Does transparent monetary policy lead to economic stability?

In his various writings, the champion of the monetarist school, Milton Friedman, argued that there is a variable time lag between changes in money supply and its effect on real output and prices. Friedman holds that in the short run changes in money supply will be followed by changes in real output.


However, in the long-run changes in money will only have an effect on prices. All this means that changes in money with respect to real economic activity tend to be neutral in the long-run and non-neutral in the short-run. Thus according to Friedman,

In the short-run, which may be as much as five or ten years, monetary changes affect primarily output. Over decades, on the other hand, the rate of monetary growth affects primarily prices.[1]


According to Friedman because of the difference in the time lag, the effect of the change in money supply shows up first in output and hardly at all in prices. It is only after a longer time lag that changes in money start to have an effect on prices. This is the reason according to Friedman why in the short-run money can grow the economy, while in the long run it has no effect on the real output.


According to Friedman, the main reason for the non-neutrality of money in the short-run is the variability in the time lag between money and the economy.

Consequently, he believes that if the central bank were to follow a constant money growth rate rule this would eliminate fluctuations caused by variable changes in the money supply growth rate. The constant money growth rate rule could also make money neutral in the short-run and the only effect that money would have is on general prices in the long run.


Thus according to Friedman,

On the average, there is a close relation between changes in the quantity of money and the subsequent course of national income. But economic policy must deal with the individual case, not the average. In any case, there is much slippage.

It is precisely this leeway, this looseness in the relation, this lack of mechanical one-to-one correspondence between changes in money and in income that is the primary reason why I have long favored for the USA a quasi-automatic monetary policy under which the quantity of money would grow at a steady rate of 4 or 5 per cent per year, month-in, month-out.[2]


In his Nobel lecture, Robert Lucas expressed disagreement. According to Lucas,


If everyone understands that prices will ultimately increase in proportion to the increase in money, what force stops this from happening right away?[3]


Consequently, Lucas has suggested that the reason why money does generate a real effect in the short run is not so much due to the variability of monetary time lags but more bound up with whether money changes were anticipated or not. If monetary growth is anticipated then people will adjust to it rather quickly and there will not be any real effect on the economy. Only unanticipated monetary expansion can stimulate production.


Moreover, according to Lucas,

Unanticipated monetary expansions, on the other hand, can stimulate production as, symmetrically, unanticipated contractions can induce depression.[4]

Both Friedman and Lucas are of the view, although for different reasons, that it is desirable to make money neutral in order to avoid unstable and therefore unsustainable economic growth. The current practice of Fed policy makers seems to incorporate the ideas of Friedman and Lucas into the so-called transparent monetary policy framework. This framework accepts Lucas’s view that anticipated monetary policy can lead to stable economic growth. This framework also accepts that a gradual change in monetary policy in the spirit of Friedman’s constant money growth rule, could reinforce the transparency.


If unexpected monetary policies can cause real economic growth, what is wrong with this? Why not constantly surprise people and cause more real wealth?



Money, expectations and economic growth

What is required for economic growth is a growing pool of real savings, which funds various individuals that are engaged in the build-up of capital goods. An increase in money, however, has nothing to do as such with this. On the contrary, this increase only leads to consumption that is not supported by production of real wealth. Consequently, this leads to a weakening in the real pool of savings, which in turn undermines real economic growth. All that printing money can achieve is a redirection of real savings from wealth generating activities towards non-productive wealth consuming activities. Unanticipated monetary growth will undermine real economic growth via the dilution of the pool of real savings.


Why is it then that one observes that rising money is associated with a rise in economic indicators like real GDP? All that we observe in reality is an increase in monetary spending – this is what GDP depicts. The more money that is printed, the higher GDP will be.


So-called real GDP is merely nominal GDP deflated by a meaningless price index. Hence, so-called observed economic growth is just the reflection of monetary expansion and has nothing to do with real economic growth, which cannot be measured by quantitative methods. After all, it is not possible to establish a meaningful total by adding potatoes and tomatoes.


Therefore, while unanticipated monetary growth cannot grow the economy it definitely produces a real effect by undermining the pool of real savings and thereby weakening the real economy. Likewise anticipated money growth cannot be harmless to the real economy. Even if the money growth rate is fully anticipated, there is always someone who gets it first.


Even if the money is pumped in such a way that everybody gets it instantaneously, changes in the demand for money will vary – after all every individual is different from other individuals. There will always be somebody who will spend the newly received money before somebody else. This will lead to the redirection of real wealth to the first spender from the last spender.


We can thus conclude that regardless of expectations, tampering with the economy by means of monetary policies will always undermine the foundations of the real economy. Hence, monetary policy can never be neutral.



[1] Milton Friedman The Counter-Revolution in Monetary Theory. Occasional Paper 33, Institute of Economic Affairs for the Wincott Foundation. London: Tonbridge, 1970.

[2] Milton Friedman The Counter-Revolution in Monetary Theory

[3] Robert E. Lucas, Jr Nobel Lecture:Monetary Neutrality, Journal of Political Economy, 1996, vol. 104,no. 4

[4] Ibid.

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