The impact of Milton Friedman on modern monetary economics: Setting the record straight on Paul Krugman's “Who was Milton Friedman?”

Paul Krugman's essay “Who Was Milton Friedman?” seriously mischaracterizes Friedman's economics and his legacy. In this paper, we provide a rejoinder to Krugman on these issues. In the course of setting the record straight, we provide a self-contained guide to Milton Friedman's impact on modern monetary economics and on today's central banks. We also refute the conclusions that Krugman draws about monetary policy from the experiences of the United States in the 1930s and of Japan in the 1990s.     

Can learnability save new-Keynesian models?

McCallum (2009) argues that “learnability” can save new-Keynesian models from indeterminacies. He claims the unique bounded equilibrium is learnable, and the explosive equilibria are not. However, he assumes that agents can directly observe the monetary policy shock. Reversing this assumption, I find the opposite: the bounded equilibrium is not learnable and the unbounded equilibria are learnable. More generally, I argue that a threat by the Fed to move to an “unlearnable” equilibrium for all but one value of inflation is a poor foundation for choosing the bounded equilibrium of a new-Keynesian model.     

THE SUBJECTIVITY OF THE FASB'S CONCEPTUAL FRAMEWORK: A COMMENTARY ON BRYER

Bryer argues that the FASB's conceptual framework is inherently subjective because it is based on the concept of “economic value”, or the anticipated net cash inflows attributable to presently owned assets. By contrast, Marxist economics is based on objective facts that can be measured to a “socially required level of accuracy”. The objective facts of a Marxist conceptual framework rest on the theory that capital circulates in three forms: money, commodities to be sold, and commodities to be used in production. Capital, and, therefore assets, are essentially physical (or technical) in nature rather than monetary in nature. Measurement of assets is objective because Marxist theory emphasizes management stewardship and requires historical cost and a strict realization criterion for recognition of revenue. Bryer's argument that the FASB's conceptual framework is “unacceptably subjective” because it is based on “economic value” is misplaced. A careful reading of the FASB's concepts statements suggests that assets represent service-potential, or “use-value” in Marxist terms, and that economic-value is never advocated as a conceptual basis for the measurement of assets. The reason the FASB's conceptual framework is “subjective and vague” is that the FASB lacked the political will to advocate a conceptual preference for any particular measurement method.     

Beyond epistemological pluralism: Towards an integrated vision of the future

This paper is a response to Epistemological Pluralism in Futures Studies, featured as a special edition of Futures (42:2). Since that special edition was a response to Integral Futures, a previous special edition of Futures (40:2), this paper begins with a treatment of some of the critiques of IF, as well as the critiques of Ken Wilber and integral theory. I examine the validity of those critiques, focusing in particular on the accuracy of the “portraits” given of Ken Wilber and his contribution to integral theory. I also examine the claims of “epistemological pluralism” to determine whether it is a more appropriate framework for futures inquiry and practice. In this consideration, I treat epistemological pluralism (devoid of an “integrating” theory) as an expression of skeptical postmodernism. Finally, I conclude with a historical overview of integral theory.     

What are the effects of monetary policy on output? Results from an agnostic identification procedure

This paper proposes to estimate the effects of monetary policy shocks by a new agnostic method, imposing sign restrictions on the impulse responses of prices, nonborrowed reserves and the federal funds rate in response to a monetary policy shock. No restrictions are imposed on the response of real GDP to answer the key question in the title. I find that “contractionary” monetary policy shocks have no clear effect on real GDP, even though prices move only gradually in response to a monetary policy shock. Neutrality of monetary policy shocks is not inconsistent with the data.     

Seven Fallacies Concerning Milton Friedman's “The Role of Monetary Policy”

This paper analyzes Milton Friedman's (1968a) article “The Role of Monetary Policy,” via a discussion of seven fallacies concerning the article. These fallacies are as follows: (i) “The Role of Monetary Policy” was Friedman's first public statement of the natural rate hypothesis. (ii) The Friedman–Phelps Phillips curve was already present in Samuelson and Solow's (1960) analysis. (iii) Friedman's specification of the Phillips curve was based on perfect competition and no nominal rigidities. (iv) Friedman's (1968a) account of monetary policy in the Great Depression contradicted the Monetary History’s version. (v) Friedman (1968a) stated that a monetary expansion will keep the unemployment rate and the real interest rate below their natural rates for two decades. (vi) The zero lower bound on nominal interest rates invalidates the natural rate hypothesis. (vii) Friedman's (1968a) treatment of an interest-rate peg was refuted by the rational expectations revolution. The discussion lays out the reasons why each of these seven items is a fallacy and infers key aspects of the framework underlying Friedman's (1968a) analysis.     

