American Finance Association

Friedman On MoneyThe Optimum Quantity of Money and Other Essays. by Milton FriedmanReview by: Gregory C. ChowThe Journal of Finance, Vol. 25, No. 3 (Jun., 1970), pp. 687-689Published by: Wiley for the American Finance AssociationStable URL: http://www.jstor.org/stable/2325868 .

Accessed: 07/07/2014 19:53

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact support@jstor.org.

.

Wiley and American Finance Association are collaborating with JSTOR to digitize, preserve and extend accessto The Journal of Finance.

http://www.jstor.org

This content downloaded from 31.220.200.67 on Mon, 7 Jul 2014 19:53:48 PMAll use subject to JSTOR Terms and Conditions

REVIEW ARTICLE

FRIEDMAN ON MONEY*

GREGORY C. CHOW**

MILTON FRIEDMAN, more than any other individual, has reshaped the thinking of contemporary economists and economic policy-makers on monetary theory and policy. The book under review is a collection of his essays on the subject, and should be read by every serious student of monetary economics.

The first group of essays, Chapters 2 through 5, provides an overall view of the development of Friedman's thoughts and research efforts on monetary theory and policy. The second group, Chapters 6 and, to some extent, 7, deals with the demand for money, and the third, Chapters 7 through 12, with the effects of money on prices and output. The last chapter, "In Defense of Destabilizing Speculation," is on a separate topic. Only the first chapter, bearing the title of this volume, is heretofore unpublished.

Chapter 2, "The Quantity Theory of Money: A Restatement," first published in 1956, is the classic paper that revived the interest of the profession in monetary economics. Eight years later, Friedman was able to report on "a counter-revolution" toward the importance of money in "Post-War Trends in Monetary Theory and Policy" (Chapter 3), trends to which he and his associates had significantly con- tributed. Another five years later, in his Presidential address to the American Eco- nomic Association, "The Role of Monetary Policy" (Chapter 5), Friedman was ready to assert that "the pendulum may well have swung too far" towards the potency of monetary policy (p. 99). Certainly, other events had also been responsible for the change of view, some of which were suggested by Friedman (pp. 71-72, 96-97, 262). Yet, as a single individual, he has done an impressive amount to foster the trend.

What accounts for Friedman's great impact? As a beneficiary, I can testify to his effective teaching. His former students have continued to spread his ideas. He is a stimulating lecturer, a quick debater, a persuasive writer, and an original thinker. Moreover, he has chosen to develop and advocate simple and often-attractive propo- sitions that every economist feels he can grasp. Money is important. The quantity theory contains a stable empirical relationship, more so than the simple version of the income-expenditure theory. Federal Reserve actions should bear a major re- sponsibility for the Great Depression (Chapter 4). The effect of the change in money supply on income has a long and variable lag. The rate of growth in money supply should be kept constant, and so forth.

What has led Friedman to develop the kind of monetary theory and policy, to perform the kind of empirical analyses, and in general, to interpret the world, as he did? Perhaps a hint to the answer is contained in Chapter 4. On the occasion of the third Henry Simons Lecture, delivered at the Chicago Law School, Friedman chal- lenged the view-shared by Simons, Keynes, and others-that the Great Depression was caused by the inherent instability of the monetary system, with the collapse of

* The Optimum Quantity of Money and Other Essays. By Milton Friedman. Chicago: Aldine Publishing Company, 1969. Pp. vii + 296. $9.75.

** IBM Research Center and Columbia University.

687

This content downloaded from 31.220.200.67 on Mon, 7 Jul 2014 19:53:48 PMAll use subject to JSTOR Terms and Conditions

688 The Journal of Finance

business confidence affecting velocity and the supply of money, and proposed an alternative explanation in the failures of the Federal Reserve officials (abstracted from Friedman and Schwartz, Monetary History). "Those intuitions, those con- clusions were derived from a sophisticated body of economic theory that had devel- oped over centuries. Such a body of theory has implicit in it a set of empirical judgments about the character of the world." (p. 92).

Friedman's work on the demand for money, Chapter 6 (1959), was pioneering in its field. Although subsequent works may have modified some of its theoretical and empirical propositions, it was responsible for the development that "empirical work on the demand for money is a dramatic growth industry" (p. 143).

Of the third group of essays, Chapter 7 is mainly theoretical, being concerned with the relation between the interest elasticity of demand for money and the "neu- trality" of money. The others are mainly empirical. Chapter 8, "Price, Income, and Monetary Changes in Three Wartime Periods" (1952), probably marked the begin- ning of Friedman's effort to use the quantity theory to explain price (and income) changes in preference to the income-expenditure theory; it anticipated the later work with David Meiselman on comparing simple versions of the two theories and attempts (in the later chapters of this volume) to answer the question: Granted a stable de- mand function for money, how can one ascertain the causal effects of money on prices and output? In Chapter 9, "The Supply of Money and Changes in Price and Output" (1958), some basic propositions were already developed: the rate of change in money preceded the level of economic activity at turning points (p. 180); the "policy of keeping the money supply growing at a predesignated rate . . . with no attempt to adjust the rate of growth to monetary conditions" (p. 186) was advocated. Chapter 10, "Money and Business Cycles" (1963), attempted to answer the above question in more detail, and contains a tentative sketch of the mechanism transmit- ting monetary changes. Chapter 11 offers replies to some of his critics. Chapter 12, "The Monetary Studies of the National Bureau" (1964), summarizes some of the previous findings and includes warnings to uncritical readers about the limitations of our knowledge. "Our assertion that money matters is therefore very far indeed from an assertion that we know enough about the role it plays . . . we are still a long way from having a detailed and tested theory of the mechanism that links money with other economic magnitudes." (p. 280).

