Youll sometimes hear people assigning a liberal slant to quantitative easingbut it was actually proposed by Milton Friedman. In 2000, he was asked what more the Bank of Japan could do to combat deflation, since they were constrained by the zero lower bound. Friedman said, Its very simple. They can buy long-term government securities. Which is exactly what the Fed has been doing.

Incidentally, despite what some critics have said, this benign outcome for inflation is actually quite consistent with my reading of Milton Friedman’s analysis. The measures of money he associated with inflation were broad measures that include money created by the banking system. The increases we have seen in those measures have been much more moderate. One of the big points from his Monetary History of the United States[3] was that focusing too much on the size of the Fed’s balance sheet was a bad idea. Indeed, in the early 1930s, the Fed increased the size of its balance sheet quite substantially. But it wasn’t enough. Given the struggles of the banking system, broad measures of money actually declined, leading to deflation. The conclusion was that the Fed needed to have increased its balance sheet even more. That’s a lesson the Bernanke Fed has taken to heart this time around.

“I think he would’ve supported what we are doing,” Mr. Bernanke said, pointing to Mr. Friedman’s work with Anna Schwartz on the lessons learned from the Great Depression. 

Specifically, their identification of two main problems of that period — overly tight monetary policy and allowing the collapse of the banking system — were instructive in the current environment.

“We took that very much to heart, we were aggressive early on,” Mr. Bernanke said.

While criticisms of the Fed’s actions are a dime-a-dozen, the Fed chief said he doesn’t think Mr. Friedman would join in, especially the chorus of laments when the central bank announced it was embarking on a third round of bond buying last month.

“In fact, a dozen years ago … Friedman was asked what the Japanese should do at that time and he said, ‘well, they ought to go out and buy securities’,” Mr. Bernanke said. “That’s exactly what the Federal Reserve is doing now.” (Read excerpts of Friedman’s prescriptions for Japan here.)

From the Wall Street Journal's coverage of the Q&A.)

The idea that monetary policy should be conducted in a systematic and predictable way is not new. One of the earliest, and most controversial, proposals was Milton Friedman’s famous k-percent money growth rule.2 Friedman argued that monetary policy was a major contributor to cyclical fluctuations. He argued that efforts by the central bank to “stabilize” or “fine-tune” the real economy were fraught with danger because we didn’t know enough about the short-run dynamics of monetary actions to reliably predict their effects on the real economy. As a result, monetary policy ended up being a source of real instability rather than a stabilizing influence.

In addition, Friedman correctly argued that sustained inflation was always a monetary phenomenon and that in a world of paper or fiat money, the central bank had the obligation to preserve money’s purchasing power so that markets would not be distorted by inflation. Price stability would therefore promote a more efficient allocation of resources. At the time, this view of the importance of price stability was controversial, but today it is widely accepted.

Thus, Friedman highlighted two central features of good monetary policy that are hallmarks of the rules that I will turn to shortly. First, he argued that monetary policy should be formulated in a way that stabilized the purchasing power of money. Second, he stressed monetary policy should not be used to “fine-tune” real economic activity because attempting to do so often introduced instability into the real economy instead of improving economic performance. His actual proposal was that the Federal Reserve should announce that the money supply would be allowed to grow at k-percent a year -- period. With k a suitably low number, such a policy rule would ensure that inflation would never become a problem and that monetary policy would cease to be an independent source of cyclical fluctuations.

The Friedman rule is simple and easy to communicate. It also gives a high degree of predictability to monetary policy. Had it been implemented, it surely would have prevented the double-digit inflation the U.S. economy suffered in the late 1970s, as well as much of the subsequent economic disruptions in the early 1980s that occurred as inflation was brought back down to acceptable levels.

Yet the rule has several shortcomings that have limited its appeal. Most important, many economists view money demand as volatile, so that a constant supply of money could lead to more variability in inflation, and perhaps output, than necessary. Thus, most economists believe that some sort of policy that responds to the state of the economy could perform better.

Over time, this research, as well as Friedman's predictions that expansionary monetary policy in the 1960s would lead to high inflation and high interest rates (Friedman, 1968), had a major impact on the economics profession, with almost all economists eventually coming to agree with the Friedman's famous adage, "Inflation is always and everywhere a monetary phenomenon" (Friedman 1963, p. 17), as long as inflation is referring to a sustained increase in the price level (e.g., Mishkin, 2007a).

General agreement with Friedman's adage did not mean that all economists subscribed to the view that the money growth was the most informative piece of information about inflation, but rather that the ultimate source of inflation was overly expansionary monetary policy. In particular, an important imprint of this line of thought was that central bankers came to recognize that keeping inflation under control was their responsibility.

