Milton Friedman Was Right About Monetary Fine-Tuning

I n 1976, Milton Friedman won the Nobel Prize in economics. Among the reasons the Nobel Committee awarded him the prize was his “demonstration of the complexity of stabilization policy.” Fifty years later, Friedman’s ideas on the topic are still relevant today, at a time when many academics and economic commentators are reviving the idea that monetary policy can fine-tune employment. This is an idea Friedman spent his career challenging.

Friedman did not deny that monetary policy mattered. In fact, he believed the Great Depression was caused by the Federal Reserve’s failure to prevent a contraction of the money supply. But he warned that the power of monetary policy was limited, especially when policymakers tried to use it to permanently push unemployment below its natural level, determined by market forces.

Despite keeping company with plenty of conservatives, Friedman did not use the term to describe himself — but he was a conservative in his approach to monetary theory. At a time when orthodox Keynesian ideas dominated economics, Friedman revived an older tradition in the quantity theory of money. That tradition held that inflation was “always and everywhere a monetary phenomenon,” that monetary policy could affect real output and employment only in the short run, and that attempts to exploit those short-run effects would eventually fail. Friedman’s work combined theory, empirical evidence, and historical narrative to argue that money still mattered, even when many economists believed fiscal policy had displaced it as the primary tool of economic stabilization.

One of Friedman’s main critiques of orthodox Keynesianism was its interpretation of the Phillips curve. The Phillips curve appeared to show an inverse relationship between inflation and unemployment. When unemployment was low, inflation tended to be high; when unemployment was high, inflation tended to be low. Many policymakers interpreted this relationship as a menu of choices. They believed they could accept higher inflation in exchange for permanently lower unemployment.

Friedman rejected this view. In his 1968 presidential address to the American Economic Association, “The Role of Monetary Policy,” he argued that there was no permanent tradeoff between inflation and unemployment. Monetary expansion might temporarily reduce unemployment. When central banks expand the money supply, aggregate demand rises, firms demand more labor, and output increases before prices. Friedman believed that since prices and wages were set in advance, workers expected prices to be stable. Those unemployed will supply more labor at the old nominal wage due to higher demand from firms.

However, Friedman argued that the prices of factors of production, such as labor, adjust more slowly to expansions in demand than the prices of goods and services that workers buy. Thus, workers’ real wages have decreased. Once workers adjust their expectations, they will demand a higher wage and supply less labor. Unemployment will then return to its natural rate, and inflation will remain higher.

Today, this idea has been rebranded as using monetary policy to “heat up” labor markets. Some argue that using expansionary monetary policy to increase economic output causes firms to need more workers, leading to lower unemployment, higher wages, and greater worker bargaining power. This idea was used to justify keeping monetary policy too loose for too long after the Covid-19 pandemic ended, which resulted in the post-pandemic inflation surge.

This view of monetary policy risks undermining price stability. It also ignores the fact that price stability is necessary for a healthy labor market. Attempts to fine-tune the economy through monetary stimulus cause central banks to shift their focus from price stability to employment goals, but prices are essential for transmitting economic information, including wages, which are the price of labor. Inflation erodes the role of prices in transmitting that information. When prices become unreliable as signals of economic information, firms have a harder time making decisions about hiring and investments, and workers about saving and consumption. The costs of restoring price stability can also harm the very workers the policy was meant to help.

Monetary policy can offset shocks to aggregate demand (total spending in the economy) that risk harming the economy and its workers. It can prevent a collapse in spending from causing sharp falls in output and employment. It can also counter excessive spending growth that threatens price stability. Friedman recognized this in “The Role of Monetary Policy.” As he put it, “monetary policy can contribute to offsetting major disturbances in the economic system arising from other sources.”

If policymakers are serious about helping American workers, they should focus on labor-market reforms that enhance productivity growth, as well as direct transfer payments to those in poverty. Better access to higher education, greater competition in our K-12 education system, and lower barriers to entering the labor market would do more to improve the lives of American workers than attempts to fine-tune employment through monetary policy.