2026 marks the fiftieth anniversary of University of Chicago professor Milton Friedman’s Nobel Memorial Prize in Economic Sciences. Michael D Bordo reflects on how Milton Friedman’s legacy has developed in this time. While Friedman’s revolutionary idea of monetarism has been superseded in some ways, his contributions have played a key role in the evolution of monetary policy and remain critical to contemporary macroeconomic research and central bank policy.
Milton Friedman (1912-2006) was one of the most prominent and influential economists of the twentieth century. From 1946 to 1977, he was the leader, along with George Stigler, of the University of Chicago’s Chicago School of Economics, which was known for free-market price theory and monetary economics.
One of Milton Friedman’s major contributions was monetarism, for which he received the Nobel Prize in Economics in 1976. He developed the idea that controlling an economy’s money supply is the best instrument for supporting economic growth while limiting inflation. This revolutionized monetary policymaking during the inflation crisis of the 1970s that plagued the United States and the rest of the world. In a new NBER working paper, I reflect on how Milton’s monetarism developed as a modern monetary policy tool and how Milton’s legacy lives on in current economic theories and research and the practices of central banks.
The adoption of Friedman’s monetarism
Friedman made notable contributions to economic theory and to public policy, including floating exchange rates and advocacy to end the draft and promote programs to alleviate poverty. However, his most well-known contribution, monetarism, revived the Quantity Theory of Money, a concept first discussed in the sixteenth century, which posited that changes in the quantity of money (physical currency and commercial bank deposits) led to changes in the overall level of the prices of goods and services. Friedman’s Modern Quantity Theory of Money challenged and defeated the prevailing Keynesian orthodoxy that “money did not matter” and that only fiscal policy could be used to stabilize the economy.
The core of Friedman’s modern quantity theory of money theorizes that the demand for money (ie, the amount of money that the public chooses to hold to conduct their economic activity) is based on a limited number of important economic variables, including wealth and the rates of return on key assets. The amount of money that people choose to hold rises with their wealth and declines as the rates of return on other assets rise. The interaction between the supply of money, determined by monetary policy makers changing their policy interest rates or by directly purchasing financial assets, and the demand for money, would determine the public’s spending and its impact both on real economic activity and on the prices of goods and services.
Friedman and his long-time coauthor, Anna Jacobson Schwartz, provided empirical and historical evidence to support the modern quantity theory in their monumental A Monetary History of the United States. Their key findings were that changes in the supply of money were the leading cause of business cycle fluctuations (i.e. changes in real economic activity and employment) and to inflations and deflations (sustained increases and decreases in the price level).
As such, they attributed many of the U.S. recessions in the twentieth century to the policy actions of the Federal Reserve. Their key finding was that the Great Depression reflected the Fed’s unforced error in not using expansionary monetary policy to increase liquidity to troubled banks, which could have prevented four serious banking panics.
Their evidence made the case for the Fed to follow Milton Friedman’s so-called “k% monetary rule.” Rather than allowing the Fed to use discretionary judgment to determine interest rates, the Fed should keep money growth at a constant rate (k%) sufficient to maintain both price level and output stability. Friedman also criticized the Fed’s actions leading to the dangerously high inflation of the 1970s, which accompanied a drastic weakening of the U.S. dollar. This led to the Federal Reserve Act of 1977, requiring the Fed to submit to Congress projections of money growth, among other things. In accordance with Friedman’s approach, Fed Chair Paul Volcker clamped down on money growth in 1979 and permitted sky-high interest rates (known as the “Volcker Shock”). This action dramatically reduced inflation and ended the Great Inflation of 1965-1982. During that extended period, the Consumer Price Index had risen 300%.
The waning of Friedman’s monetarism
Friedman’s monetarism contributed to taming the Great Inflation but beginning in the 1980s, it struggled to define monetary policy. The development of new financial instruments, for example money market mutual funds, and changing financial regulations, such as allowing banks to pay interest on demand deposits, changed both the definition of the money supply and the demand for money. Friedman preferred the M2 definition of money—the sum of physical currency in circulation, checking accounts, and interest earning savings accounts. He believed it was both very liquid and was a good means of preserving wealth. Other economists preferred M1, made up of currency and checking accounts only, while others preferred M3 which added large certificates of deposits to M2. All these measures became unreliable in the 1980s as a target for monetary policy.
Financial innovation also destabilized the demand for money. Thus, Friedman’s monetarism could no longer reliably generate an amount of spending in the economy that would produce sustained healthy economic growth and stable prices. Consequently, both central banks and the economics profession in general abandoned Friedman’s monetarism in the 1980s and returned to controlling interest rates to influence spending, as they had done before Friedman.
Friedman’s monetary policy legacy
Yet, the profound insights of Friedman’s monetarism have in subsequent years led to a new paradigm, the New Keynesian model, which has become the workhorse for both monetary policy makers and academic economists.
