Chapter 15 Milton’s Paradise: Friedman Leads a Monetary Counterrevolution

1) Milton Friedman a) Focus on monetary policy and quantity theory of money was particularly attractive in an age of inflation b) Countered Keynes and restored the fundamental principles of classical economics c) Responsible for income tax withholding in WWII—regret? d) Wrote A Monetary History of the United States, 1867‐1960 e) Wrote Capitalism and Freedom i) Introduced policy recommendations: flexible exchange rates, school vouchers, and negative income tax 2) Permanent Income Hypothesis a) Friedman demonstrated that households adjust their expenditures only according to long‐term or permanent income changes, and pay little attention to transitory patterns. i) Keynesian consumption function was fundamentally flawed and any leveraging of government expenditure through the multiplier was much smaller than expected ii) Permanent‐income thesis showed that higher incomes would not necessarily lead to higher savings rates 3) Real cause of the Great Depression a) “From the cyclical peak in August 1929 to the cyclical trough in March 1933, the stock of money fell by over a third.” (Friedman and Schwartz 1963,299) b) Totally changed thoughts that during the Great Depression the Feds did everything they could to counteract the depression c) Replaced the idea that the Great Depression was a market failure to government failure 4) Phillips Curve…Friedman doesn’t think so a) Friedman concluded that any acceleration of inflation would eventually bring about higher, not lower, unemployment i) In the 1970’s he was proved right when inflation and unemployment rose together opposite of Britain in the 50s 5) Rules vs. Authority a) Monetary rules are preferable to discretionary decision making by the government i) Friedman argued that any system which gives so much power and discretion to a few men that mistakes can have such far reaching effects is a bad system ii) Studied two monetary systems with rules (1) Gold standard‐full fledged commodity standard in which banknotes were backed 100 percent by gold or silver (a) Rejected by Friedman because: (i) High resource cost (ii) Impractical implementation (2) Fiat monetary rule standard‐ monetary system based on irredeemable paper money that included a 100 percent reserve requirement on demand deposits (checking accounts) at banks, and then to adopt a legislative rule which required the money supply to increase at a steady rate approximately equal to a nation’s economic growth rate (a) Friedman suggested between 3‐5 percent