Milton Friedman and the Rise of Monetarism Explained

Introduction to Monetarism and Friedman's Challenge to Keynesian Thought

Monetarism, an economic doctrine that stresses the important role played by money supply in promoting economic stability and growth, was largely developed by Milton Friedman in the mid-twentieth century. Countering Keynesian thought, Friedman postulated that the "quantity theory of money," originally developed by the economist Simon Newcomb, did in fact illuminate most questions concerning inflation or deflation (Ross, 1998). Friedman therefore proposed that regulating the supply of money could have a real effect on economic factors such as inflation, deflation, output, and employment.

The Great Depression and the Decline of Monetary Policy

Prior to the work done by Friedman and other economists of the Chicago school of monetarists, the role played by monetary factors in regulating economic change had fallen into disrepute. So much so that the view became widespread that "money does not matter," and that the stock of money was a purely passive concomitant of economic change. Most economists consequently came to believe that the only role assigned to monetary policy should be to keep whatever interest rates it affected low, so that investments were unaffected (Friedman, p. 1).

The view that monetary factors played only a minor role in regulating the economy developed largely as a fallout of the Great Depression of the 1930s. By that time, the United States had passed the Federal Reserve Act (1913), established the Federal Reserve System, and assigned it the primary responsibility of achieving monetary stability — or at the least, of preventing pronounced periods of instability. This action was taken in the wake of the banking panic of 1907. The relative stability of the 1920s, following the economic fluctuations created by World War I, created a great deal of confidence in the ability of monetary policy to bring about positive economic change (Friedman, p. 13–17). However, the economic collapse and chaos of the 1930s reversed that confidence and instead created skepticism over the role money supply could play in preventing or reversing economic contraction. This skepticism led to the theory that monetary policy could be used to stop inflation but not deflation (Friedman (a), p. 95–6).

Friedman's Historical Analysis and the Rehabilitation of Money Supply

The experience of the Great Depression thus led to the search for alternative economic models. One such model was found in Keynesian economics. Based on Keynes' premise that the preference for liquidity is likely to be absolute, or nearly so, in times of high unemployment, Hansen and several other Keynesians posited that lower interest rates could not stimulate either investment or consumption. They therefore proposed that the only answer lay in fiscal policy — an increase in government spending accompanied by lower taxes (Friedman (a), p. 96).

Indeed, it was the view that fiscal policy was a more important determinant of economic growth that provided the framework for Roosevelt's economics (Ross, 1998) and subsequently produced a worldwide trend of cheap money policies. This trend came to a halt only after worldwide experience with inflation proved that interest rates could not indefinitely be kept at low levels (Friedman, p. 2). Inflation, as Ross (1998) points out, erodes the value of savings and reduces the return on loans. Economies the world over were therefore forced to realize the damaging consequences of cheap money policies and the neglect of monetary controls. Indeed, no country succeeded in checking the price rise other than those — such as Germany — that restrained the growth of the money supply (Friedman, p. 2).