Seven Fallacies Concerning Milton Friedman's “The Role of Monetary Policy”

• Published date: 01 February 2020
• Author: EDWARD NELSON
• Date: 01 February 2020
• DOI: http://doi.org/10.1111/jmcb.12591

DOI: 10.1111/jmcb.12591

EDWARD NELSON

Seven Fallacies Concerning Milton Friedman’s “The

Role of Monetary Policy”

This paper analyzes Milton Friedman’s (1968a) article “The Role of Mone-

tary Policy,”via a discussion of seven fallacies concerning the article. These

fallacies are as follows: (i) “The Role of Monetary Policy” was Friedman’s

first public statement of the natural rate hypothesis. (ii) The Friedman–

Phelps Phillips curve was already present in Samuelson and Solow’s(1960)

analysis. (iii) Friedman’s specification of the Phillips curve was based on

perfect competition and no nominal rigidities. (iv) Friedman’s (1968a) ac-

count of monetary policy in the Great Depression contradicted the Monetary

History’s version. (v) Friedman (1968a) stated that a monetary expansion

will keep the unemployment rate and the real interest rate belowtheir natural

rates for two decades. (vi) The zero lower bound on nominal interest rates

invalidates the natural rate hypothesis. (vii) Friedman’s (1968a) treatment

of an interest-rate peg was refuted by the rational expectations revolution.

The discussion lays out the reasons why each of these seven items is a fal-

lacy and infers key aspects of the frameworkunderlying Friedman’s (1968a)

analysis.

JEL codes: E31, E43, E52

Keywords: Milton Friedman, Phillips curve, natural rate hypothesis, price

stickiness, zero lower bound, Fisher effect, liquidity effect.

THE YEAR 2018 SAWTHE FIFTIETH anniversary of the publication

of Milton Friedman’s article “The Role of Monetary Policy” (Friedman 1968a).

This paper is well known for its articulation of the natural rate hypothesis, which

provided the basis for challenging the notion of a long-run trade-off between inflation

and unemployment. Friedman (1968a) was described by Tobin (1981, p. 40) as

“seminal and influential.” In the years since Tobin wrote those words, the validity

The author is grateful to Sarah Baker, Mauro Boianovsky, Gurubala Kotta, and David L´

opez-Salido

for comments on earlier versions of this paper. In addition, Robert King providedextensive and extremely

helpful suggestions, and the paper has also benefited greatly from the detailed comments of two anonymous

referees. The views expressed here are the author’s alone and should not be interpreted as those of the

Federal Reserve or the Board of Governors.

EDWARD NELSON is senior adviser, Division of Monetary Affairs, Federal Reserve Board (E-mail:

Edward.Nelson@frb.gov).

Received February 5, 2018; and accepted in revised form November 6, 2018.

Journal of Money, Credit and Banking, Vol. 52, No. 1 (February 2020)

Published 2018. This article is a U.S. Government work and is in the public domain in the

USA.

146 :MONEY,CREDIT AND BANKING

of his description of Friedman’s article has been confirmed. This is reflected in

the prominence given to Friedman (1968a) in the narratives regarding monetary

policy strategy in Goodhart (1992) and Bernanke et al. (1999) and in the accounts

of developments in monetary analysis in Svensson (2008) and Nelson and Schwartz

(2008), as well as by the recent retrospectives on Friedman’s paper by Hall and

Sargent (2018) and Mankiw and Reis (2018). In addition, Christiano, Eichenbaum,

and Trabandt (2018, pp. 115−16) havepointed to the framework of Friedman (1968a)

as an antecedent of modern dynamic stochastic general equilibrium models.

This is not the place for a further detailed assessment of the impact of Friedman’s

paper on the modern practice of monetary policy. But it is clear that, although the

specific policy recommendation—monetary aggregate targeting—made by Friedman

(1968a) was not enduringly influential on policymaking, there has been widespread

and lasting acceptance of the paper’s position that monetary policy can achieve a

long-run target for inflation but not a target for the level of output (or for other real

variables). For example, in the United States, the Federal Open Market Committee’s

(2018) “Statement on Longer-Run Goals and Policy Strategy” included the observa-

tions that the “inflation rate over the longer run is primarily determined by monetary

policy, and hence the Committee has the ability to specify a longer-run goal for infla-

tion,” and that, in contrast, the “maximum level of employment is largely determined

by nonmonetary factors,” so “it would not be appropriate to specify a fixed goal for

employment.”

Therefore, among monetary specialists in both the research and policy spheres,

some aspects of Friedman’s (1968a) analysis are well understood and have formed

part of their modern consensus. However, a number of misconceptions or fallacies

have also emerged concerning the content and implications of the article. Sevenof the

more prevalent and substantive fallacies are considered in this paper, together with

an account of why, in the author’sview, each is fallacious.1After a capsule summary

of Friedman (1968a) in Section 1, Section 2 gives the analysis of the fallacies, and

Section 3 draws conclusions from the analysis.

1. A BRIEF RECAPITULATION OF “THE ROLE OF MONETARY POLICY”2

Friedman (1968a, p. 1) opened his article endorsing the “wide agreement” on the

goals of economic policy: high employment, stable prices, and economic growth. His

concern was with the status of monetary policy in achieving these goals. Monetary

policy, he stressed, was far more important in affecting aggregate demand than had

1. In settling on what fallacies to discuss here, the concern was with misconceptions appearing in

analyses of Friedman (1968a) by economists working in Friedman’s own fields of monetary economics

and macroeconomics—as distinct from discussions of Friedman (1968a) by analysts in fields outside

monetary economics (such as abstract general equilibrium theory or the history of economic thought).

2. This capsule review brings out the main themes of Friedman’s paper, which are further explored

in Section 2. It is not a substitute for reading the Friedman (1968a) article or for the other retrospectives

cited elsewhere in this paper.