One of its tenets is the concept of monetary neutrality: changes in money supply first affect real economic activity and over time, are fully absorbed into changes in prices.
A second pillar of Friedman’s research was the natural rate hypothesis, which he articulated in his 1968 presidential address to the American Economic Association. Friedman’s natural rate hypothesis posited that the Fed could not permanently reduce unemployment below its natural rate (which was determined by the free-market forces underlying the labor market). Attempting to do so with expansionary monetary policy would only accelerate inflation because both workers and firms would eventually expect wage and prices to rise, leaving the “real wage” (the value of wages accounting for inflation) that cleared the labor market unchanged.
Later in 1972, Friedman’s student Robert Lucas, who received the Nobel Prize in Economics in 1995, extended Friedman’s natural rate hypothesis by arguing that if private sector households and businesses and those in financial markets had rational expectations, i.e. that they understood the policy model used by the Fed and had full information about how the policy would affect the economy, they would instantly adjust their expectations of inflation incorporating the new policy, thereby completely negating the Fed’s actions.
After Friedman retired from the University of Chicago, he set up shop at the Hoover Institution at Stanford University. One of his noted colleagues there, John B Taylor, extended Friedman’s theoretical foundations and the case for rules-based conduct. He developed a rule based on interest rates as the Fed’s policy instrument rather than on the money supply to achieve stable low inflation and maximum (full) employment output. Since the 1990s, the Taylor Rule has been the central unifying benchmark for evaluating the Fed’s (and other global central banks’) conduct of monetary policy.
The Shadow Open Market Committee
Friedman’s legacy has continued in other venues, too. In 1973, Schwartz founded the Shadow Open Market Committee (SOMC) with Karl Brunner of Rochester University and Allan Meltzer of Carnegie Mellon University to advocate the tenets of Milton Friedman’s monetarism and serve as an outside watchdog of the Fed and its Open Market Committee, the body that sets monetary policy. Along with Friedman, the SOMC influenced Congress to modify the Federal Reserve Act of 1977 to require the Fed to follow targets for monetary supply and to report to Congress on their performance in hitting and reducing their targets. Since the 1970s, the SOMC has notably criticized the Fed’s unforced errors in not preventing the Global Financial Crisis of 2007-2008 and the post pandemic inflation of 2020-2021. In 2021, the SOMC highlighted the 40% rise in money supply since before the pandemic in 2019 and predicted the high inflation that would unfold, even as the Fed ignored the unprecedented surge in money supply and erroneously argued that the inflation was due to a “transitory supply shock.”
The hard currency European Central Banks
Two European Central banks (the Deutsche Bundesbank and the Swiss National Bank) are direct descendants of Friedman’s monetarism. Both followed “the stability culture” of sound money and price stability that the Chicago School long promoted. Both central banks avoided the Great Inflation of the 1970s and kept targeting the growth of the money supply long after the Fed (and others) had given up. The European Central Bank (ECB), established in 1999, kept a strong role for controlling money growth. Otmar Issing, chief economist for the Bundesbank from 1990-1998 and for the ECB from 1998-2006, originated the ECB’s “Two Pillar Strategy” for it to follow its mandate of price stability. Pillar one was to monitor the growth in the Bundesbank’s measure of money supply to ensure long-run price stability, especially to prevent outbreaks of inflation. Pillar two was to use real and financial analysis (conventional macro modelling) to ensure stable prices in the short to medium term.
Milton in recent research
Today, several researchers continue to study the quantity theory using new concepts of money based on ideas developed by Friedman and Schwartz in 1970. They argue, following Friedman, that the choice of the correct monetary variable to use in quantity theory analysis is that combination of monetary assets that provides the best flow of monetary services (e.g., liquidity). Peter Ireland of Boston College and I, both former students of Friedman, and others, use measures of the flow of services of money based on the difference between the yields on safe assets like Treasury bills and on the several components of money. With these measures, which consider the modern financial innovations and regulations that Friedman did not account for, we estimate a stable long-run demand for money. Our research confirms that changes in the quantity of money interacting with our revised demand for money explain the recent post-pandemic inflation, as Friedman would have argued.
Conclusion
Milton Friedman’s legacy is very much present in today’s money macroeconomic models. Unfortunately, Friedman’s message to follow systematic monetary rules to achieve low and stable inflation tends to be pushed aside by the Fed and other central banks who covet their discretion and like to use their judgment in conducting monetary policy. The recent post-pandemic inflation in the U.S. highlights what can go wrong when systematic rules and Friedman’s monetary policy prescriptions are ignored. In 2020-2021, every measure of the money supply increased, sending up a red flag that inflation would surge, as Friedman, were he alive, would have broadcast.
Author’s Disclosure: The author reports no conflicts of interest. You can read our disclosure policy here.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
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