Global liquidity trap

How should monetary policy respond to a “global liquidity trap,” where the two countries may fall into a liquidity trap simultaneously? Using a two-country New Open Economy Macroeconomics model, we first characterize optimal monetary policy, and show that the optimal rate of inflation in one country is affected by whether or not the other country is in a liquidity trap. We next examine how well the optimal monetary policy is approximated by relatively simple monetary policy rules. The interest-rate rule targeting the producer price index performs well in this respect.     

Bank loan portfolios and the monetary transmission mechanism

We study the portfolio behavior of bank loans following a monetary tightening and find that real estate and consumer loans sharply decrease, while commercial and industrial (C&I) loans increase. These responses are compared with responses following non-monetary shocks, which also reduce output but keep interest rates roughly unchanged. During such a “non-monetary” downturn, C&I loans sharply decrease, while real estate and consumer loans show no substantial response. These responses, together with the responses of relevant lending rates, are hard to reconcile with a decline in the supply of C&I bank loans during a monetary downturn as stressed by the bank-lending channel. Several arguments are presented explaining why the supply of C&I loans may actually increase after a monetary contraction.     

The changing nature of financial disclosure in Japan

This paper investigates whether Japanese companies listed on the Tokyo Stock Exchange (TSE) altered their voluntary accounting disclosure behavior over the period of the 1990s. It implicitly tests for whether the collapse of Japan's “Financial Bubble” in the late 1980s altered the incentives of Japanese managers to be more forthcoming about corporate information. Previous research on Japanese disclosure practices highlights the “secretive” nature of Japanese managers and suggests that cultural preferences strongly discourage disclosure. Our findings suggest that Japanese disclosure practices are sensitive to economic conditions.     

An optimum-currency-area odyssey

The theory of optimum-currency-areas was conceived and developed in three highly influential papers, written by (Mundell, 1961) and (McKinnon, 1963) and Kenen (1969). Those authors identified characteristics that potential members of a monetary union should ideally possess in order to make it feasible to surrender a nationally-tailored monetary policy and the adjustment of an exchange rate of a national currency. We trace the development of optimum-currency-area theory, which, after a flurry of research into the subject in the 1960s, was relegated to intellectual purgatory for about 20 years. We then discuss factors that led to a renewed interest into the subject, beginning in the early 1990s. Milton Friedman plays a pivotal role in our narrative; Friedman's work on monetary integration in the early 1950s presaged subsequent optimum-currency-area contributions; Mundell's classic formulation of an optimal currency area was aimed, in part, at refuting Friedman's “strong” case for floating exchange rates; and Friedman's work on the role of monetary policy had the effect of helping to revive interest in optimum-currency-area analysis. The paper concludes with a discussion of recent analytical work, using New Keynesian models, which has the promise of fulfilling the unfinished agenda set-out by the original contributors to the optimum-currency-area literature, that is, providing a consistent framework in which a country's characteristics can be used to determine its optimal exchange-rate regime.     

Generalizing the permanent-income hypothesis: Revisiting Friedman's conjecture on consumption

Friedman's contribution to the consumption literature goes well beyond the seminal permanent-income hypothesis. He conjectured that the marginal propensity to consume out of financial wealth shall be larger than out of “human wealth”, the present discounted value of future labor income. I present an explicitly solved model to deliver this widely noted consumption property by specifying that the conditional variance of changes in income increases with its level. A larger realization of income not only implies a higher level of human wealth, but also signals a riskier stream of future labor income, inducing a higher precautionary saving, and thus giving rise to Friedman's conjecture. Appropriately adjusting human wealth for income risk, I show that Friedman's conjecture may be formulated as a “generalized” permanent income hypothesis. I further show that Friedman's conjecture captures the first-order effect of stochastic precautionary savings. Finally, I propose a natural decomposition of the optimal saving rule to formalize various motives for holding wealth as emphasized in [Friedman, M., 1957. A Theory of the Consumption Function. Princeton University Press, Princeton].     

One monetary policy and 18 central bankers: The European monetary policy as a game of strategic delegation

This paper employs a multi-country delegation monetary policy model and argues that a decision-making mechanism based on the median voter theorem where intensity of preferences cannot play a role does not capture important aspects of policy setting in the European Monetary Union. Replacing the median voter mechanism with a less restrictive “weighted mean mechanism”, it is shown that strategic delegation can lead to a surprising degree of central bank inflation aversion. This finding supports the “The Twin Sister Hypothesis” and the perception of the European Central Bank implementing the policy of the Bundesbank rather than a more inflationary monetary policy.     

