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YODA AND MILTON FRIEDMANTWO TIMELESS CRUSADERS AGAINST THE DARK SIDE" rel="bookmark">YODA AND MILTON FRIEDMANTWO TIMELESS CRUSADERS AGAINST THE DARK SIDE

25 years ago Mil­ton Fried­man was an eco­nomic Yoda teach­ing that money sup­ply was an ever present “Force” con­trol­ling the econ­omy. With a new finan­cial Death Star threat­en­ing, Fried­man is remem­bered by the Fed­eral Reserve’ Jedi Knights of money supply.

Before his death, Mas­ter Fried­man was the “mon­e­tarists” leader. He taught that money sup­ply deter­mines eco­nomic activ­ity and changes in the amount of money directly affects infla­tion, GDP and employment.

Like Jedi Knights in hid­ing, Friedman’s dis­ci­ples are qui­etly emerg­ing and using money sup­ply as a light saber to avoid an eco­nomic cat­a­stro­phe cre­ated by the bank­ing cri­sis and defeat infla­tion caused by soar­ing com­mod­ity prices.

The Quan­tity The­ory of Money

Mon­e­tarists’ uni­fy­ing the­ory is called the “quan­tity the­ory of money” which states that GDP and infla­tion are directly affected by changes in the level of money sup­ply. The quan­tity the­ory of money holds that GDP is equal to the amount of money avail­able mul­ti­plied by the veloc­ity of money. The veloc­ity of money is the speed that money turns over or is spent and respent.

As an exam­ple, if a con­sumer has $100 that is used to buy din­ner at a restau­rant, $100 of GDP is cre­ated. When the restau­rant respends the $100 to pay for food and elec­tric­ity, GDP is $200 (the orig­i­nal $100 pur­chase and the respend­ing of the $100) and the veloc­ity is 2x. If the restaurant’s food sup­pli­ers and elec­tric com­pany respend the $100, GDP increases by another $100 and veloc­ity is 3x. Every time the $100 is respent, GDP increases by $100 and the num­ber of times it is respent is the veloc­ity of money. As such, mon­e­tarists believe that GDP must equal the amount of money mul­ti­plied by the num­ber of times it is respent.

Also, mon­e­tarists believe that there is a max­i­mum veloc­ity that money can be respent based upon prac­ti­cal and real world lim­its on how fast peo­ple can spend money. Mon­e­tarists teach that veloc­ity will accel­er­ate to the the­o­ret­i­cal max­i­mum rate and there­fore is more or less con­stant. As a result, if the Fed­eral Reserve sets the amount of money and the veloc­ity is con­stant, then the Fed­eral Reserve can deter­mine GDP through mon­e­tary policy.

Mon­e­tarists believe that increas­ing money sup­ply is the only way to have grow­ing GDP (so if the con­sumer has $125 to spend rather than $100, GDP will be greater). Mon­e­tarists also believe that if money sup­ply grows faster than the growth rate in GDP, then infla­tion will result. Sim­i­larly, if money sup­ply grows slower than GPD growth, mon­e­tarists believe that defla­tion will be the consequence.

The Lim­its of Monetarism

While mon­e­tarism is a pow­er­ful eco­nomic force, in the 1970s and 1980s Friedman’s Jedi Knights at the Fed­eral Reserve used money sup­ply growth as their pri­mary pol­icy tool with poor results.

There were two prin­ci­pal prob­lems with the Fed’s over reliance on mon­e­tarism. First, the amount of money in “money sup­ply” is uncer­tain and changes for rea­sons beyond the Fed­eral Reserve’s con­trol. Sec­ond, the veloc­ity of money is vari­able and also out­side the Fed­eral Reserve’s con­trol. Since GDP is a com­bi­na­tion of two fac­tors beyond the Fed­eral Reserve’s con­trol, tar­get­ing money sup­ply growth didn’t work well.

Mon­e­tarism and the Fed­eral Reserve Today

Mas­ter Fried­man wrote in Two Lucky Peo­ple about a cause of the Great Depression:

The Fed was largely respon­si­ble for con­vert­ing what might have been a garden-variety reces­sion, although per­haps a fairly severe one, into a major cat­a­stro­phe. Instead of using its pow­ers to off­set the depres­sion, it presided over a decline in the quan­tity of money by one-third from 1929 to 1933…Far from the depres­sion being a fail­ure of the free-enterprise sys­tem, it was a tragic fail­ure of government.”

The Fed­eral Reserve Jedi Knights know that with­out inter­ven­tion, the cur­rent credit cri­sis will destroy money sup­ply just like in the Depres­sion. With aggres­sive action the Fed­eral Reserve has pre­served money sup­ply and avoided dis­as­ter. The mea­sure­ment prob­lems of the 1970s and 1980s are irrel­e­vant when money sup­ply is being destroyed in an uncon­trolled meltdown.

Also, Fried­man warned that con­trol­ling money sup­ply is the only way to con­trol infla­tion. In A Mon­e­tary His­tory of the United States 1867 – 1960, Fried­man wrote

Infla­tion is always and every­where a mon­e­tary phenomenon.”

Since March, the money sup­ply (as mea­sured by M2) has been essen­tially unchanged and has shrunk in real terms. While hold­ing short term inter­est rates low, the Fed­eral Reserve used tight money sup­ply to con­trol infla­tion, pro­mote a strong dol­lar and prick the com­mod­ity bub­ble.  The Fed seems to have adopted a “new way” of apply­ing the old prin­ci­pals of the mon­e­tarists with good results to date. 

Just Luke Sky­walker blow­ing up the Death Star, the money sup­ply Jedi Knights have shown cre­ativ­ity as they honor their own per­sonal Yoda, Mas­ter Mil­ton Friedman.

Posted in: BANKS, Bernanke, Credit Crisis, Deflation, Federal Reserve, Finance, GDP, Inflation, Milton Friedman, monetary policy, Money Supply

5 Comments

  1. Free Economy Blogs» Blog Archive » - United States Economic Depression

    […] YODA AND MILTON FRIEDMAN ? TWO TIMELESS CRUSADERS AGAINST THE DARK … By Mark Sun­shine In A Mon­e­tary His­tory of the United States 1867 ? 1960, Fried­man wrote. ?Infla­tion is always and every­where a mon­e­tary phe­nom­e­non.? Since March, the money sup­ply (as mea­sured by M2) has been essen­tially unchanged and has shrunk in real … Sun­shine Notes — http://www.firstcapital.com/blogs/mark_sunshine […]

  2. Online Information Info » Blog Archive » YODA AND MILTON FRIEDMAN – TWO TIMELESS CRUSADERS AGAINST THE DARK …

    […] Here’s an inter­est­ing post I found today.Have a look for your self, Here’s an excerpt, please read the full story at the blo­gAs an exam­ple, if a con­sumer has $100 that is used to buy din­ner at a restau­rant, $100 of GDP is cre­ated. When the restau­rant respends the $100 to pay for food and elec­tric­ity, GDP is $200 (the orig­i­nal $100 pur­chase and the respending … […]

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