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What Should Central Banks Peg? Arguments for the Money Supply

By Renato Lembe Agurto

Besides being one of the most brilliant economists of the twentieth century, Milton Friedman was also an excellent communicator, understood by the specialists of the field and the laymen who watched him on tv alike. So clear was his speech that, still today, people’s common intuition on monetary policy is based on his main thesis: inflation is caused by an increase in the quantity of money supplied by the government. Authorities are to blame for taxing the purchasing power of the poor by printing too much money.

In the economists’ community, nevertheless, this assertion aimed to do something more than supplying the public with tools to judge politicians or bureaucrats: its purpose, in fact, was to refute once and for all the belief that central bankers could systematically target interest rates so to keep price levels under control.

Imagine that interest rates are deliberately lowered by the authorities, through bond’s purchases from private banks. Their non-interest-bearing reserves would increase and most of them would eventually be lent to the bank’s customers (an expansion of money supply). More credit means more private spending, either in capital or in consumption goods – and, therefore, higher income to producers and laborers.

The outcome, eventually, would be a rise in the demanded loans for the same interest rate, since that higher spending pushes the price level up and makes it necessary for families and enterprises to hold more cash as to fulfill their usual demand for goods. Once income is also higher, families and enterprise could afford demanding more loans at the same cost. Private banks, then, with limited credit resources, would have either to increase bank spread or to sell more bonds to the government. The first option is not recommended in a market environment, because it means losing clients to competitors.

Thus, most banks would choose the second option, whose main effect is the decrease of a bond’s price and, therefore, the increase of interest rates. According to Friedman, these would be back to its original level in one- or two-years’ time. Any governmental attempt to counteract this tendency would require larger bond’s purchase in comparison with the previous one – which means an increasing rate of money supply growth over time and, consequently, explosive inflation on the medium run.

In addition to its inability to stabilize the price level, interest rate pegging is also an ambiguous indicator of monetary policy: once the same policy-decision drives interest rates to opposing directions on the short run, neither analysts nor authorities are able to recognize a clear cause-effect net between bond’s purchase and interest rate in a given period of time. In practice, it means that an interest rate rise cannot be solely attributed to neither tighter nor easier monetary policy, since it is the effect of both, in different instants of the short run.

In the mid-seventies, interest rate target’s policy was harshly attacked again by Thomas Sargent and Neil Wallace: pegging interest rate would not only be useless at that time, as Friedman affirmed, but also useless all the time.

Let’s add two more elements to our previous scenario: Imagine, first, that businessmen set current prices based on their expectation for future prices. Moreover, private banks believe that the government is determined to peg interest rate at a specific level. Having this belief means, in other words, to assume that authorities would always purchase banks’ bonds or provide them with financial loans at the targeted interest, in order to maintain it.

If that is the case, private banks will have no liquidity constraint, selecting loans solely based on default risk analysis, because they know that the authorities would always supply them with enough cash. Businessmen, on the other hand, would assume the analogous behavior towards private banks: their demand for loans would always be answered, if they prove their business profitable.

Money supply would then be almost infinite in the short run, and there will be no monetary limits on businessmen’s price expectations. Every expectation on future price level is consistent with an equilibrium level that equates money supply and money demand, without triggering counterbalancing factors. In its turn, current prices can also assume whatever level – and, therefore, they are indeterminate. In other words, authorities are completely unable to influence prices, which are solely determined by arbitrary private expectations.

After these strong arguments against interest rate pegging, one might ask himself: why, then, current central banks do target interest rate? Why the price level, as stable as it can be, seems controlled by the monetary authorities? That’s the subject of my next article.


FRIEDMAN, M. The Role of Monetary Policy. The American Economic Review, Washington, v. 58, n. 1, p. 1-17, mar. 1968.

SARGENT, T. J.; WALLACE, N. “Rational” Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rate. The Journal of Political Economy, Chicago, v. 83, n. 2, p. 241-254, abr. 1975.

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