In various writings, Milton Friedman argued that there is a variable lag between changes in money supply and its effect on real output and prices. Friedman held 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. This means, according to Friedman, 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.
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.
Friedman was of the view that 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. On this Friedman suggested,
On the average, there is a close relation between changes in the quantity of money and the subsequent course of national income. But economic policy must deal with the individual case, not the average. In any case, there is much slippage. It is precisely this leeway, this looseness in the relation, this lack of mechanical one-to-one correspondence between changes in money and in income that is the primary reason why I have long favoured for the USA a quasi-automatic monetary policy under which the quantity of money would grow at a steady rate of 4 or 5 per cent per year, month-in, month-out.
Friedman held that if the central bank were to follow a constant money growth rule this would eliminate the variability in the time lag. Consequently, money would become neutral also in the short-run.
In his Nobel lecture, Robert Lucas raised an issue with this. According to Lucas,
If everyone understands that prices will ultimately increase in proportion to the increase in money, what force stops this from happening right away?
Lucas is of the view that the reason why money generates real effect in the short run is not so much due to the variability of monetary time lags but more bound up with whether monetary changes are anticipated or not. If monetary growth is anticipated then people will adjust to it rather quickly and there will not be any real effect on the economy. Only unanticipated monetary expansion can stimulate production. Moreover, according to Lucas,
Unanticipated monetary expansions, on the other hand, can stimulate production as, symmetrically, unanticipated contractions can induce depression.
Both Friedman and Lucas are of the view that it is desirable to make money neutral in order to avoid unstable and therefore unsustainable economic growth.
The current practice of Fed policy makers seems to incorporate the ideas of Friedman and Lucas into the so-called transparent monetary policy framework. This framework accepts Lucas’s view that anticipated monetary policy could lead to economic stability. This framework also accepts that a gradual change in monetary policy in the spirit of Friedman’s constant money growth rule could reinforce the economic stability.
We suggest that even if the central bank policy makers could implement precisely Friedman’s and Lucas’s framework this could not secure stable economic growth. Here is why.
Money, expectations and economic growth
Now, according to Robert Lucas if monetary growth is expected, then people will adjust to it rather quickly and there will not be any real effect on the economy. Only unanticipated monetary expansion can stimulate production.
On this way of thinking, anticipated money supply growth is going to result in the corresponding increase in the prices of goods, which is going to offset the increase in money supply.
Note that a price of a good is the amount of money paid for the good. Hence, an increase in money supply implies more money is going to be spend on goods, all other things being equal. This means that the average price of goods will be higher.
Thus, if money supply increases by 10% and as a result monetary outlays on goods increase by 10%, this implies that the average price of goods also rises by 10%. Consequently, the increase in outlays in real terms on goods is going to be 0% i.e. 10% minus 10%.
This means that anticipated money growth will not have any real effect on the economy since this increase is going to be offset by the equivalent increase in prices.
For instance, one dollar can buy one loaf of bread. An increase in money supply, which is fully anticipated by 10%, results in the price of the loaf of bread also increasing by 10%. As a result, with one dollar and ten cents an individual could secure one loaf of bread – the same quantity as before the increase in money supply by 10%. No change in real terms.
We suggest that even if everyone were to anticipate precisely the money supply growth rate and the corresponding increase in the prices of goods, this cannot prevent the fact that there are always first recipients of the new money and late recipients.
As a result, this is going to set in motion the transfer of real wealth from last recipients to the early recipients of money i.e. this will set in motion an exchange of nothing for something, which in turn is going to set the foundations for the menace of the boom-bust cycle.
Even if the money is pumped in such a way that everybody gets it instantaneously, changes in the demand for money will vary – after all every individual is different from other individuals -there will always be somebody who will spend the newly received money before somebody else. This of course will lead to the redirection of real wealth to the first spender from the last spender.
Whilst the anticipated money supply growth rate does not generate real effect on the economy this is not the case with respect to unanticipated money growth.
Now if we begin with the same assumption as before that one dollar can buy one loaf of bread. Then an unexpected increase in money supply by 10% does not produce an immediate increase in the price of bread in the short run. Note that the increase in money supply by 10% will lift temporarily the people’s holdings of money. Once people were to decide to spend the money they will discover that given an unchanged prices their buying power has increased.
If previously our individual had only one dollar now he has one dollar and ten cents. Our individual can now secure 1.1 loaves of bread versus one loaf before the unexpected increase in money supply by 10%.
Clearly, what we have here is an increase in the real buying power of individuals by 10%. Because of the increase in real demand by 10%, this will lead to the increase in the production of goods by 10% i.e. demand creates supply – so it is argued by mainstream economists.
Whilst it is possible that the unexpected monetary increase is going to result in stronger economic growth in the short-run through the overuse of the existing infrastructure, in the medium to longer-term because of the exchange of nothing for something the infrastructure will weaken. Hence, we suggest that over time unanticipated money growth is going to undermine real economic growth via the dilution of the pool of real savings.
It follows then that unanticipated monetary growth will eventually weaken the real economy by undermining the pool of real savings.
We can conclude that both anticipated and non-anticipated money supply growth will weaken the pool of real savings, which over time will lead to a weakening in real economic growth and setting in motion economic instability.
We also suggest that Milton Friedman’s constant money growth rule cannot make money neutral since the constant money growth rule is about increases in money supply although at a constant rate. This means that in Friedman’s framework we will also have an exchange of nothing for something and therefore boom-bust cycles and economic instability.
What is required for economic growth is a growing pool of real savings, which supports various individuals that are engaged in the enhancement and the maintenance of the infrastructure.
We can thus conclude that neither Friedman’s constant money growth rule nor people’s perfect anticipation of money growth can eliminate boom-bust cycles and thus set the platform for economic stability.
We suggest that to make money truly neutral with respect to the real economy it is necessary to close all the loopholes for the generation of money out of “thin air”. The major loopholes are the central bank’s buying of assets and fractional reserve banking.
 Milton Friedman The Counter-Revolution in Monetary Theory. Occasional Paper 33, Institute of Economic Affairs for the Wincott Foundation. London: Tonbridge, 1970.
 Milton Friedman The Counter-Revolution in Monetary Theory
 Robert E. Lucas, Jr Nobel Lecture:Monetary Neutrality, Journal of Political Economy, 1996, vol. 104,no. 4