Why I disagree with Milton Friedman on monetary policy

Milton writes to Greg Mankiw:

Nothing that I have observed in
recent decades has led me to change my mind about the desirability of a
monetary rule which simply increased the quantity of money at a fixed
rate month after month, year after year. That rule would get rid of the
mistakes and that is probably about all you could expect to get from a
monetary system.

Greg counters that the lender of last resort function of the central bank may interfere with a fixed monetary rule.  Fair enough (in fact I think the earlier Milton admitted this point, although the later Milton may agree with Larry White’s comment on Greg), but my objection is more day-to-day.  Hardly anyone is willing to live with the consequences of a strict rule for the monetary base.

In particular, the resulting short-term interest rate volatility would be much higher than, prior to experience, most people had expected.  Liquidity is quite scarce.  The demand for funds goes up and sometimes, in the absence of Fed smoothing, the supply just isn’t there.  Price has to adjust.  No, interest rate volatility is not the end of the world but few people believe this makes for a better marketplace.  That is why hardly anyone in the world of central banking defends monetary base targeting these days, even though the idea was fairly popular twenty-five or thirty years ago.

The Swiss tried to target their monetary base, briefly, in the mid 1980s.  No one was willing to live with the resulting interest rates and especially the exchange rates; the latter is an additional problem for small open economies.  So they stopped.  Times since then have not exactly been the Weimar hyperinflation in Bern and Zurich.  The Swiss are better off for having a multitude of targets.

We shouldn’t target the monetary base either.  If we have enough discipline to stick to a base target, we also have enough discipline to endure a regime of acceptable "muddling through."

Addendum: Correct me if I am wrong, but didn’t Milton repudiate the money target idea a few years ago and suggest inflation targeting as an acceptable substitute?


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