a) Summary

Let’s start by setting the stage. When Friedman gave his address in 1967, one author
of the present essay was in grade school and the other was not yet born, so neither
of us can claim first-hand experience. But using the historical record, only a little
imagination is needed to get a sense of what was occupying the thoughts of most
macroeconomists as Friedman walked to the podium.
There seems little doubt that the focal event for macroeconomists of that era was
still the Great Depression of the 1930s. By the late 1960s, the Depression, rather
than being a recent event, had started to fade into history. (To put it in perspective,
the Depression was then about as current as the presidency of Ronald Reagan is
today.) But many of the macroeconomists listening to Friedman, especially the more
senior ones, had lived through this historic downturn, and it was often the
motivating event of their professional lives.

Today, we can say with confidence that the world is a better place for Milton
Friedman having forgone the opportunity to become an actuary!
In the decades after Friedman graduated from college, economists slowly developed
an understanding of how to view fluctuations. That understanding was founded on
John Maynard Keynes’s landmark book The General Theory of Employment, Interest
and Money (1936). Keynes’s vision was clarified and simplified—some would say
oversimplified—in the work of Hicks (1937) and Hansen (1953). Their IS–LM model
provided the benchmark theory for explaining how insufficient aggregate demand
led to economic downturns, as well as how monetary and fiscal policy could combat
those downturns. It also provided the starting point for larger econometric models
used for forecasting and policy analysis, such as the Federal Reserve’s MPS model,
work on which began in 1966 under the leadership of Franco Modigliani, Albert
Ando, and Frank de Leeuw. The name MPS is derived from MIT, University of
Pennsylvania, and Social Science Research Council (Brayton, Levin, Lyon, and
Williams 1997).

The IS–LM model takes the price level as given, which is perhaps a reasonable
assumption in the shortest of short runs, but the economists of that era were also
concerned about the forces that led the price level to change over time. One
important reference is the 1960 paper by Paul Samuelson and Robert Solow,
“Analytical Aspects of Anti-Inflation Policy.”
Samuelson and Solow discuss the many forces that influence inflation, emphasizing
the difficulty of identifying whether any rise in inflation is driven by an increase in
costs or an increase in demand. However, their essay is probably best remembered
for its emphasis on the Phillips curve as a useful addition to the macroeconomist’s
toolbox. Friedman does not cite this paper in his presidential address, but it is
nonetheless representative of the worldview which many mainstream
macroeconomists had adopted and to which Friedman was responding.
The Key Insights

A first major theme of Friedman’s (1968) address is its focus on the behavior of the
economy in the long run. Samuelson and Solow (1960) seemed to view the long run
as merely the consequence of a series of Keynesian short runs. In contrast, Friedman
(1968) viewed the long run as the timeframe under which we should apply the
principles of classical economics, especially monetary neutrality. Regardless of what
the central bank did, unemployment would over time approach its natural rate,
which he defined as “the level that would be ground out by the Walrasian system of
general equilibrium equations, provided there is imbedded in them the actual
structural characteristics of labor and commodity markets, including market
imperfections, stochastic variability in demands and supplies, the cost of gathering
information about job vacancies and labor availability, the costs of mobility, and so
on”

A second and related major theme of Friedman’s (1968) address is its focus on
expectations. As noted, Samuelson and Solow (1960) had previously mentioned the
role of expectations, and they understood that it might distinguish the short run
from the long run. But this concern was not their main focus, and they attached no
particular significance to whether actual and expected inflation are the same. By
contrast, for Friedman, expectations were the key to explaining how the economy
might appear to face a Phillips curve trade-off and how that trade-off would
disappear if we tried to exploit it. He wrote that “there is always a temporary
tradeoff between inflation and unemployment; there is no permanent trade-off. The
temporary trade-off comes not from inflation per se, but from unanticipated
inflation, which generally means, from a rising rate of inflation” (1968, p. 11).

Friedman’s focus on the long run and his emphasis on expectations are closely
connected. In some macroeconomic models, the long run is the time horizon over
which nominal wages and prices can overcome their short-run stickiness, allowing
the economy to return to its classical equilibrium. Friedman, instead, viewed the
long run as the time horizon over which people become better informed and so their
expectations align with reality.

