Mauro Boianovsky. International Encyclopedia of the Social Sciences. Editor: William A Darity, Jr., 2nd Edition, Volume 3, Macmillan Reference, 2008.
Milton Friedman is best known for his influential contributions to monetary macroeconomics and for his strong advocacy of the role of free markets in solving social problems. The son of poor Jewish immigrants in New York City, Friedman was educated under a scholarship at Rutgers University, where his main influences were Arthur F. Burns and Homer Jones. Upon graduation in 1932 with a joint major in economics and mathematics, he was offered a tuition scholarship in economics at the University of Chicago, where he was a student of Frank Knight and Jacob Viner, among others. After an academic year in Chicago, Friedman received a fellowship to move to Columbia University, where he was taught by Harold Hotelling and Wesley C. Mitchell. In his third year as a graduate student he returned to Chicago as research assistant to Henry Schultz. Apart from an academic year as visiting professor at the University of Wisconsin (1940-1941), between 1935 and 1945 Friedman worked in Washington, D.C., and New York for the National Resources Institute (1935-1937), the National Bureau of Economic Research (NBER, 1937-1940), the Treasury Department (1941-1943), and the War Research Division of Columbia University (1943-1945). His Columbia doctoral dissertation was concluded at the NBER by 1940 as part of collaboration with Simon Kuznets on incomes from independent professional practice. However, its publication and Friedman’s PhD were delayed until 1945 and 1946, respectively, because of a controversial result about the effect of monopoly powers on physicians’ income. After a year as associate professor at the University of Minnesota, Friedman joined the faculty at the University of Chicago in 1946, replacing Viner as professor of economic theory. He became full professor in 1948, the same year he rejoined the NBER to carry out (together with Anna Schwartz) study of monetary factors in business cycles, a project that culminated with the Friedman-Schwartz 1982 volume Monetary Trends in the United States and the United Kingdom. Friedman continued to teach at Chicago until 1977, when he took up a position as senior research fellow at the Hoover Institution at Stanford University. In 1951 he received from the American Economic Association the John Bates Clark Medal, and in 1976 was awarded the Nobel Memorial Prize in economics.
Consumption and Utility
Friedman’s early contributions grew out of his statistical research of incomes and consumer expenditures carried out in the 1930s; these include the development in 1937 of a nonparametric significance test for ranked data, and the research that led to his 1945 book with Kuznets. That book introduced the concepts of permanent and transitory income, which would be the focal point of Friedman’s 1957 econometric exercise in the Theory of Consumption Function. Friedman’s hypothesis that permanent aggregate consumption is a function of permanent (in the sense of long-term expected) income was a solution to Kuznets’s empirical findings that, contrary to prevailing Keynesian models at the time, the average propensity to consume does not decline with rising income. The permanent income hypothesis has had a profound impact on empirical work on the consumption function and other fields, despite its implicit treatment of lifetime as infinite, which makes it unsuitable to deal with optimization over the expected life of the economic agent. It was a crucial element of Friedman’s overall attack on Keynesian economics because it implied (1) strong criticism of the so-called Keynes-Hansen secular stagnation thesis (which depends on the assumption of a rising saving-income ratio); (2) rejection of Keynesian unemployment equilibrium, on the basis of the introduction of wealth into the consumption function and by that of the positive effect of price reduction on consumers’ expenditure; and (3) dismissal of the assumption that consumption is a stable function of current income, which undermined the stability of the Keynesian multiplier. Another important contribution by Friedman to the pure theory of statistics and decision-making was his 1948 essay (with Leonard Savage) on the implications of the von Neumann-Morgenstern cardinal utility function for risky choices, which influenced the development of portfolio selection theory. Friedman and Savage showed that choice under uncertainty could be represented by a process of maximizing expected utility, which allowed them to explain the simultaneous practice of gamble and insurance under some assumptions.
Quantity Theory of Money
Although monetary theory and policy had attracted Friedman’s attention since his discussion of the inflationary gap at the Treasury Department in the early 1940s, it was only after the 1950s that money became the main topic of his research agenda, especially with the start of the Chicago Workshop on Money and Banking, set up by him in 1951. The first product of that workshop was the 1956 volume of Studies in the Quantity Theory of Money, edited by Friedman. The book opened with his “restatement” of the quantity theory as a proposition about the empirical stability of the demand for real money balances in relation to a few arguments, including income. Friedman’s claim that his approach to money demand—as the outcome of the agents’ portfolio decision about how to allocate their wealth among alternative assets—was in tune with the Chicago quantity theory tradition was challenged, however, by Don Patinkin and other commentators. In any event, Friedman’s point that the velocity of circulation of money is determined mainly by changes in real income represented an alternative to the prevailing Keynesian income-expenditure mechanism based on the stability of the investment multiplier. It led to Friedman’s proposition that substantial changes in prices or nominal incomes are the result of changes in the nominal supply of money. The empirical investigation of that claim was the object of Friedman and Schwartz’s Monetary History (1963), the first of their books for the NBER. That book is the most important contribution to the “monetarist” approach to the business cycle, and it followed the NBER founder Wesley Mitchell’s practice of extracting cycles and trends from detailed time series. It is also congruent with Friedman’s emphasis on testing the empirical implications of theories, worked out in his influential 1953 essay on the methodology of positive economics. Friedman and Schwartz examined individual episodes in U.S. monetary history to establish the determining causal influence of changes in money stock on prices and economic activity.
