In the late 1940s, Milton Friedman was considered an important economist who had made significant technical contributions. At the beginning of the 1950s, however, he moved away from Keynesian economics and as a result was increasingly viewed as a bit of a nut. Two decades later, however, Friedman had become far and away the most important macroeconomist in the world. Much of the ongoing macro debate revolved around economists addressing Friedman’s ideas, pro or con. How did this happen?

Edward Nelson’s outstanding two volume study of Friedman provides the most complete answer that I have seen. During the 1960s, Friedman rejected 4 key tenets of Keynesian economics. And within less than a decade, all four of his critiques were shown to be correct. As a result, Keynesian economics absorbed much of monetarism, and this led to the creation of a new macroeconomic framework called New Keynesianism. Keep in mind that when I talk about “Keynesians”, I am not describing the views of J.M. Keynes or the views of modern Keynesians, I am describing the views of many of the most prominent Keynesian economists during the 1960s. (Samuelson, Tobin, Modigliani, Solow, Heller, etc.)

Here are the four Keynesian ideas that Friedman rejected:

1. Nominal interest rates are the correct indicator of the stance of monetary policy.  The Fisher effect is not an important factor in the US.

2. Fiscal austerity (higher taxes) is the best way to reduce excessive aggregate demand.

3. There is a stable (negative) relationship between inflation and unemployment (the “Phillips Curve”).

4. Modern economies face an increasing problem of cost/push inflation, and hence wage/price controls are often the best way to control inflation.

Let’s take these one at a time.

In the mid-1960s, Friedman argued that nominal interest rates were rising because of increasing inflation expectations. Nelson points out that Keynesians like James Tobin rejected this claim (vol. 2, p. 113.) By the 1970s, inflation and nominal interest rates had increased much further, and there was almost universal agreement that Friedman was right and Tobin was wrong. Nominal interest rates are not a good indicator of the stance of monetary policy.

Thus the Keynesians were saying that if you want tight money to reduce inflation, you need high interest rates. Friedman basically said no, high interest rates are not the solution; you need to reduce growth in the money supply. By the late 1960s, the US had both high interest rates and a fast growing money supply, and inflation kept rising. It turned out that Friedman was right.

But Keynesians did not draw the correct inferences from this episode. Rather they decided that monetary policy must not be very effective, and instead advocated higher taxes as a way to reduce inflation (the MMT approach.) In 1968, LBJ raised income taxes so high that the US budget went into surplus, but inflation continued to increase.

Friedman had two reasons for doubting the efficacy of higher taxes. First, his permanent income theory suggested that temporary tax changes would be offset by changes in private saving, leaving aggregate demand almost unaffected. More importantly, he saw that a tax increase could only slow inflation by reducing velocity, which would have only a one-time effect. Even if velocity fell one or two percent, the contractionary effects (on M*V) would soon be overwhelmed by increasingly rapid growth in the money supply.

Thus Keynesians assumed that tax increases could slow inflation, while Friedman said no, you need to reduce the growth rate of the money supply.

When the tax increases failed to slow inflation, Keynesians began to focus on the Phillips curve, which suggested that there was an inverse relationship between inflation and unemployment. A policy of higher inflation would lead to lower unemployment, and vice versa. Friedman said this was wrong, as workers would eventually catch on to changes in the rate of inflation and demand compensating changes in nominal wage rates. In the long run, unemployment would return to the natural rate, regardless of the trend rate of inflation.  By 1970, we had high inflation and high unemployment, which showed that Friedman was right.  (Note that this was three years before the first oil shock.)

Thus the Keynesians thought that high unemployment was the solution to inflation.  Friedman said no, you need to reduce the growth rate of the money supply.

When the high unemployment of 1970 did not work, Keynesian economists blamed inflation on “cost-push factors”, such as monopoly power or strong labor unions.  They supported wage/price controls, which President Nixon implemented in August 1971.  After a brief decline in inflation, the problem got much worse during the mid and late-1970s.  Friedman saw that while wage/price controls might lead to a one-time drop in the price level of a few percentage points, as long as the money supply was growing rapidly, any gains from wage/price controls would be soon overwhelmed by a rising money supply.

Thus Keynesians said that the solution for high inflation is wage-price controls, whereas Friedman said no, these controls will not work; you need to reduce the growth rate of the money supply.  See a pattern here?

In the early 1980s, the Fed finally began reducing the growth rate of the money supply, and inflation fell sharply.

Why isn’t the amazing success of Friedman’s ideas better understood?  It’s partly because his preferred policy target—stable growth in a monetary aggregate such as M2—was not adopted due to concerns about unstable velocity.   Even Friedman eventually accepted inflation targeting as a reasonable alternative.  And the other four ideas discussed above all got incorporated in 1990s-era New Keynesianism.  NKs accepted the importance of the Fisher effect, switching their focus from nominal to real interest rates.  They accepted that monetary policy is the appropriate tool to control inflation, not fiscal policy.  They accepted Friedman’s Natural Rate Hypothesis, the idea that higher inflation will not permanently reduce unemployment.  And they accepted that a contractionary monetary policy, not wage/price controls, is the solution to inflation.

In one important respect, Friedman’s achievement is even more amazing than what I have outline here.  In all four cases, Friedman’s claims were made at a time when they looked wrong.  The Fisher effect had not been a very important factor in the setting of US interest rates when inflation expectation were near zero, including the period when the price of gold was pegged at $20.67/oz (1879-1933).  And during 1934-68, when gold was $35/oz, inflation expectation were generally pretty low (even as actual inflation bounced around unpredictably.)  During the early to mid-1960s, inflation expectations were probably not much more than 1%.  The Fisher effect became a major factor after Friedman began warning about the issue.  Similarly, in the mid-1960s it was widely believed that tax changes had a big impact on aggregate demand, as the Kennedy tax cuts of 1964 were followed by a strong economy (albeit perhaps for supply-side reasons.)  Keynesians were genuinely surprised when the big tax increase of 1968 failed to slow inflation.  When Friedman gave famous AEA Presidential address outlining the Natural Rate Hypothesis in late 1967, a stable Phillips curve seemed quite plausible, indeed the 1960s fit the model better than almost any other decade.  It was in the 1970s that the relationship completely broke down.  And the Nixon wage/price controls seemed to work at first; it was only a few years later that they began to fall apart.  Thus in all four cases Friedman rejected the orthodox view at a time when the orthodox approach seemed to be working fine, and in all four cases his views were eventually vindicated.

Milton Friedman’s achievements in the late 1960s and early 1970s were truly amazing, and deserve to be better known.

In a subsequent post, I’ll try to explain how Friedman was able to see the flaws in mainstream Keynesianism before most other economists.  Why was his model better?  We’ll see that all four of his successful critiques have something in common.


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