Implications for Monetary Policy

Friedman begins with what monetary policy cannot do. He emphasizes that, except
in the short run, the central bank cannot peg either interest rates or the
unemployment rate. The argument regarding the unemployment rate is that the
trade-off described by the Phillips curve is transitory and unemployment must
eventually return to its natural rate, and so any attempt by the central bank to
achieve otherwise will put inflation into an unstable spiral.
The argument regarding interest rates is similar: because we can never know with
much precision what the natural rate of interest is, any attempt to peg interest rates
will also likely lead to inflation getting out of control. From a modern perspective, it
is noteworthy that Friedman does not consider the possibility of feedback rules from
unemployment and inflation as ways of setting interest rate policy, which today we
call “Taylor rules” (Taylor 1993).

When Friedman turns to what monetary policy can do, he says that the “first and
most important lesson” is that “monetary policy can prevent money itself from being
a major source of economic disturbance” (p. 12).
It is significant that, while Friedman is often portrayed as an advocate for passive
monetary policy, he is not dogmatic on this point. He notes that “monetary policy
can contribute to offsetting major disturbances in the economic system arising from
other sources” (p. 14). Fiscal policy, in particular, is mentioned as one of these other
disturbances. Yet he cautions that this activist role should not be taken too far, in
light of our limited ability to recognize shocks and gauge their magnitude in a timely
fashion.

The final section of Friedman’s presidential address concerns the conduct of

monetary policy. He argues that the primary focus should be on something the
central bank can control in the long run—that is, a nominal variable. He considers
the nominal exchange rate, the price level, and monetary aggregates. He says that
the exchange rate is not sufficiently important, given the small role of trade in the US
economy. While the price level is the most important of these variables, he argues
that the link between central bank actions and the price level is too long and
unpredictable for the price level to serve as a useful policy target. He concludes that
steady growth in some monetary aggregate is the best starting point for policy.

The Current State of Play

The Great Recession that followed the financial crisis of 2007–2008 may become the
defining moment for a new generation of macroeconomists, just as the Great
Depression was for Milton Friedman’s generation.
Like classical economics in the 1930s, which had been criticized for not explaining
why so many people who wanted a job could not find one, modern economics was
criticized for not forecasting the crash.

It is a testament to the reach of Friedman’s (1968) presidential address that its two
main themes—the use of the long-run time frame and the centrality of expectations
—remain integral to macroeconomics and have not been greatly affected by the
crisis. Most classes in macroeconomics for more than two decades have started with
the long run, as many graduate and undergraduate textbooks will testify. Students
first learn about the Solow (or Ramsey) models for the evolution of real variables and
then use the classical dichotomy and the Fisher equation for interest rates to discuss
nominal variables.

When Friedman wrote his address, most students organized their thoughts about
business cycles using the IS–LM model. This model gives at best a secondary role to
expectations. While early Keynesians sometimes emphasized the animal spirits of
investors, these were taken to reflect irrational exogenous sentiments rather than
purposeful forward-looking behavior. This is far from the reality of modern
macroeconomics. Almost all macroeconomic analyses now emphasize intertemporal
trade-offs, so the beliefs of economic agents about the future have become a crucial
part of the story. Expectations remain at the forefront of macro- economic analysis,
just as Friedman advised.

At the same time, the current state of play is also quite different from either the
adaptive expectations that Friedman seemed to use or the rational expectations that
were at the center of research in the 1970s. With rational expectations, there is, as
Sargent (2008) noted, a “communism of beliefs”: All economic agents believe the
same thing, because they perfectly observe all the same variables and use the exact
same model to combine them.

Friedman’s analysis of macroeconomic fluctuations from the perspective of a Phillips

curve that is anchored by the long run is also alive and well. In fact, the last decade
has provided a new application of Friedman’s logic. Friedman predicted that the
Phillips curve that had appeared in the data throughout the 1950s and 1960s would
break down if policymakers followed Samuelson and Solow’s (1960) advice and
started exploiting it.
At the heart of this new synthesis was a Phillips curve built on the work of Taylor and
Calvo (discussed in Taylor 2016). Firms were assumed to set prices equal to the
average of their expected future marginal costs, but to alter prices in an infrequent
and staggered way. From the start, however, researchers saw flaws in this Phillips
curve. Ball (1994) provided a pointed critique of its use for policy- making: He
showed that the model predicted that times of announced disinflation should be
times of economic expansion, which was almost never true in reality. And, because
the firms that are adjusting their prices today respond strongly to future expected
events, inflation in the model can jump without any of the inertia observed in the
data.

