Friedmans Argument against the Relationship between Keynesian Interest Rate Monetary Policy and Economic Growth - Essay Example

College: Friedman’s Argument against the Relationship between Keynesian Interest Rate Monetary Policy and Economic Growth Introduction Throughout the 1960s and 1970s, Milton Friedman waged a fierce battle against Keynesian theories on monetary policy. According to the Keynesians, the best monetary policy was one that employed a stimulative approach, helping the economy to grow by precipitating lower interest rates. Lowering of interest rates increases the money supply in the economy. Thus, increased spending by consumers and businesses leads to positive economic growth. Keynesian economics is based on the precinct that government can make up for inadequate private investment by increasing its spending. These economic views on monetary policy persisted unchallenged for two decades before the Great Depression. Economists and laymen alike did not consider money a crucial element of facilitating economic sustenance and growth. It only played the minor role of maintaining low interest rates so as to suppress interest payments in the government budget, in addition to stimulating investment, and in the process, supplement government spending efforts to maintain aggregate demand at a sufficiently high level (Keynes, 135 – 157). Friedman’s Views However, Milton Friedman disputed the Keynesian theory of economics and in particular, its views on monetary policy with regard to interest rates. Friedman had a strong belief that interest rates do not play the most significant role of driving economic growth. Instead, he argued that money supply plays the crucial role of driving economic growth. Firstly, Friedman argued that Keynesians misunderstood the relation between interest rates and money. The Federal Reserve Board will attempt to keep the interest rates down by buying securities, raising their prices and lowering their yields. In addition, this move leads to an increase in the total bank reserve, in effect increasing bank credit. Banks will lend money to individuals and businesses, ultimately increasing the total amount of money in the economy. This is the reason why Keynesian economics stipulates that an increase in the quantity of money lowers interest rates (Keynes, 139 – 147). However, Friedman disputes this by asserting that this process does not terminate at this point. Spending increases due to a rapid rate of monetary growth. This takes place through the impact on alternative spending and the effect derived from investment on lower interest rates. However, increased spending in one sector increases the income in another sector. Rising income leads to increased demand for loans, prices and raises the liquidity preference. Therefore, the ultimate effect is a reduction in the quantity of money. The overall effect is a reversal of the initial downward shift in interest rates within a year or two, and may even rise beyond the initial level due to the tendency of the economy to overreact. This initiates a continuous adjustment process that is cyclic in nature (Friedman, 6). Friedman provides an alternative way of looking at this process. The immediate effect of increasing the quantity of money by the Federal Reserve Board is the unbalancing of people’s portfolios. If the assets available in the economy fall into three general groups, one group will consist of physical assets such as household belongings and business equipment; the second category will comprise financial assets such as bonds and stocks, and the third category will comprise money. An increase in the amount of money in the economy will influence individuals and businesses to eliminate their surplus money, because it exceeds the value of their financial and physical assets by far. When they spend this money, all that happens is that it passes on to someone else, further increasing the portfolio imbalance. Eventually, the value of the physical and financial assets rises. Rising values of physical assets mean the economy is exhibiting positive growth, whereas increasing values for financial assets indicate that an increase in the rate of borrowing has taken place (Friedman, 6 – 7). In addition, there is the possibility of a fourth effect occurring which will further contribute towards increasing interest rates in response to a higher rate of monetary expansion. A higher rate of monetary growth will push prices upwards. The public will develop the expectation that increase in prices will persist for some time. As a result, borrowers will become more willing to settle their debts, and lenders will increase interest rates. This fourth effect which involves price expectation is a slow-acting process and, therefore, takes quite a long while to develop and to disappear. In fact, it may take decades for the price expectation effect to develop, run its course, and then disappear before completing a full adjustment. This is exactly as Irving Fisher predicted decades before Friedman began to dispute Keynesian theories of economics. It provides a logical explanation as to why all previous attempts of the Federal Reserve Board to sustain interest rates at low levels, had forced the Board to engage in increasingly larger purchases on the open market. It also provides a credible explanation as to why economists have historically associated falling and low interest rates with a low rate of monetary growth, such as in the U.S. during the economic slump of the Great Depression, and why they associated high and rising interest rates with a high rate of money growth such as in Brazil in the 1990s. In the simplest sense, low interest rates act as a reliable indicator that the monetary policy implemented by the regulatory body has been tight. This means that the rate of monetary growth has been low. High levels of interest rates indicate that the measures taken by the monetary authority have been easy with regard to monetary policy, portraying that the rate of monetary growth has been considerably high. Milton Friedman not only did a remarkable job pulling apart Keynesian theories of monetary policy, but also provided an alternative monetary policy theory that could achieve national fiscal goals much more effectively than Keynesianism. Contrary to expectations, the monetary policy that Friedman suggested was not complex. The theories that he proposed were the opposite of Keynesian theories of monetary policy. He suggested that the Federal Reserve Board could sustain nominal interest rates at a low level by embarking on an initiative which is quite Keynesian in nature, but starts in the opposite direction. In effect, this means implementing a deflationary monetary policy. Alternatively, the monetary authority could achieve the same effect by implementing an inflationary, almost Keynesian, monetary policy, but allowing interest rates to move temporarily in the opposite direction (Friedman, 7 – 8). Conclusion The overall theme of Milton Friedman’s argument with regard to the link between interest rates and monetary policy is that monetary policy has no capability of pegging interest rates. Additionally, he provides conclusive evidence in support of his argument that interest rates cannot serve as a reliable indicator on whether a monetary policy that is in implementation is “tight” or “easy”. Ultimately, he concludes that the most effective way of determining whether monetary policy is tight or easy is to consider the rate of monetary growth. Works Cited Friedman, Milton. “The Role of Monetary Policy”. The American Economic Review (53). 1 (1968): 5 – 8. Keynes, John Maynard. Essays in Persuasion. New York: Norton & Company Inc., 1947. Read More