Rather than examine Friedman's propositions individually, which would require a lengthy discourse, I will try to characterize the methods by which these propositions are obtained and point out alternative methods for comparison. The statistical methods are characterized by simplicity. Generally two variables are compared, such as the rate of change in money stock and the level of output (Chapters 9 and 10)- Friedman admits that "peaks in the rate of change of income precede . . . peaks . . . in the stock of money" (p. 249), but still argues, on other grounds, that AM may often have causal influence on income. Even multiple regression is seldom used, not to mention systems of simultaneous equations. We might not know enough to build complicated systems, but we probably do know enough to specify, for the purpose of testing, the role of money in connection with other important variables.' In com- paring the relative roles of money and investment (p. 211), the consumption function could include at least lagged consumption in addition to current income (via Fried- man's permanent income), thus providing two predetermined variables, investment

1. See, for example, G. C. Chow, "Multiplier, Accelerator, and Liquidity Preference in the Determination of National Income in the United States," Review of Economics and Statistics, February, 1967.

This content downloaded from 31.220.200.67 on Mon, 7 Jul 2014 19:53:48 PMAll use subject to JSTOR Terms and Conditions

Review Article 689

and lagged consumption, for the income-expenditure theory.2 Spectral methods were tried but failed (p. 196). Perhaps these more-sophisticated methods should require as much care as (if not more care than) Friedman gave to the two-variable analyses.3

The varying leads (however measured) of one economic time series over another are to be expected if the time series satisfy a multivariate system of stochastic dif- ference equations. Thus the varying leads of AM cannot provide additional ground for advocating the simple control rule of maintaining a constant rate of increase in M. Some would believe that our knowledge, although imperfect, justifies the use of a carefully designed multivariate econometric system, if not for optimal control, at least for checking how nearly optimal a proposed rule would turn out to be.4 Further- more, as a consequence of not applying a stochastic system, the possible importance of stochastic disturbances on business cycles can hardly be investigated.5

The characteristics of Friedman's method of theorizing can be illustrated by Chapter 1: (1) Willingness to make artificial (not simple) assumptions (pp. 2-3) which may be designed to yield desirable implications, and yet artificial in terms of correspondence to reality. (2) Ingenuity in applying marginal conditions. (3) Willing- ness to ignore effects for certain variables when their effects cannot be ascertained a priori (pp. 19 and 28). (4) Willingness to discard certain implications of the as- sumptions and continue to draw other, more-pleasing implications (p. 23 and p. 26, note 19). (5) Use of equilibrium conditions to infer dynamic behavior (p. 30). Dy- namics are not explicitly formulated. By Samuelson's Correspondence Principle, one would have to specify dynamics explicitly even to say something about comparative statics. (6) Willingness to treat "long run" phenomena as separable from "short run." Short-run frictions (p. 45) might prevent the attainment of long-run optimum. (7) Related to (6) is the underlying viewpoint that long-run dynamics would give a smooth time path, once the supply of money is smooth. Schumpeter's view of business cycles and Samuelson's multiplier-accelerator model exemplify the possibil- ity that the internal dynamics of an economic system may be oscillating. (8) In- genious theorizing with an artificial model is combined with the willingness to modify the conclusions in a somewhat arbitrary fashion, when the theoretical implications are applied to the real world (p. 46). Should any reader dislike some of the characteris- tics just mentioned, let him not overlook this very ingenious paper-he should decide for himself whether some of the above characterizations are inaccurate.

It has been a delight to read or reread the essays in this volume. Friedman's im- portant contributions to monetary economics could not be fully appreciated if the reader failed to take his warning seriously about accepting economic propositions without critical examination, be they propositions by Keynes or by Friedman.

2. Given lagged consumption, one can easily check that the partial correlations between income and money are not in general higher than the partial correlations between income and autonomous expenditures for the data used by Friedman and Meiselman.

3. For an application of cross-spectral methods to lead-lag relationships, see G. C. Chow and R. E. Levitan, "Nature of Business Cycles Implicit in a Linear Economic Model," Quarterly Journal of Economics, August, 1969.

4. See G. C. Chow, "Optimal Stochastic Control of Linear Economic Systems," IBM Research Report, RC-2711, November, 1969. Also to be published in the Journal of Money, Credit and Banking, August, 1970.

5. See G. C. Chow, "The Acceleration Principle and the Nature of Business Cycles," Quarterly Journal of Economics, August, 1968.

This content downloaded from 31.220.200.67 on Mon, 7 Jul 2014 19:53:48 PMAll use subject to JSTOR Terms and Conditions