Etzkowitz, Keynes Friedman Final Paper

Keynes and Friedman on Monetary Policy:
How Influential Were Their Views and How Would They
Interpret Recent Fed Policy?
Alex Etzkowitz
Thanks to Rick Mishkin for helping to clarify.

1
The present institutional structure of the U.S. Federal Reserve system (“the Fed”) is in
large part a product of past failures to maintain macroeconomic growth and financial stability
while controlling inflation. The American experience during the Great Depression from 1929-
1939 provided a powerful catalyst for change at the Fed, as did the period from 1972-1982
known as the Great Inflation. Though at the time of these events it was quite clear that
something should be done to prevent repeated failures, it was not clear which policy changes
provided the best way forward. Many eminent economists contributed to these debates, but the
arguments of John Maynard Keynes and Milton Friedman, stand out as particularly influential. I
will discuss the contributions of these two great economists, their lasting impact on the Fed, and
finally the degree to which they both would have supported the Fed’s actions during the financial
crisis of 2007-2009 and the ensuing recession.
Originally created in 1913, the Fed was, according to a contemporary senator, meant to
“provide a means by which periodic panics which shake the American Republic and do it
enormous injury shall be stopped.”1
Whether such a means had actually been created was
severely tested after 1929 when a stock market crash and rolling bank panics roiled the nation.
Ultimately, with unemployment peaking at over 20% and industrial production falling by nearly
half at the trough of the downturn, the Fed had failed. Economists like Irving Fisher and Knut
Wicksell stepped in with new theoretical models and policy prescriptions to fill the breach,
though Keynes was indisputably the man of the hour.
In the popular discourse, Keynes’ main contribution to political economy following the
Great Depression is the establishment of fiscal policy as the primary tool for policymakers in
light of the failure of monetary policy. Though he certainly advocated for the effectiveness of
fiscal policy in a demand-constrained economy, that he believed monetary policy was powerless
1
Quoted from Bernanke (2013).

2
could not be further from the truth. In the context of a recession brought on by excess savings
and lack of consumption, Keynes writes: “It is to our best advantage to reduce the rate of interest
to that point relatively to the schedule of the marginal efficiency of capital at which there is full
employment. There can be no doubt that this criterion will lead to a much lower rate of interest
than has ruled hitherto.”2
This is a straight-forward critique of the Fed, which Keynes’ believed
had failed to lower rates sufficiently, but not necessarily a critique of the effectiveness of
monetary policy in general. As one Keynesian scholar argues: “The standard ‘Keynesian’
argument against monetary policy is simply not to be found in the General Theory but was a
later development about which Keynes expressed the deepest reservations.”3
Keynes goes on, “It may turn out that the propensity to consume will be so easily
strengthened by the effects of a falling rate of interest, that full employment can be reached with
a rate of accumulation little greater than at present.”4
On the other hand, he also recognized that
“the collapse in the marginal efficiency of capital may be so complete that no practicable
reduction in the rate of interest will be enough.”5
Keynes had a nuanced understanding that the
effectiveness of monetary policy depended on the specific condition of the economy. Keynes
felt that central banks had historically refused to test the natural limits of monetary policy by
restricting themselves to purchases of specific securities.6
In contrast, many Keynesians felt that
the U.S. had fallen into a “liquidity trap,” ironically a condition first described by Keynes, in
which even a willing monetary authority can no longer force rates lower. Modern empirical
evidence suggests that Keynes was likely correct. Although rates on short-term government
bonds fell close to zero, rates on other instruments, including corporate debt, bank loans, and
2
Keynes, The General Theory of Employment, Interest, and Money, ch. 24, II.
3
Leijonhufvud (1968), p. 98.
4
5
6
Keynes, The General Theory of Employment, Interest, and Money, ch. 15, III.

