From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm. “Monetary Policy in Developing Countries” by Milton Friedman In Nations and Households in Economic Growth: Essays in Honor of Moses Abramovitz, edited by Paul A. David and Melvin W. Reder, pp. 265-278. New York: Academic Press, 1973. © El Sevier 1. Cyclical versus Secular Policy In the developed countries, most discussion of monetary policy is concerned with the problem of business fluctuations—cyclical expansions and recessions—and hence with the effect of monetary policy on stability. Even for such countries, some of us have concluded that monetary policy is a poor instrument for this purpose thanks to the length and variability of the lag in the effects of monetary policy, the limitations of our knowledge about the actors responsible for such lags and about other short-term effects of monetary policy, the conflicting objectives pursued by monetary authorities, and the pressures of politics. These factors, we believe, have made discretionary monetary policy a major independent source of economic instability rather than an offset to instability arising from other sources. We have concluded that the wisest policy, at least for the present, would be to shape monetary policy in the light of longer run objectives and to aim, in the short run, for steady monetary growth in order to provide a favorable climate for stability without either actively promoting stability or unintentionally introducing instability. For developing countries, the case against using monetary policy primarily as an instrument for short-run stabilization is far stronger than for developed countries. The crucial problem for developing countries is to achieve sustained growth not to smooth short-run fluctuations. In addition, such countries seldom have financial markets and banking institutions sufficiently developed and sufficiently sophisticated to permit what has come (most inaccurately) to be called “fine-tuning” of monetary policy. These policy and institutional considerations reinforce a scientific consideration: We know much more about the long-run effects of monetary changes than we do about their short-term effects. Over short periods, the monetary effects may be swamped by transitory forces that will average out over longer periods. As a result, for developing countries even more than for developed ones, it seems wise to determine monetary policy from long-term considerations. Parenthetically, this conclusion holds equally for fiscal policy, and for the same reasons, regardless of the relative importance attached to fiscal and monetary effects as determinants of economic change. Accordingly, in the rest of this paper, I shall deal primarily with long-run considerations. 2. Monetary Policy and Inflation From the long-run point of view, the problem of desirable monetary policy reduces primarily to the desirable rate and form of inflation. Two intermediate steps lead to this identification: the recognition first, that monetary policy is concerned primarily with the quantity of money, not with the terms and availability of credit; second, that inflation is always and everywhere a result of a rapid rate of increase in the quantity of money. I shall comment briefly on these two intermediate steps before turning to the relation between inflation and development. From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm. a. What Is Monetary Policy? Central banks grew out of commercial banks, and most central bankers have been drawn from the banking community. Even when they have not, most of their dealings have been with the commercial banks. The individual commercial banker rightly regards himself as an intermediary in the credit market, borrowing from some (his depositors) and lending to others. He does not regard himself as in any way “creating” money. The central banker tends to accept this view and thus he tends to regard himself as concerned primarily with the “money market” in the sense of the “credit market” and with the “price of money” in the sense of interest rates. Yet, as students of fractional reserve banking have recognized for over a century, what is true for the individual bank is not true for the banking system. The system as a whole “creates” most of its deposits. Any one bank that makes a loan from excess funds indirectly adds to deposits in other banks. These banks in turn can make further loans, so producing a “multiple” expansion. This process means that deposit money is mostly the counterpart of credit. But much money is not the counterpart of credit: gold or silver under specie standards, paper money issued by government. More important, “bank credit” is only a minor part of total credit. Credit and money are related but they are not synonymous. A country’s monetary authorities can play a dominant role in determining the amount of money; they are a minor factor the “credit” market. The confusion between money and credit has been paralleled and fostered a confusion between nominal and real magnitudes. In the process of adding the quantity of money, the banking system can create credit in nominal terms—that is, in terms of the monetary unit: dollars, or pesos, or pounds. But the effect may be to leave unchanged or even to reduce the real amount of credit, if the monetary creation leads to inflation in ways that discourage saving. Similarly, the monetary authorities may affect the nominal interest rate it, over any long period, they have little effect on the real interest rate. A nominal interest rate of 10% when prices are rising at 4% per year is a real turn of 6%, since the rest of the nominal return goes only to make good the loss in the buying power of the principal. Over short periods, by adding to the quantity of money, the monetary authorities may lower both the nominal and real rate, but over longer periods, the result will be inflation that will raise the nominal rate above its earlier level while having little effect on the real rate. Ultimately, the real rate depends far more on the real forces of thriftiness and productivity than on the activities of the monetary authorities. b. Importance of Quantity of Money Given that monetary policy is concerned primarily with the quantity of money, why is it important how the quantity of money is controlled or what happens to it? The answer is that changes in the nominal quantity of money are always and often the major determinant of changes in nominal income or nominal spending. In the short run, a change in the rate of growth of nominal income produced by a change in the rate of monetary growth will be divided between prices and output in proportions that will vary from time to time. That is why short-run fluctuations in the rate of monetary growth produce short-run fluctuations in economic activity, varying in timing and intensity in ways that may bear no very precise relation to the monetary impulse. However, over the long run, the rate of output growth is largely determined 2 From The Collected Works of Milton Friedman, compiled and edited by Robert Leeson and Charles G. Palm. by other forces, so that the long-run rate of monetary growth determines primarily the rate of inflation. In this sense, inflation is always a monetary phenomenon, always a result of a more rapid increase in the quantity of money than in output. But in another sense, there are many different sources of inflation because there may be many different reasons for the increase in the quantity of money. The quantity of money increased in the United States, and produced inflation in the 1850s because of gold discoveries; in the 1860s and from 1916 to 1918 because of government deficits to finance wars; in 1919–1920 because of bank credit expansion to finance private investment. 3. Inflation and Development It is widely believed that there is a close relation between inflation and development. The relation is sometimes supposed to be that economic development is a cause of inflation; sometimes, that inflation fosters economic development. In my opinion, neither is consistently true. Some striking examples of development without inflation are the development of Great Britain in the eighteenth and nineteenth century, of the United States in the nineteenth century, of Japan from the Meiji restoration in 1867 to World War I; of Hong Kong, Malaysia, and Singapore in the past 30 years, of Greece in the late 1950s and early 1960s. Examples of inflation without development include India in recent decades, many South American countries, Indonesia until perhaps recent years, all the hyperinflations after World Wars I and II. Examples of no inflation and no development include Venezuela, many European countries and India in the interwar period, and numerous examples from earlier times. So all four possible combinations can be found in experience. What underlies the belief that inflation promotes development? I believe there are two systematic effects that might work in this direction. First, if inflation is not anticipated, it may for a time transfer resources to active businessmen, innovators, or entrepreneurs, and in this way add to investment. Apparently, this is what happened in Europe in the sixteenth and seventeenth century as a consequence of Spanish imports of specie from the New World. These imports raised the quantity of money, which produced inflation, the inflation was not anticipated so prices of final products went up more rapidly than wages, interest rates failed to reflect inflation fully so that the real interest rate fell, and this process transferred wealth from landowners and landworkers to entrepreneurs. Professor Earl Hamilton’s studies of the price revolution are by now classic documentations of this process (Hamilton, 1934, 1936, 1947).