As a card-carrying monetarist, I argued the steady money growth case vigorously in years past, and it is still my conviction that a central bank ignores money growth at its peril...

Everything Milton argued about money stock control is true, but the effect of inflation expectations on the practice of monetary policy itself was, I believe, a missing element in the analysis...

...I believe that the Fed’s actual adjustments of its federal funds rate target have yielded superior outcomes since 1982 to what we would have observed under steady money growth. I also believe that advances in knowledge permit us to say with some confidence that these gains are not just an accident of Alan Greenspan’s special skills and intuition.

To paraphrase the late Milton Friedman, inflation is always and everywhere an expectational phenomenon.  To put it another way, inflation expectations are an outcome of monetary policy, not an autonomous help or hindrance.  Central banks are as responsible for the behavior of inflation expectations as they are for the behavior of inflation.  

As Milton Friedman famously said many years ago, “Inflation is always and everywhere a monetary phenomenon.” Unfortunately, given the lack of a stable relationship between money growth and inflation, the pure monetarist view has taken a beating since then. However, Friedman was right that inflation is, ultimately, something that central banks determine, at least on average, over time.

In the early 1960s, in my Ph.D. studies at the University of Chicago, I was fortunate to be a member of Milton Friedman’s Money Workshop. Friedman stoked my interest in flexible exchange rates, in an era when mainstream thinking was focused on the advantages of fixed exchange rates and central banks everywhere were committed to maintaining the gold standard. Well, I should say central banks almost everywhere, given that Canada had a floating rate system from 1950 to 1962. Friedman got me interested in doing my Ph.D. dissertation on the Canadian experience with a floating exchange rate, and later I did a paper on nine other floating rate regimes in the 1920s. For this paper I collected daily data on exchange rates from musty paper records at the Board of Governors in Washington.

What was striking about the debates over floating rates in the 1950s is that economists were so willing to speculate about how currency speculators would destabilize foreign exchange markets without presenting any evidence to support those views. In this and many other areas, careful empirical research has resolved many disputes.

Back in 1968, Milton Friedman warned economists and policymakers not to try to stimulate economic growth at the cost of "just a little more" inflation.  He predicted that people would come to anticipate that little bit of extra inflation, and then would change their behavior in various ways. The end result would be slower economic growth and ever-higher inflation. In effect, Friedman was warning policymakers not to treat inflation as a static concept, but to appreciate the interdependence between inflation and inflation expectations.

Unfortunately, the economic events of the 1970s bear out Friedman's warning. Households and businesses did adjust their behavior to minimize the costs they faced from rising inflation. And once inflation expectations became unglued, we watched with dismay as the costs arising from inflation expectations took a huge toll on our resources. The economy spiraled into "stagflation" - an environment of worsening economic performance and higher inflation.

Over a short period, then, higher inflation might bring lower unemployment, consistent with the empirical results found by Phillips. However, this logic applies only during the period in which wages and workers' expectations of inflation are fixed. If inflation were to rise persistently, Friedman and Phelps argued, workers' expectations of inflation would not remain unchanged but would adjust to match the actual rate of inflation...This work was both brilliant and prescient. In particular, among the seminal contributions of the Friedman and Phelps analyses was the identification of the key role of inflation expectations in determining the behavior of the economy, a point that remains central to our thinking today.

In my view, the most fundamental policy recommendation put forth by Milton Friedman is the injunction to policymakers to provide a stable monetary background for the economy. I take this to be a stronger statement than the Hippocratic injunction to avoid major disasters; rather, there is a positive argument here that monetary stability actively promotes efficiency and growth. (Hence Friedman's suggestion that the long-run Phillips curve, rather than vertical, might be positively sloped.) Also implicit in Friedman's focus on nominal stability is the view that central banks should avoid excessively ambitious attempts to manage the real economy, which in practice may exacerbate both nominal and real volatility. In Friedman's classic 1960 work, A Program for Monetary Stability, he suggested that monetary stability might be attained by literally keeping money stable: that is, by fixing the rate of growth of a specific monetary aggregate and forswearing the use of monetary policy to "fine-tune" the economy.

A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.  [18]

[18] A tax cut financed by money creation is the equivalent of a bond-financed tax cut plus an open-market operation in bonds by the Fed, and so arguably no explicit coordination is needed. However, a pledge by the Fed to keep the Treasury's borrowing costs low, as would be the case under my preferred alternative of fixing portions of the Treasury yield curve, might increase the willingness of the fiscal authorities to cut taxes.

What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.