3
mortgages still had room to fall throughout the Great Depression.7
Keynes’ belief in the power
of both fiscal and monetary policy to combat depression was enshrined in the Employment Act
of 1946, which required the federal government to promote employment.8
In 1977, the Fed was
given even clearer instructions to attain “maximum employment.”9
In addition to believing in the effectiveness of monetary policy, Keynes felt that the role
of the central bank in supporting the financial system was crucial. However, he saw that the
institutional structure of the Fed prevented aggressive policies from being pursued on the
financial stability front, as well as on the monetary front. Thus, he felt that central bank
independence was of paramount importance, noting that “The less direct the democratic control
and the more remote the opportunities for parliamentary interference with banking policy the
better it will be.”10
This principle was established to some degree with the passage of the
Banking Reform of 1935, which established the Fed’s legal independence and removed the
Secretary of the Treasury and the Comptroller of the Currency from the Fed’s Board. In 1951
the Fed reached an accord with the Treasury for even fuller independence, bringing the Fed’s
institutional structure yet closer to Keynes’ ideal.11
Keynes advocated for a strong and independent central bank unconstrained by politicians,
private interests, or any other institutions, save for the overarching objectives governing their
conduct, which Keynes believed ought to be democratically determined.12
He believed the
central bank should act forcefully, if need be pushing directly on long-term interest rates, rather
than being satisfied with controlling only short-term rates.13
These preferences bear a striking
7
See Basile, Landon-Lane, and Rockoff (2010) for a full discussion of this issue.
8
Bernanke (2013).
9
Ibid.
10
Quoted from Bibow (2002), p. 775.
11
Bernanke (2013).
12
Bibow (2002), pp. 774-782.
13
Leijonhufvud (1968), p. 107.

4
resemblance both to the current institutional frameworks of the world’s leading central banks and
to the policies they have adopted since 2007.
Though Keynes himself assumed that monetary policy was a powerful and useful tool,
the same cannot be said for his disciples. In 1968, Milton Friedman wrote that as a result of the
wide acceptance of Keynesian views, “for some two decades monetary policy was believed by
all but a few reactionary souls to have been rendered obsolete by economic knowledge. Money
did not matter.”14
Friedman believed that this outlook was entirely mistaken.
To Friedman, not only did money matter, it mattered always and everywhere. While
Keynes pointed to a number of factors, Friedman assigned full blame for the Great Depression to
the Federal Reserve, which in his view “forced or permitted a sharp reduction in the monetary
base, because it failed to exercise the responsibilities assigned to it in the Federal Reserve Act to
provide liquidity to the banking system.”15
In the late 1990’s, when many observers believed
that Japan had exhausted the usefulness of monetary policy, Friedman wrote that even with
interest rates stuck near zero, “The Bank of Japan can buy government bonds on the open
market…Higher money supply growth would have the same effect as always. After a year or so
the economy will expand more rapidly; output will grow, and after another delay, inflation will
increase moderately.”16
In fact, Friedman was so concerned with the inflationary potency of monetary policy that
he advocated for a pure rule-based regime for monetary policy. Friedman wrote that “Mistakes,
excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few
men great power, and which thereby makes important policy actions highly dependent on
14
Friedman (1968), p. 2.
15
Friedman (1968), p. 3.
16
Quoted from http://online.wsj.com/news/articles/SB10001424052702303443904575578202202857136.

5
accidents of personality.”17
As such, he believed central banks should be tethered to a strict
policy rule. However, unlike some of his disciples, Friedman felt that a return to the gold
standard was “neither a feasible nor desirable solution” to the problem of discretionary policy.18
Rather, Friedman believed that the most effective regime would be one in which a constant
increase in the price level would be targeted through steady growth in the money supply. This
solution would not only avoid disruptive swings in the price level, but would also have
“favorable effects on people’s attitudes and beliefs and expectations that would not follow even
from the discretionary adoption of precisely the same policy on a series of separate occasions.”19
Friedman was quite prescient on the issue of inflation, as his warnings preceded two
spikes of double digit inflation that arose in the mid 1970’s and early 1980’s. Largely as a result
of Milton Friedman’s work and advocacy, by the end of the 1970’s, economic orthodoxy, and
thinking at the Fed largely reflected Friedman’s view that inflation is a monetary phenomenon.20
New emphasis was placed on the need for the Fed to credibly commit to controlling inflation lest
inflationary expectations get carried away. In 2012, the Fed established a long-run target of 2%
inflation, fortifying its commitment.21
Though Milton Friedman would certainly not agree with
the mixed discretionary/rule-based system the Fed operates under today, there is no doubt that
his ideas helped to push the pendulum away from what had been almost a purely discretionary
system. Former Fed Chair Ben Bernanke has even suggested that Friedman’s monetary
framework has “nearly become identical with modern monetary theory and practice.”22
Many
economists and policymakers, most notably those associated with the nascent market monetarist
17
Friedman, Capitalism and Freedom, p. 50.
18
19
20
Bernanke (2013).
21
http://www.reuters.com/article/2012/01/25/us-usa-fed-inflation-target-idUSTRE80O25C20120125
22
Quoted from Nelson (2011), p. 2.

