The Triumph of Monetarism

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The Triumph of Monetarism

J. Bradford DeLong

U.C. Berkeley and NBER

(510) 643-4027

August 14, 1999

Why do we today speak of “New Keynesian” rather than “New Monetarist” economics? A look back at the intellectual battle lines between “Keynesianism” and “Monetarism” in the 1960s cannot help but be followed by the recognition that there is a sense in which one of the two leading schools of business cycle fluctuations macroeconomics today is misnamed. We may not all be Keynesians now, but the influence of Monetarism on how we today all think about macroeconomics has been deep, pervasive, and subtle.

Of today’s two leading schools of macroeconomics, the New Classical research program is quickly summarized. It holds that the best way to make progress in understanding economic fluctuations is to recognize the stochastic character of economic growth and attempt to understand the “cycle” using the same models that we use to understand the “trend” (see Black (1982), Kydland and Prescott (1982)).
But how do we characterize the second school, the one called “New Keynesian”? The New Keynesian research program is harder to summarize briefly. But any list of its key ideas and premises would include the propositions that:

  • The key to understanding real fluctuations in employment and output is to understand the process by which business cycle-frequency shocks to nominal income and spending are divided into changes in real spending and changes in the price level.

  • Under normal circumstances, monetary policy is a more potent and useful tool for stabilization than is fiscal policy.

  • Business cycle fluctuations in production are best analyzed from a starting point that sees them as fluctuations around the sustainable long-run trend (rather than as declines below some sustainable potential output level).

  • The right way to analyze macroeconomic policy is to consider the implications for the economy of a policy rule, not to analyze each one- or two-year episode in isolation as requiring a unique and idiosyncratic policy response.

  • Any sound approach to stabilization policy must recognize the limits of stabilization policy—the long lags and low multipliers associated with fiscal policy; the long and variable lags and uncertain magnitude of the effects of monetary policy.

But all of these propositions saw their origin in or saw a large chunk of their development take place in the work of Milton Friedman. The importance of the stochastic effects of policy in imposing limits on stabilization policy comes from Friedman (1953a). The importance of thinking not just about what policy would be best in response to this particular shock but what policy rule would be best in general comes from Friedman (1960). That policy should be stabilization policy rather than gap-closing policy was the principal message of Friedman (1968). Friedman and Schwartz (1963) and Friedman and Meiselman (1963) are key moments in the recognition of the power of monetary policy. And a large chunk of the way that New Keynesians think about aggregate supply saw its development in Friedman’s discussions of the “missing equation” in Gordon (1974).

