Milton Friedman

1912-2006

Milton Friedman was an American economist. Milton was a Nobel laureate economist and a leading figure of the Chicago School of Economics, championing free-market capitalism and monetarism. His core theories challenged Keynesian orthodoxy and had a profound influence on global economic policy.  Friedman is the most influential exponent of the monetarist school of economic thought. Monetarists maintain that the money supply and interest rates primarily determine the economic cycle. The impact of fiscal policy is confined to its effect on the money supply. His best-known book, A Monetary History of the United States, 1867-1960 (1963), written with Anna Schwartz, traces changes in the supply of money and assesses the impact of those changes on economic events. In 1976, Friedman won the Nobel Memorial Prize in economics. He has written numerous books, pamphlets, and articles that expound his ideas. He frequently acts as an advisor to the US Government on matters of economic policy. Today, an increasing number of countries are adopting monetarist policies.

Monetarism (His Most Famous Contribution):

• • Core Idea: Inflation is always and everywhere a monetary phenomenon. It’s primarily caused by the money supply growing faster than the output of goods and services.

  • The Equation: Friedman revived and refined the Quantity Theory of Money, expressed as MV = PY:

    • M: Money Supply

    • V: Velocity of Money (how quickly money circulates)

    • P: Price Level (inflation)

    • Y: Real Output (real GDP)

  • Key Argument: Friedman argued that V is relatively stable and predictable in the long run (contrary to Keynesian views that saw V as volatile). Therefore, changes in M (money supply) directly lead to changes in nominal GDP (PY). In the short run, an increase in M can boost output (Y), but in the long run, it primarily affects prices (P), causing inflation.

  • Policy Implication: Central banks should focus on steadily and predictably increasing the money supply at a low rate (e.g., 3-5% per year) roughly matching the growth rate of potential real GDP. This “k-percent rule” would ensure price stability and avoid causing booms and busts through erratic monetary policy.

Milton had written about the floating exchange rate system and how it would serve as a check and balance against governments as early as 1953 in his Essays in Positive Economics – some 18 years before the collapse of Bretton Woods on August 15th, 1971.

Milton saw three types of monetary systems: Fixed, pegged, and floating rates. Most never looked deeply into the exchange rate system. Under a floating exchange rate monetary system, the central bank sets an economic policy. Still, it has no exchange-rate policy itself, as the free market creates that on an almost autopilot basis. Therefore, the monetary base is determined domestically by a central bank.

Now, compare that to Bretton Woods’ fixed exchange rate system. Milton saw that politicians set the exchange rate, yet they have no power over the money supply, as that is the central bank’s domain. Hence, under a fixed exchange-rate regime, a country’s monetary base is determined by the balance of payments, moving in a one-to-one correspondence with changes in its foreign reserves. That often led to trade wars and protectionism, as was the case under the gold standard during the Great Depression.

Many assumed that pegged exchange rates were just the same as fixed exchange rates. Milton saw them as quite different. A pegged exchange rate system involves the central bank aiming for a money supply and the exchange rate that would lead to exchange controls, and was an anti-free-market mechanism focusing on international balance-of-payments adjustments. Therefore, pegged exchange rates lacked any free-market automatic response mechanism that would produce natural balance-of-payments adjustments. Consequently, pegged rates would require a central bank to manage both the exchange rate and monetary policy.

Unlike floating and fixed exchange rate systems, pegged exchange rate systems would result in conflicts between monetary and exchange rate policies. Under a pegged exchange rate system, a central bank often attempts to sterilize the ensuing increase in capital inflows, which expands the domestic money supply by selling government bonds to reduce the domestic component of the base interest rate. When outflows become “excessive,” a central bank attempts to offset the decrease in the foreign element in the base by buying bonds, increasing the domestic component of the base.

Balance-of-payments crises typically erupt when a central bank begins to offset the withdrawal of the foreign component of the monetary base by increasing the domestic money supply, thereby buying government bonds. FX traders will then sell the currency in response to the increase in the money supply, based on their perception of what is happening.

Therefore, Milton theorized what would happen going back to 1953.  Milton’s work in the chapter The Case for Flexible Exchange Rates was perhaps THE MOST influential forward-thinking on economics ever written. Milton concluded that what I was observing running around the world was indeed true back in 1953.

“The nations of the world cannot prevent changes from occurring in the circumstances affecting international transactions. And they would not if they could. For many changes reflect natural changes in weather conditions and the like; others arise from the freedom of countless individuals to order their lives as they will, which it is our ultimate goal to preserve and widen; and yet others contain the seeds of progress and development. The prison and the graveyard alone provide even a close approximation to certainty.”