By Arnold Kling
Milton Friedman describes the consensus in macroeconomics as having moved in his direction.
That Keynesian vision was thoroughly discredited by experience in the ’70s and ’80s. It has since been replaced by what has become known as New Keynesian Economics, which incorporates some key quantity theory (monetarist) propositions: that inflation is always and everywhere a monetary phenomenon; that monetary policy has important effects on real magnitudes in the short run but no important effects in the long run (the long run Phillips curve is vertical), the crucial function of a central bank is to produce price stability, interpreted as a low and relatively steady recorded rate of inflation.
By the same token, Friedman is willing to concede that the velocity of money is not constant.
The improvement in [policy] performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply — a veritable bubble in velocity. Chart 2 shows what happened. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003.
…During the rise in velocity from 1988 to 1997, the Fed kept monetary growth down to 3.2% a year; during the subsequent decline in velocity, it boosted monetary growth to 7.5% a year.
For Discussion. Krugman and Friedman would agree that monetary and fiscal policy do not permanently affect output and employment. They would agree that the inflation rate is an important indicator for monetary policy, and that velocity may be unstable. But when Friedman says that “the crucial function of a central bank is to produce price stability,” would New Keynesians like Krugman agree?