New on FinoLib · Volume III: Finance Encyclopedia
I have just published a new article on FinoLib, my free finance education library: Monetarism and Milton Friedman: The Chicago School Explained. It is part of Volume III: Finance Encyclopedia. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
The idea in plain words
Milton Friedman argued that sustained inflation is always caused by money growing faster than output, and that there is no permanent trade-off between inflation and unemployment. His ideas shaped monetarism and the Chicago School. But the Fed’s dual mandate comes from statutes of 1977 and 1978, and Friedman opposed the second.
Key points
■The equation of exchange: with money growth of 6% and real growth of 2%, inflation is 3.92% if velocity is flat but 0.80% if it falls 3%.
■US M2 velocity fell 48.6% from 1997 to 2020, which is why central banks dropped money targets for inflation targets.
■Friedman (1968) and Phelps (1967): holding unemployment below its natural rate makes inflation accelerate, as 1969–80 showed.
■Section 2A of the Federal Reserve Act (1977, amended by Humphrey-Hawkins in 1978) sets the mandate; Friedman attacked the Humphrey-Hawkins bill in 1976.
A closer look
Milton Friedman, the leading figure of the University of Chicago’s economics department in the mid-20th century, challenged the Keynesian consensus from a different direction, arguing that the money supply, not fiscal policy, was the dominant driver of the business cycle and of inflation over the medium term. The primary texts. His best-known line, from a 1970 lecture, is longer than the slogan: “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” It restates the quantity theory of money, which Irving Fisher had written as the equation of exchange.
A worked example
Worked Example — Compare the Scenarios: The Quantity Theory With Velocity Moving
The equation of exchange, M × V = P × Y, says money (M) times velocity (V, how often each dollar is spent on final output in a year) equals the price level (P) times real output (Y). In growth rates, inflation = (1 + money growth) × (1 + velocity growth) ÷ (1 + real growth) − 1. Hold money growth at 6% and real growth at 2%, and let velocity vary: Scenario Velocity change Inflation Money growth needed for 2% inflation A: stable velocity (Friedman’s assumption) 0% 1.06 × 1.00 ÷ 1.02 − 1 = 3.92% 1.02 × 1.02 ÷ 1.00 − 1 = 4.04% B: velocity falls −3% 1.06 × 0.97 ÷ 1.02 − 1 = 0.80%…
Under the hood
Under the Hood: Why a Permanent Trade-off Between Inflation and Unemployment Fails
The 1958 Phillips curve suggested a menu: accept more inflation, get less unemployment. Friedman and Phelps argued that wage bargains are about real wages, so the trade-off works only while inflation surprises people: inflation = expected inflation − β × (unemployment − natural rate). If expectations follow last year’s inflation, holding unemployment below the natural rate makes inflation rise every year. Illustrative numbers: natural rate 6%, target unemployment 4% (the goal the 1978 Humphrey-Hawkins Act set), β = 0.5, starting inflation 6%. Each year inflation rises by 0.5 × (6 − 4) = 1 point: 7%, 8%, 9%, 10%, 11% after five years. The US record looked like that.
Decision rule
Use the quantity theory as a long-horizon check, not a forecasting machine. If money growth exceeds real growth by more than about 10 percentage points a year for several years, expect high inflation unless velocity is clearly falling; at that scale money dominates. If the gap is a few points in a low-inflation economy, velocity swings of 3% or more a year can swamp it, so look at inflation expectations, wages and the labor market instead.
The costliest mistake
Reading money growth without velocity. In the scenario table, money growth of 6% implies 3.92% inflation if velocity is flat, 0.80% if it falls 3%, and 6.00% if it rises 2%: a 5.2-point range from one money number. An investor who bought $1 million of inflation protection sized for the 3.92% case and got 0.80% would see the inflation accrual fall short by about $1 million × (3.92% − 0.80%) = $31,200 in the first year alone. Avoid it by treating velocity as a variable to forecast, not a constant.
Recap
Friedman tied sustained inflation to money growing faster than output and, with Phelps, showed there is no permanent trade-off between inflation and unemployment. Unstable velocity ended money targeting, and the Fed’s dual mandate comes from the 1977 and 1978 statutes, the second of which Friedman opposed.
What the full article covers
The full article includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume III: Finance Encyclopedia
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The complete article, Monetarism and Milton Friedman: The Chicago School Explained, with every worked example, diagram, quiz and source, is free to read in Volume III, Finance Encyclopedia on finolib.com.
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