Even those New Keynesians who dissent from some of these five propositions (I, for example, still cling to the belief—albeit without much supporting empirical evidence—that policy is as much gap-closing as stabilization policy) have a hard time denying that they structure how the New Keynesian wing of macroeconomics thinks about the issues. And it is hard to find prominent Keynesian analysts in the 1950s, 1960s, or early 1970s who gave these points as much prominence in their work as Milton Friedman did in his (with Brainard ()) being one of a few exceptions).
So why, then, do we speak of “New Keynesians” rather than “New Monetarists”? I think that to answer this question we need to look at the history of what has been called “Monetarism,” and to distinguish between four different subspecies of Monetarism that have been seen in the century just past.
The first subspecies of monetarism was the monetarism of Irving Fisher (1911): the quantity theory of money, the equation of exchange, and the determination of the price level. But even though the business cycle analysis of some believers in this first subspecies of monetarism was subtle and sophisticated (see Fisher (1933)), the business cycle theory of this first generation was by and large not. It was exasperation with the monetarist analyses of events made by his colleagues in the immediate aftermath of World War II that led one of the very best of this first subspecies of monetarists—John Maynard Keynes—to declare in his Tract on Monetary Reform (1923) that the standard quantity-theoretic analyses were of no use whatsoever:
Now ‘in the long run’ this [way of summarizing the quantity theory: that a doubling of the money stock doubles the price level] is probably true.... But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.
Milton Friedman does not disagree: in “The Quantity Theory of Money—A Restatement” Friedman sets out that one of its goals is to rescue monetarism from the “atrophied and rigid caricature” of an economic theory that it had become in the interwar period at the hands of analysts like Lionel Robbins (1934) (see Friedman (1974)). According to Friedman, it was the inadequacies of this framework that opened the way for the original Keynesian Revolution: a “dismal picture” in contrast to which “Keynes’s interpretation of the depression and of the right policy to cure it must have come like a flash of light on a dark night” (Friedman (1974).
Alongside or slightly later than this first subspecies of monetarism is what Friedman has always called the Chicago School oral tradition—composed of those who saw deflation as the source of depression—who blamed monetary and fiscal policies for “permitting banks to fail and the quantity of deposits to decline,” and who called for both monetary expansion and large government deficits to fight depression. Don Patinkin (1969, 1972) and Harry Johnson (1971) denied that this Chicago School oral tradition existed: they saw Friedman (1956, 1970, 1971a, 1971b) as using “Keynesian” tools and insights to provide a retrospective post-hoc theoretical justification for policies advocated by Simons, Mints, Knight, and Viner that were sensible but also free-floating and only tenuously connected with their monetary theory. Friedman does not completely disagree: “after all, I am not unwilling to accept some credit for the theoretical analysis,” he says, while insisting that “The Quantity Theory—A Restatement” does give the flavor of what he and others who contributed to Studies in the Quantity Theory of Money had learned at Chicago.
My view is that it has long been sterile to debate whether the kind of analysis carried out by Viner (1933) (and by Keynes (1923)!) is (as Patinkin would have it) unjustified by their theoretical framework or is (in Friedman’s (1956) words) a “subtle and relevant version… of the quantity theory… a flexible and sensitive tool for interpreting movements in aggregate economic activity and for developing relevant policy prescriptions.” It depends what you mean by “theory.” What is worth noting is, as pointed out by Tavlas (), that this second subspecies of monetarism did not believe in the stability of the velocity of money, and did not believe that control of the money supply was easy.
It did not believe in the stability of the velocity of money because the phase of the business cycle and the concommitant general price level movements powerfully affected incentives: economic actors had strong incentives to economize on money holdings during times of boom and inflation, and to hoard money balances during times of recession and deflation. These swings in velocity amplified the effects of monetary shocks on total nominal spending.
It did not believe that control of the money supply was easy because in the absence of general deposit insurance fear of bank bankruptcy on the part of consumers could cause substantial swings in the deposit-currency ratio, and fear of being caught illiquid on the part of banks could cause substantial swings in the deposit-reserve ratio. The overall level of the money supply was as much a product of these two as of the stock of high-powered money itself—the only thing that the Federal Reserve could quickly control. Indeed, in Friedman and Schwartz (1963) the monetary forces that cause depression and boom are as often changes in the deposit-currency and deposit-reserve ratios as changes in the stock of high-powered money.
Then there is post-World War II monetarism, monetarism-subspecies-three, classic monetarism. It contains the analysis of the limits of stabilization policy, the stress on the importance of policy rules, the belief that the natural rate of unemployment is inevitably close to the average rate of unemployment, the belief in the relative potency of monetary policy. It contains much of what the New Keynesian wing of macroeconomics believes very deeply today.
