and under those circumstances it is desirable that it should have those effects. But it will only stay up for a long time if there is a great demand for foreign exchange relative to domestic exchange. In that case you want to conserve your foreign change. You want to make imported goods expensive. On the other hand, the people who cite this argument always refer to the speculators as causing the exchange crisis. If it’s the speculators, it’s only going to last a week, it’s not going to last three months. Under those circumstances it will have negligible effects on the prices of imports. So you have to decide whether there is a real, underlying shortage of foreign exchange, in which case it’s desirable that the rate move, or whether you have a speculative attempt by some people to get their capital out of the country, in which case a free rate enables those who have faith in Israel to buy up the capital of those who don’t, at a cheap price.

Chairman: I think we should nominate Professor Friedman as our emissary to the next United Jewish Appeal, and with that I would like to thank you very much.


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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