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The Pseudo-Psychology Behind Monetary Policy

The Pseudo-Psychology Behind Monetary Policy

In his various writings, the champion of the monetarist school, Milton Friedman, argued that there is a variable time lag between changes in money supply and its effect on real output and prices. Friedman holds that in the short run changes in money supply will be followed by changes in real output.

However, in the long-run changes in money will only have an effect on prices. All this means that changes in money with respect to real economic activity tend to be neutral in the long-run and non-neutral in the short-run. Thus according to Friedman,

In the short-run, which may be as much as five or ten years, monetary changes affect primarily output. Over decades, on the other hand, the rate of monetary growth affects primarily prices.1

According to Friedman because of the difference in the time lag, the effect of the change in money supply shows up first in output and hardly at all in prices. It is only after a longer time lag that changes in money start to have an effect on prices. This is the reason according to Friedman why in the short-run money can grow the economy, while in the long run it has no effect on the real output.

According to Friedman, the main reason for the non-neutrality of money in the short-run is the variability in the time lag between money and the economy.

Consequently, he believes that if the central bank were to follow a constant money growth rate rule this would eliminate fluctuations caused by variable changes in the money supply growth rate. The constant money growth rate rule could also make money neutral in the short-run and the only effect that money would have is on general prices in the long run.

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