But there is another component of classic monetarism: a reaction to the sources of monetary instability as perceived by monetarism version II. Friedman’s (1960) Program for Monetary Stability, for example, is a proposal to change institutions to make simple monetarism—with a constant velocity of money, and a central bank in direct and immediate control of the money stock—true. The money stock shifts in response to changes in the deposit-reserve and deposit-currency ratios? Then require 100% reserve banking. Then shifts in the deposit-reserve ratio are illegal. And in the absence of any possibility that banks will be caught illiquid there is no reason for there to be any shifts in the deposit-currency ratio. The velocity of money moves procyclically because of monetary shocks that temporarily boost or subtract from the money supply? Then enforce a constant growth rate of the money stock: without cyclical fluctuations in the money stock and in inflation, there will be no reason for cyclical fluctuations in the velocity of money.
And classic monetarism contains yet a third current. The work of Karl Brunner and Alan Meltzer, for example, tends to emphasize the political economy of monetary policy to a greater extent. They see one great advantage of a fixed nominal money growth rule as its constraining the government’s ability to confiscate resources via the inflation tax, and in the process redistribute wealth. One can fear discretionary monetary policy for two reasons: it can be conducted incompetently, or it can be conducted competently by a government with its own objectives different from the public interest. In Friedman’s hands classic monetarism is more likely to stress the first; in Brunner and Meltzer’s the second (although these are differences of degree).
But this three-pronged doctrine of classic monetarism—with its institutional reform side, its analytical side, and its political-economy side—was not the “Monetarism” that became a powerful political doctrine in the 1970s. That was the fourth subspecies of Monetarism.
The fourth subspecies of Monetarism argued not that velocity could be made stable if monetary shocks were avoided, but that velocity was stable: thus the money stock became a sufficient statistic for forecasting nominal demand. It argued not that institutional reforms were needed to give the central bank the power to tightly control the money supply, but that the central bank was the source (in its actions or in its failure to neutralize private actions) of shifts in the money supply. Thus everything that went wrong in the macroeconomy had a single, simple cause: the central bank had failed to make the money supply grow at the appropriate rate.
[Figure 1: M2 Velocity, 1950-2000]
And it was this brand of monetarism that crashed and burned in the early 1980s. The velocity of money turned unstable (but as William Poole () argued at the time, why should anyone expect velocity to be unstable when the rate of inflation was varying so much?). Charles Goodhart’s () law made itself felt: whatever monetary aggregate was being targeted by a central bank turned out to be the one with the lowest correlation with nominal income: controlling the money supply relevant for total spending turned out to be very difficult indeed. And financial innovation began to undermine the strength of the money-spending correlation (but as Robert Hall () argued at the time, why should anyone expect a tight money-income correlation to be more durable than the institutional setup that had produced it?).
[Figure 2: Breakdown of the Correlation Between the Growth Rates of Different Monetary Aggregates, 1960-2000]
But even as Monetarism subspecies four was failing its empirical test, Monetarism subspecies three was expanding its intellectual hegemony.
University of Michigan Professor Matthew Shapiro passed through the border of its expansion in the summer of 1981, as he moved from undergraduate economics at Yale to graduate economics at MIT. At Yale, he said, the first thing he had been taught was that the “Chicago School was in error because it”—that is, Friedman, Brunner, Meltzer, and company—“thought that money affected output.” At MIT, by constrast, the first thing he learned was that the “Chicago School was in error because it”—that is, Lucas, Sargent, and Prescott—“thought that money didn’t affect output.”
This sudden change in just why the Chicago School was in error struck him as a considerable surprise. We can see in it an index of the intellectual hegemony exercised by post-World War II monetarism: the name may be largely gone, but the ideas and principles are very much alive.


Fischer Black (1982), “General Equilibrium and Business Cycles”

Mark Blaug (), Economic Theory in Retrospect
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Milton Friedman (1971a), “A Monetary Theory of Nominal Income,” Journal of Political Economy 79:2 (April), pp. 323-37.
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Milton Friedman (1972), “Comments on the Critics,” Journal of Political Economy. Reprinted in Robert J. Gordon, ed. (1974), Milton Friedman’s Monetary Framework: A Debate with His Critics (Chicago: University of Chicago Press: 0226264076).
Milton Friedman and David Meiselman (1963), “The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1897-1958,” in Stabilization Policies (Englewood Cliffs: Prentice-Hall).
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Peter Hall ()
Robert Hall ()
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William Poole ()
Lionel Robbins (1934), The Great Depression (London: Macmillan).
George Tavlas (),
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Jacob Viner (1933), Balanced Deflation, Inflation, or More Depression (Minneapolis: University of Minnesota Press).

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