When prices rise on supermarket shelves, the cause sometimes lies in a decision made months earlier by a central bank. Milton Friedman spent his career demonstrating the link between the amount of money in circulation and the price level. His central proposal can be summed up in one sentence: the money supply should grow at a steady, predictable rate in line with the economy’s real growth.
Money supply and inflation: the mechanism Friedman brought to light
Have you ever noticed that some periods of rising prices seem to come out of nowhere? For Friedman, the explanation is almost always monetary. If a central bank injects more money than the economy produces in goods and services, prices eventually rise.
This reasoning is based on the quantity theory of money. In simplified terms, when the amount of cash and bank deposits grows faster than output, each unit of currency loses value. The visible result is inflation.
Friedman developed this idea in the book he co-authored with Anna Schwartz, A Monetary History of the United States, 1867-1960. Their work showed that major American crises, including the Great Depression, were linked to the Federal Reserve’s mismanagement of the money supply. Understanding Milton Friedman’s golden rule helps explain why he argued that central bankers should have no room to improvise.
Inflation is always a monetary phenomenon: this now-famous phrase sums up the conviction that earned Friedman the Nobel Prize in Economics.
The golden rule of monetary policy: a fixed growth rate instead of case-by-case management
Friedman’s specific proposal has a name: the k-percent rule. The idea is to set the annual rate of money supply growth in advance, without adjusting it to economic conditions. If the economy grows by a few percent a year on average, the money supply should grow at the same rate, and no faster.
Why reject adjustments? Because monetary policy takes effect with long and unpredictable lags. Friedman showed that when a central bank decides to cut or raise interest rates, the effects on prices and employment take months—sometimes more than a year—to materialize. As a result, discretionary interventions often come too late and amplify economic cycles instead of smoothing them out.
Rules versus discretion: the heart of the debate
Friedman’s monetarism sets two visions of the central bank against each other. On one side is discretionary management, in which policymakers adjust interest rates and liquidity based on their assessment of the situation. On the other is an automatic rule that eliminates arbitrariness.
For Friedman, discretion creates three problems:
- Central bankers do not have real-time information about the exact state of the economy, which leads them to react too late or too forcefully.
- The lags in monetary policy transmission make course corrections risky, because the effects of a decision made today will materialize in circumstances that have since changed.
- The political temptation to use the printing press to boost employment in the short term ultimately generates inflation without delivering lasting gains in reducing unemployment.
This last point connects to another of Friedman’s contributions: the concept of the natural rate of unemployment. Any attempt to keep unemployment below this threshold over the long term through money creation only fuels rising prices.
The practical limits of the golden rule in today’s economy
While the logic is elegant, putting it into practice has run into serious obstacles. Several central banks tried targeting the money supply in the years after monetarism gained prominence. The results were not always conclusive.
The relationship between the money supply and inflation varies over time. It tends to be stronger during periods of high inflation, but becomes less consistent when prices are stable. This is one reason why most major central banks have gradually abandoned strict monetary aggregate targeting in favor of inflation targeting.
Money creation does not work like a faucet
The Bank of England has explained a technical point that challenges a simplified interpretation of the golden rule. When a commercial bank makes a loan, it creates a deposit at the same time. Central bank reserves do not mechanically determine the volume of lending. Credit depends on funding constraints, the bank’s capital, and borrower demand.
This means that the central bank does not directly control the amount of money in circulation through a simple, stable multiplier, as the classical monetarist model assumed.
Friedman’s legacy in today’s monetary policy
Pure monetarism has receded since the 1990s, but Friedman’s influence remains visible. The idea that a central bank should operate according to transparent rules, rather than the whims of its policymakers, has become widely accepted.
In its strategic review, the European Central Bank confirmed that it takes monetary aggregates into account in its assessments, without treating them as its sole guide. Monetary aggregates inform the assessment but do not, on their own, determine interest rate policy.
Post-pandemic inflation reignited the debate. When central banks injected massive amounts of liquidity to support the economy and prices then soared, the Friedmanian framework regained an audience. This time, the link between rapid monetary expansion and an inflationary surge seemed difficult to ignore.
Friedman’s golden rule of monetary policy is no longer applied as written by any major central bank. Nevertheless, it has transformed how economists analyze inflation and the credibility of monetary institutions. Any central bank that announces an inflation target and commits to meeting it over the long term is following, whether it acknowledges it or not, part of the path laid out by Chicago monetarism.