6
movement, continue to follow in Friedman’s footsteps, agitating for a stricter rules-based
system.23
During and after the financial crisis of 2007-2009, the Fed took a number of aggressive
actions that many observers criticized as unconventional, experimental. Nonetheless, each of
these policies had been considered either directly or tangentially by both Friedman and Keynes
decades earlier. These policies fall into three main categories: provision of short-term liquidity to
banks, provision of short-term liquidity to non-banks, and large-scale asset purchases (LSAPs).24
Although Keynes’ and Friedman had markedly different values and disagreed forcefully on
many economic issues, they would have agreed that these interventions were both appropriate
and likely to be effective.
Keynes and Friedman would have spoken with one voice in support of the Fed’s
interventions to prop up banks during the financial crisis. In fact, they would likely have seen
the decision of the Fed and Treasury to let Lehman Brothers fail as in error. Milton Friedman
believed that the Federal Reserve’s inaction in the face of the 1930 banking panic was a grave
mistake and that if it had lived up to its mandate, “the bank closings would have been cut short
and the monetary debacle averted.”25
Though he would no doubt prefer an automatic and non-
discretionary system for saving failing banks, Milton Friedman would have seen the Fed’s efforts
on this front as, if anything, too timid. Keynes would certainly have agreed. He wrote on the
subject, describing the mutually reinforcing feedback loops between economic weaknesses and
23
For an example of a market monetarist policy prescription, see Sumner (2012):
http://mercatus.org/sites/default/files/NGDP_Sumner_v-10%20copy.pdf.
24
For a full description of the Fed’s crisis interventions see:
http://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm;
http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm.
25

7
banking panic which only government could break.26
Empirical evidence suggests that the Fed’s
interventions were at least partially successful.27
Keynes and Friedman would almost certainly have supported interventions to prop up
non-banking financial institutions and markets given their vital roles in the modern financial
system. Chief among these interventions were the Fed’s attempts to unfreeze the $2.2 trillion
commercial paper market and rescue the $3.5 trillion money market mutual fund industry.
Keynes saw lending markets as crucial, and would not have batted an eyelash at these actions.
During the Great Depression, he suggested that “In every way the more effective remedy would
be that the Central Banks of these three great creditor nations (i.e. the U.S., the U.K., and France)
should join together in a bold scheme to restore confidence in the international long-term loan
market; which would serve to revive enterprise and activity everywhere.”28
Friedman would
have agreed. He understood that the vital process of credit creation was carried out by a variety
of institutions, and criticized the Fed ferociously for allowing banks that were not Federal
Reserve member banks to fail during the Great Depression.29
Empirical evidence confirms that
these interventions also succeeded at least to some degree.30
Finally, Keynes and Friedman would have agreed both on the necessity and effectiveness
of LSAPs, known in the U.S. as “quantitative easing.” The Fed has come under relentless
criticism for these purchases by academics, investors, and journalists alike. Their fears have run
the gamut from accelerating inflation and currency debasement to the creation of future
speculative bubbles.31
Keynes believed that during an economic contraction the monetary
26
Keynes (1931), Ch. 7, “The Consequences to the Banks of the Collapse of Money Values.”
27
See Wu (2008) for a full discussion of this issue.
28
Keynes (1931), Ch. 5, “The Great Slump of 1930.”
29
Nelson (2011), pp. 23-24.
30
See Duygan-Bump, et al. (2013) for a full discussion of this issue.
31
See for example: http://blogs.wsj.com/economics/2010/11/15/open-letter-to-ben-bernanke/;
http://online.wsj.com/news/articles/SB10001424052702303763804579183680751473884;

