Money, Expectations, and Economic Growth

In various writings, Milton Friedman argued that there is a variable lag between changes in money supply and its effect on real output and prices. Friedman held that in the short run changes in money supply will be followed by changes in real output. However, in the long run changes in money will only have an effect on prices. This means, according to Friedman, that changes in money with respect to real economic activity tend to be neutral in the long run and non-neutral in the short run.

In the short-run, which may be as much as five or ten years, monetary changes affect primarily output. Over decades, on the other hand, the rate of monetary growth affects primarily prices.1

Friedman was of the view that the main reason for the non-neutrality of money in the short run is the variability in the time lag between money and the economy. On this Friedman suggested,

On the average, there is a close relation between changes in the quantity of money and the subsequent course of national income. But economic policy must deal with the individual case, not the average. In any case, there is much slippage. It is precisely this leeway, this looseness in the relation, this lack of mechanical one-to-one correspondence between changes in money and in income that is the primary reason why I have long favoured for the USA a quasi-automatic monetary policy under which the quantity of money would grow at a steady rate of 4 or 5 per cent per year, month-in, month-out.

Friedman held that if the central bank were to follow a constant money growth rule it would eliminate the variability in the time lag. Consequently, money would become neutral in the short run also.

In his Nobel lecture, Robert Lucas raised an issue with this. According to Lucas,

If everyone understands that prices will ultimately increase in proportion to the increase in money, what force stops this from happening right away?2

Lucas is of the view that the reason why money generates a real effect in the short run is not so much due to the variability of monetary time lags but more bound up with whether monetary changes are anticipated or not. If monetary growth is anticipated, then people will adjust to it rather quickly and there will not be any real effect on the economy. Only unanticipated monetary expansion can stimulate production. Moreover, according to Lucas,

Unanticipated monetary expansions, on the other hand, can stimulate production as, symmetrically, unanticipated contractions can induce depression.

Both Friedman and Lucas are of the view that it is desirable to make money neutral in order to avoid unstable and therefore unsustainable economic growth.

The current practice of Fed policymakers seems to incorporate the ideas of Friedman and Lucas into the so-called transparent monetary policy framework. This framework accepts Lucas’s view that anticipated monetary policy could lead to economic stability. This framework also accepts that a gradual change in monetary policy in the spirit of Friedman’s constant money growth rule could reinforce the economic stability.

But even if the central bank policymakers could implement it precisely, Friedman’s and Lucas’s framework could not secure stable economic growth.

Money, Expectations, and Economic Growth

According to Robert Lucas, if monetary growth is expected, people will adjust to it rather quickly and there will not be any real effect on the economy. Only unanticipated monetary expansion can stimulate production.

In this way of thinking, anticipated money supply growth is going to result in the corresponding increase in the prices of goods, which is going to offset the increase in money supply.

The price of a good is the amount of money paid for the good. Hence, an increase in money supply implies that more money is going to be spent on goods, all other things being equal. This means that the average price of goods will rise.

Thus, if the money supply increases by 10 percent and as a result monetary outlays on goods increase by 10 percent, this implies that the average price of goods also rises by 10 percent. Consequently, the increase in outlays on goods in real terms is going to be zero, i.e., 10 percent minus 10 percent.

This means that anticipated money growth will not have any real effect on the economy since this increase is going to be offset by the equivalent increase in prices.

For instance, one dollar can buy one loaf of bread. An increase in money supply of 10 percent that is fully anticipated results in the price of the loaf also increasing by 10 percent. As a result, with one dollar and ten cents an individual could secure one loaf of bread — the same quantity as before the 10 percent increase in money supply. No change in real terms.

Even if everyone were to anticipate precisely the money supply growth rate and the corresponding increase in the prices of goods, however, it could not alter the fact that there are always first recipients of the new money and late recipients.

This reality will set in motion the transfer of real wealth from last recipients to the early recipients of money, i.e., an exchange of nothing for something, which in turn lays the foundation for the menace of the boom-bust cycle.

Even if the money was pumped in such a way that everybody got it instantaneously, changes in the demand for money vary. After all, every individual is different from others — there will always be somebody who will spend the newly received money before somebody else does. This, of course, will lead to the redirection of real wealth to the first spender from the last spender.

While the anticipated money supply growth rate does not generate a real effect on the economy, this is not the case with respect to unanticipated money growth.

Now if we begin with the same assumption as before, that one dollar can buy one loaf of bread, an unexpected increase of 10 percent in money supply by does not produce an immediate increase in the price of bread in the short run. The increase in money supply by 10 percent will lift temporarily the people’s holdings of money. Once people decide to spend the money they will discover that, given unchanged prices, their buying power has increased.

If previously our individual had only one dollar now he has one dollar and ten cents. Our individual can now secure 1.1 loaves of bread versus one loaf before the unexpected increase of 10 percent in money supply.

Clearly, what we have here is an increase in the real buying power of individuals of 10 percent — an increase in real demand by 10 percent. This will lead to a 10 percent increase in the production of goods, i.e., demand creates supply — so it is argued by mainstream economists.

While it is possible that the unexpected monetary increase is going to result in stronger economic growth in the short run through the overuse of the existing infrastructure, in the medium to longer term, because of the exchange of nothing for something, the infrastructure will weaken. Hence, we suggest that over time unanticipated money growth will undermine real economic growth via the dilution of the pool of real savings.

It follows that unanticipated monetary growth will eventually weaken the real economy by undermining the pool of real savings.

Thus, both anticipated and unanticipated money supply growth will weaken the pool of real savings, which over time will lead to a weakening in real economic growth, setting in motion economic instability.

In fact, Milton Friedman’s constant money growth rule cannot make money neutral, since the constant money growth rule is about increases in money supply, although at a constant rate. In Friedman’s framework we will still have an exchange of nothing for something, and therefore boom-bust cycles and economic instability.

What is required for economic growth is a growing pool of real savings, which supports various individuals engaged in the enhancement and the maintenance of the capital infrastructure.

We can thus conclude that neither Friedman’s constant money growth rule nor people’s perfect anticipation of money growth can eliminate boom-bust cycles and establish economic stability.

To make money truly neutral with respect to the real economy it is necessary to close all the loopholes for the generation of money out of “thin air”. The major loopholes are the central bank’s asset purchasing and fractional reserve banking.

• 1. Milton Friedman, The Counter-Revolution in Monetary Theory (London: Tonbridge, 1970).
• 2. Robert E. Lucas Jr., “Nobel Lecture: Monetary Neutrality,” Journal of Political Economy 104, no. 4 (1996).