II. What Monetary Policy Can Do Monetary policy cannot peg these real magnitudes at predetermined levels. But monetary policy can and does...
II. What Monetary Policy Can Do Monetary policy cannot peg these real magnitudes at predetermined levels. But monetary policy can and does have important effects on these real magnitudes. The one is in no way inconsistent with the other. 12 THE AMERICAN ECONOMIC REVIEW My own studies of monetary history have made me extremely sympathetic to the oft-quoted, much reviled, and as widely misunderstood, comment by John Stuart Mill. "There cannot . .. ," he wrote, "be intrinsically a more insignificant thing, in the economy of society, than money; except in the character of a contrivance for sparing time and labour.
It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order" [7, p. 488]. True, money is only a machine, but it is an extraordinarily efficient machine. Without it, we could not have begun to attain the astounding growth in output and level of living we have experienced in the past two centuries-any more than we could have done so without those other marvelous machines that dot our countryside and enable us, for the most part, simply to do more efficiently what could be done without them at much greater cost in labor. But money has one feature that these other machines do not share. Because it is so pervasive, when it gets out of order, it throws a monkey wrench into the operation of all the other machines. The Great Contraction is the most dramatic example but not the only one.
Every other major contraction in this country has been either produced by monetary disorder or greatly exacerbated by monetary disorder. Every major inflation has been produced by monetary expansion-mostly to meet the overriding demands of war which have forced the creation of money to supplement explicit taxation. The first and most important lesson that history teaches about what monetary policy can do-and it is a lesson of the most profound importance-is that monetary policy can prevent money itself from being a major source of economic disturbance. This sounds like a negative proposition: avoid major mistakes. In part it is. The Great Contraction might not have occurred at all, and if it had, it would have been far less severe, if the monetary authority had avoided mistakes, or if the monetary arrangements had been those of an earlier time when there was no central authority with the power to make the kinds of mistakes that the Federal Reserve System made. The past few years, to come closer to home,
would have been steadier and more productive of economic wellbeing if the Federal Reserve had avoided drastic and erratic changes of direction, first expanding the money supply at an unduly rapid pace, then, in early 1966, stepping on the brake too hard, then, at the end of 1966, reversing itself and resuming expansion until at least November, 1967, at a more rapid pace than can long be maintained without appreciable inflation. Even if the proposition that monetary policy can prevent money it- FRIEDMAN: MONETARY POLICY 13 self from being a major source of economic disturbance were a wholly negative proposition, it would be none the less important for that. As it happens, however, it is not a wholly negative proposition.
The monetary machine has gotten out of order even when there has been no central authority with anything like the power now possessed by the Fed. In the United States, the 1907 episode and earlier banking panics are examples of how the monetary machine can get out of order largely on its own. There is therefore a positive and important task for the monetary authority-to suggest improvements in the machine that will reduce the chances that it will get out of order, and to use its own powers so as to keep the machine in good working order. A second thing monetary policy can do is provide a stable background for the economy-keep the machine well oiled, to continue Mill's analogy. Accomplishing the first task will contribute to this objective, but there is more to it than that. Our economic system will work best when producers and consumers, employers and employees, can proceed with full confidence that the average level of prices will behave in a known way in the future-preferably that it will be highly stable. Under any conceivable institutional arrangements, and certainly under those that now prevail in the United States, there is only a limited amount of flexibility in prices and wages. We need to conserve this flexibility to achieve changes in relative prices and wages that are required to adjust to dynamic changes in tastes and technology. We should not dissipate it simply to achieve changes in the absolute level of prices that serve no economic function. In an earlier era, the gold standard was relied on to provide confidence in future monetary stability. In its heyday it served that function reasonably well. It clearly no longer does, since there is scarce a country in the world that is prepared to let the gold standard reign unchecked-and there are persuasive reasons why countries should not do so. The monetary authority could operate as a surrogate for the gold standard, if it pegged exchange rates and did so exclusively by altering the quantity of money in response to balance of payment flows without "sterilizing" surpluses or deficits and without resorting to open or concealed exchange control or to changes in tariffs and quotas. But again, though many central bankers talk this way, few are in fact willing to follow this course-and again there are persuasive reasons why they should not do so. Such a policy would submit each country to the vagaries not of an impersonal and automatic gold standard but of the policies-deliberate or accidental-of other monetary authorities. In today's world, if monetary policy is to provide a stable background for the economy it must do so by deliberately employing its powers to that end. I shall come later to how it can do so. 14 THE AMERICAN ECONOMIC REVIEW Finally, monetary policy can contribute to offsetting major disturbances in the economic system arising fromi other sources.
If there is an independent secular exhilaration-as the postwar expansion was described by the proponents of secular stagnation-monetary policy can in principle help to hold it in check by a slower rate of monetary growth than would otherwise be desirable. If, as now, an explosive federal budget threatens unprecedented deficits, monetary policy can hold any inflationary dangers in check by a slower rate of monetary growth than would otherwise be desirable.
This will temporarily mean higher interest rates than would otherwise prevail-to enable the government to borrow the sums needed to finance the deficit-but by preventing the speeding up of inflation, it may well mean both lower prices and lower nominal interest rates for the long pull. If the end of a substantial war offers the country an opportunity to shift resources from wartime to peacetime production, monetary policy can ease the transition by a higher rate of monetary growth than would otherwise be desirablethough experience is not very encouraging that it can do so without going too far. I have put this point last, and stated it in qualified terms-as referring to major disturbances-because I believe that the potentiality of monetary policy in offsetting other forces making for instability is far more limited than is commonly believed.
We simply do not know enough to be able to recognize minor disturbances when they occur or to be able to predict either what their effects will be with any precision or what monetary policy is required to offset their effects. We do not know enough to be able to achieve stated objectives by delicate, or even fairly coarse, changes in the mix of monetary and fiscal policy. In this area particularly the best is likely to be the enemy of the good. Experience suggests that the path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a "clear and present danger."
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