8
authority should not be satisfied with adjusting short-term interest rates, only to “leave the price
of long-term debts to be influenced by belated and imperfect reactions from the price of short-
term debts.”32
Quantitative easing, through the purchases of long-dated treasuries and mortgage-
backed securities, closely follows Keynes’ advice.
In general, Friedman thought that monetary policy should be used aggressively only
when financial conditions presented a “clear and present danger,”33
but there can be little doubt
that such a danger existed from 2007 to the present. He believed that central bank operations
should be restricted to short-term debt under ordinary circumstances, but purchases of long-term
debt could be used when needed and were certain to increase the money supply and thus lower
interest rates.34
Theoretical35
and empirical36
evidence confirm the efficacy of LSAPs both in the
U.S. and abroad37
, which would come as no surprise to Keynes or Friedman.
http://business.time.com/2012/11/15/is-there-a-reckoning-coming-thanks-to-quantitative-easing/;
http://www.forbes.com/sites/jamesdorn/2012/09/20/bernanke-administers-another-cruel-dose-of-financial-
morphine-with-qe3/.
32
Keynes, The General Theory of Employment, Interest, and Money, ch. 15, III.
33
Friedman (1968), p. 14.
34
Nelson (2011), pp. 12-16.
35
See Curdia & Woodford (2011).
36
See Gagnon, et al. (2011); Krishnamurthy & Vissing-Jorgensen (2011).
37
See Weale & Wieladek (2014).

9
References
Basile, Peter F., John Landon-Lane & Hugh Rockoff. “Money and Interest Rates in the United
States during the Great Depression," NBER Working Papers 16204, 2010.
Bernanke, Ben S. A Century of U.S. Central Banking: Goals, Frameworks, Accountability.
Remarks delivered on July 10, 2013.
http://www.federalreserve.gov/newsevents/speech/bernanke20130710a.htm
Bibow, Jorg. "Keynes on Central Banking and the Structure of Monetary Policy." History of
Political Economy, Volume 34, Number 4, pp. 749-787, 2002.
Curdia, Vasco, and Michael Woodford. “The Central-Bank Balance Sheet as an Instrument of
Monetary Policy,” Journal of Monetary Economics, 58(1), pp. 54-79, 2011.
Duygan-Bump, Burcu, Patrick Parkinson, Eric Rosengren, Gustavo A. Suarez, & Paul Willen.
"How Effective Were the Federal Reserve Emergency Liquidity Facilities? Evidence from the
Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility." The Journal
of Finance, Volume 68, Issue 2: 715-737, April 2013.
Friedman, Milton. Capitalism and Freedom, Fortieth Anniversary Edition, Chicago: University
of Chicago Press, 1962.
Friedman, Milton. “The Role of Monetary Policy,” The American Economic Review, Volume
LVIII, Number 1, 1968.
Gagnon, Joseph, Matthew Raskin, Julie Remache, & Brian Sack, “The Financial Market Effects
of the Federal Reserve’s Large-Scale Asset Purchases,” International Journal of Central
Banking 7(1), pp. 3-43, 2011.
Keynes, John Maynard. The general theory of employment, interest, and money. New York:
Harcourt, Brace & World, 1965.
Keynes, John Maynard. Essays in Persuasion. London: Macmillan and Co., 1931.
Krishnamurthy, Arvind, and Annette Vissing-Jorgensen “The Effects of Quantitative Easing on
Interest Rates: Channels and Implications for Policy,” Brookings Papers Econ. Activity, pp.215–
65, Fall 2011.
Leijonhufvud, Axel. "Keynes And The Effectiveness Of Monetary Policy." Economic Inquiry,
Volume 6, Issue 2, pp. 97-111, March 1968.
Nelson, Edward. “Friedman’s Monetary Economics in Practice,” unpublished, Federal Reserve
Board, April 2012.
Sumner, Scott. “The Case for Nominal GDP Targeting,” Mercatus Center, George Mason
University Working Paper, 2012.

10
Weale, Martin, and Tomasz Wieladek, “What Are the Macroeconomic Effects of Asset
Purchases?” Bank of England External MPC Unit Discussion Paper No. 42, April 2014.
Wu, Tao. “On the Effectiveness of the Federal Reserve’s New Liquidity Facilities,” Federal
Reserve Bank of Dallas Working Paper 0808, May 2008.

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