In particular, they put forward an explanation of the Great Depression (1929-1933), alternative to the Keynesian one, as the consequence of inept policy responses by the Federal Reserve to the contraction in money supply brought about by bank failures and rising currency/deposit and reserve/deposit ratios.
Natural Rate of Unemployment
Apart from the primacy of exogenous monetary impulses, another main element of Friedman’s monetary economics is the stress on the role of expectations in the transmission of monetary changes to nominal and real variables. Although the theme of expectations already could be found in his writings in the 1950s and early 1960s, it was only after his 1967 seminal presidential address to the American Economic Association that the distinction between expected and unexpected values of variables became prominent. Friedman argued that the trade-off between inflation and unemployment measured by the traditional Phillips curve is a temporary phenomenon that disappears in the long run, once inflation becomes anticipated by economic agents (1968). Friedman coined the phrase natural rate of unemployment to express the notion that monetary authorities are only able to keep the current unemployment rate below its long-term equilibrium level if inflation is accelerating—the “natural rate” is the rate of unemployment (determined by real factors such as labor mobility, etc.) at which inflation is nonaccelerating and agents’ expectations about the value of real variables (such as real wages) are fulfilled. In contrast with his other contributions to monetary economics, the natural rate of unemployment hypothesis was not subjected to empirical testing by Friedman, in part because his definition of the concept is not fully operational, as argued by Frank Hahn and others. As it happens, some key elements of Friedman’s 1967 address could be found already in David Champernowne’s 1936 critical reactions to J. M. Keynes’s General Theory. The real wage rate that workers would demand if they forecast future prices correctly was called the basic real wage by Champernowne, and the corresponding unemployment level was termed the basic unemployment rate, just like Friedman’s natural rate. According to Champernowne, the rate of price change will accelerate if actual unemployment differs from its “basic” value, which will bring it back to its long-run value through the effect of inflation (or deflation) acceleration on the setting of the interest rate by monetary authorities.
Money Growth Rule
The implications of Friedman’s theoretical and empirical monetary studies for the operation of monetary policy were worked out in his 1959 Program for Monetary Stability and in essays collected in 1969. One of his main empirical findings was that monetary changes affect output and prices with a long, variable, and unpredictable lag; this is behind his skepticism of the stabilizing role of discretionary monetary policy. Instead, Friedman argued—coherently with the Chicago tradition of Henry Simons and others—for a fixed rule to expand the money supply by a constant and known annual percentage. As Friedman was aware, such a rule could only be implemented with a system of flexible exchange rates, which had been advocated by him since the early 1950s on the grounds that flexible rates would lead to a more efficient process of adjustment of the balance of payments. At first, Friedman suggested that the rate of growth of money supply should aim at the stabilization of the price level (around 4%), but he later claimed that, from a purely economic-welfare perspective, the optimal money stock should grow at such a rate (around 2%) to bring about a rate of deflation equal to the rate of return of real capital. This would mean, in long-run equilibrium, that the private marginal cost of holding real cash balances (the nominal rate of interest) is the same as its social marginal cost (zero), a Pareto optimum situation. Whereas Friedman’s notion of an optimum money supply was primarily of theoretical interest, his more general point—that the main feature of the money growth rule is not the growth rate itself but the adoption of some fixed rate that would produce some known and steady moderate inflation or deflation—has influenced central banks, especially in the monetarist experiments carried out between 1979 and 1982 in the United States and during Margaret Thatcher’s premiership in the United Kingdom. Those experiments and their results were highly contended, however, as a result of the instability of the demand for money following financial deregulation and the weak link between money growth and inflation in the 1980s. Moreover, the publication of Friedman’s last important work on money at about that time (Friedman and Schwartz 1982) raised strong criticism of their empirical analysis of the relation between money, income, and prices in the United Kingdom (Hendry and Ericsson 1991).
Influence and Critical Reactions
Despite the intense controversies that surrounded Friedman’s monetary economics in the 1960s and 1970s—especially the criticism by James Tobin and others that he had not succeeded in specifying the mechanism of transmission from money to output and prices (Gordon 1974)—it is true that many of his propositions became by the end of the twentieth century part and parcel of macroeconomic theory and policy, even if they are not always explicitly associated with his name. These include the notion that monetary policy should target nominal quantities (such as inflation) instead of output and employment, as well as the view that it is usually a more potent tool for economic stabilization than fiscal policy. It is worth noting that although Friedman’s emphasis on the role of the market and limits to state intervention in the economy, plus his rejection of activist macroeonomic policies, are shared with “Austrian economics” (theories espoused by, for example, Friedrich von Hayek, Ludwig von Mises, and Murray Rothbard), his relationship with that group of economists has been difficult. Friedman’s restatement of the quantity theory of money approach to monetary economics was partly motivated by his perception that, in contrast with the Chicago tradition of Simons, Viner, and others, Austrian economists (called “London School” by Friedman) are mistaken in their argument that depressions should not be avoided because they are the inevitable result of the prior boom. For their part, the Austrian economists have criticized Friedman’s monetary economics for overlooking the role of intertemporal coordination failures and relative price changes in the business-cycle mechanism. They have also rejected Friedman’s credential as the leader of free-market economics because, in their view, some of Friedman’s proposals—such as the maintenance of government control over the money supply, state support of education by vouchers redeemable at private schools, guaranteed annual income through a negative income tax—indicate that he has intended to make the state more efficient, rather than just to remove it from the economic realm.