Finance is good for the poor but it depends where you live

I examine whether or not the incomes of the poor systematically grow with average incomes, and whether financial development enhances the incomes of the poorest quintile. Following the methodology of Dollar and Kraay (2002), I find, once extending Dollar and Kraay’s data, their findings are robust to the Lucas critique and economic growth is important for poverty reduction universally. However, in comparison to other authors’ work I show financial development aids the incomes of the poor in certain regions, whilst it may be detrimental in others. This proposes evidence against a “one size fits all” model adding a further contribution to the literature on financial development and poverty.     

In Old Chicago: Simons,Friedman, and the Development of Monetary‐Policy Rules

This paper examines the different policy rules proposed by Henry Simons, who, beginning in the mid‐1930s, advocated a price‐level stabilization rule, and by Milton Friedman, who, beginning in the late‐1950s, advocated a rule that targeted a constant growth rate of the money supply. Although both rules shared the objective of eliminating the policy uncertainty emanating from discretion, they differed because of the different views of Simons and Friedman about the stability of secular relationships. Simons’ rule relates to modern rules that emphasize the pursuit of price stability as representing optimal monetary policy.     

On the determinants of “small” and “large” foreign exchange market interventions: The case of the Japanese interventions in the 1990s

During the past 30 years, central banks have often intervened in foreign exchange markets, and the magnitude of their foreign exchange market interventions has varied widely. We develop a quantitative reaction function model that renders it possible to examine the determinants of “small” and “large” interventions. We apply the model to analyzing the intervention policy of the Japanese monetary authorities (JMA) in the yen/U.S. dollar market during the period from 1991 through 2001. To this end, we use recently released official data on the foreign exchange market interventions of the JMA. We find that the JMA tended to conduct large interventions when the yen/U.S. dollar exchange rate drifted away from an “implicit target exchange rate.”     

Financial market participation and the apparent instability of money demand

This paper uses multi-period cross-sectional data on financial assets holdings to shed light on the postwar stability of money demand in the United States. I first present a new measure of the evolution of financial market participation, by relating participation to the extensive margins of money demand, and quantify the influence of wealth on participation decisions. I then relate the increase in participation to the period of “missing money” and to the subsequent higher interest rate elasticity of monetary aggregates. The paper indicates that time-series estimations of money demand relationships are inherently flawed and tend to inappropriately suggest instability.     

Inflation dynamics: A cross-country investigation

We document that “persistent and lagged” inflation (with respect to output) is a world-wide phenomenon in that these short-run inflation dynamics are highly synchronized across countries. In particular, the average cross-country correlation of inflation is significantly and systematically stronger than that of output, while the cross-country correlation of money growth is essentially zero. We investigate whether standard monetary models driven by monetary shocks are consistent with the empirical facts. We find that neither the new Keynesian sticky-price model nor the sticky-information model can fully explain the data. An independent contribution of the paper is to provide a simple solution technique for solving general equilibrium models with sticky information.     

Central banking in the credit turmoil: An assessment of Federal Reserve practice

Central banking is understood in terms of the fiscal features of monetary, credit, and interest on reserves policies. Monetary policy - expanding reserves by buying Treasuries - transfers all revenue from money creation directly to the fiscal authorities. Credit policy - selling Treasuries to fund loans or acquire non-Treasury securities - is debt-financed fiscal policy. Interest on reserves frees monetary policy to fund credit policy independently of interest rate policy. An ambiguous boundary of responsibilities between the Fed and the fiscal authorities contributed to economic collapse in fall 2008. “Accord” principles are proposed to clarify Fed credit policy powers and secure its independence on monetary and interest rate policy. The Fed needs more surplus capital from the fiscal authorities to be fully flexible against both inflation and deflation at the zero interest bound.     

Monetary Policy and Banking Structure

In this paper, I examine the differences in optimal monetary policy in various banking systems. In particular, I compare two monetary economies: one with a competitive banking system and the other with a monopolistic one. In addition, the optimality of the discount window policy is considered. It is shown that the Friedman rule is the optimal monetary policy in a monopolistic banking economy, and the zero‐inflation policy is optimal in a competitive banking economy under appropriate parameters. In addition, the combination of the Friedman rule and the discount window policy can achieve efficient allocation in both banking systems.