Models in the early 2000s attempted to remedy these problems by assuming that
firms partially indexed their prices to lagged inflation. This approach introduced
inflation inertia by sheer assumption. Smets and Wouters (2007) found that this
model could fit the US data for the previous four decades reasonably well. Yet the
empirical success of their model could end up sharing the same fate as that of
Samuelson and Solow (1960). Just as Milton Friedman had done before, some
researchers suggested that given its shaky foundations, this new Phillips curve was
bound to break down, as soon as there was a large shock or a change in policy
regime.

The Role of Monetary Policy Today

Modern macroeconomics also focuses more on the nominal interest rate than on
monetary aggregates, both as an instrument for policy and as a guide to the state of
the economy. Friedman’s presidential address discussed Knut Wicksell’s concept of a
natural rate of interest but dismissed it as a good guide for policy. Today and for
many years now, Friedman has lost this argument to Woodford (2003), who
convinced academics and central bankers to embrace the Wicksellian use of interest
rates as the main policy tool and their deviation from natural rates as the key policy
target.

Friedman recommended strict rules to guide monetary policy because he thought

that deviating from such rules added noise into the system, leading to inefficient
fluctuations in inflation and the real economy. Many modern macro- economists
seem to agree, given the paucity of academic or applied arguments in defense of
purely discretionary choices by central bankers.
Chari and Kehoe (2006), summarizing in this journal the modern study of
commitment and the potential time inconsistency of discretionary policy,
emphatically wrote: “The message of examples like these is that discretionary policy
making has only costs and no benefits, so that if government policymakers can be
made to commit to a policy rule, society should make them do so.” At the same
time, almost no central bank has adopted a strict rule for monetary policy. Instead,
central banks have continued to use a great deal of discretion to infer the state of
the economy from many imperfect measures, and to react to the wide variety of
shocks.

At the same time, modern central banks interpret inflation targets in a flexible way,
with a willingness to trade off deviations of inflation from target against movement
in real activity (Woodford 2010). By following feedback rules that condition policy on
the state of the business cycle, central banks aggressively respond to recessions and
booms and thus explicitly commit to the countercyclical stabilization policies that
Friedman thought were fruitless.

Moreover, Friedman’s presidential address argued that “too late and too much has
been the general practice” of monetary policy because of “the failure of monetary
authorities to allow for the delay between their actions and the subsequent effects
on the economy” (p. 16). Modern central banks agree but have responded by
adopting a policy of “inflation forecast targeting” (Woodford 2007): that is, they
discuss their policies in terms of what will bring forecasted inflation two or three
years ahead back on target.

Finally, the Great Recession and the actions of the Federal Reserve provide a useful
contrast between the central bank that Milton Friedman wished for and the one that
exists today. Friedman (p. 14) thought that “monetary policy can contribute to
offsetting major disturbances in the economic system arising from other sources,”
but he says that “I have put this point last, and stated it in qualified terms—as
referring to major disturbances—because I believe that the potentiality of monetary
policy in offsetting other forces making for instability is far more limited than is
commonly believed.”
 b) Objectives of this article
The author states the article’s objective at the beginning of the reading, which is:
“Our goal here is to assess this contribution, with the benefit of a half-century of
hindsight. We discuss where macroeconomics was before the address, what insights
Friedman offered, where researchers and central bankers stand today on these
issues, and (most speculatively) where we may be heading in the future. We focus on
the presidential address alone, putting aside Friedman’s many other contributions
(discussed, for example, in Nelson 2017). “

c) Author’s conclusions
The article concludes as follows: “Finally, Friedman was an expert on financial crises,
yet in an address on monetary policy, he chose to ignore the interaction between
monetary policy and financial stability. Of course, it had long been recognized that as
the lender of last resort, the central bank has some responsibility for financial
stability. Yet any desire to exert tight control over the level of asset prices is foolish
for all the reasons that Friedman explained in his address, especially when applied to
stock prices or house prices.
There remain many hard questions about the role that central banks should play and
about how much we should expect from these important institutions. But in the
spirit of Milton Friedman’s presidential address, we suspect that it would be best for
central bankers to remain humble in what they aspire to achieve.”

d) Relation between this article’s topic and the economic reality of the DR
In most countries, the president has the role to communicate and set off the
different macroeconomic policies suggested by organizations such as the Central Bank. In
the Dominican Republic, in my opinion, this does not happen. The president and the
different organizations diverge in a way that it is not healthy for DR’s economy due to the
level of corruption currently existing in our country.

e) Thoughts on the article

I think that this article was quite interesting to read. The different topics explained in
this article are very constructive for my economic education.