An Evaluation of Friedman's Monetary Instability Hypothesis

18 Pages Posted: 6 May 2016 Last revised: 9 Sep 2016

Joshua R. Hendrickson

University of Mississippi

Date Written: May 4, 2016

Abstract

In this paper, I examine what I call Milton Friedman's Monetary Instability Hypothesis. Drawing on Friedman's work, I argue that there are two main components to this view. The first component is the idea that deviations between the public's demand for money and the supply of money are an important source of economic fluctuations. The second component of this view is that these deviations are primarily caused by fluctuations in the supply of money rather than the demand for money. Each of these components can be tested independently. To do so, I estimate an otherwise standard New Keynesian model, amended to include a money demand function consistent with Friedman's work and a money growth rule, for a period from 1875-1963. This structural model allows me to separately identify shocks to the money supply and shocks to money demand. I then use variance decompositions to assess the relative importance of shocks to the supply and demand for money. I find that shocks to the monetary base can account for up to 28% of the fluctuations in output whereas money demand shocks can account for less than 1% of such fluctuations. This provides support for Friedman's view.

Keywords: monetary policy, monetary shocks, monetary history, k-percent rule

JEL Classification: E51, E32, E41

Suggested Citation

Hendrickson, Joshua R., An Evaluation of Friedman's Monetary Instability Hypothesis (May 4, 2016). Southern Economic Journal, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2775376

Joshua R. Hendrickson (Contact Author)

University of Mississippi ( email )

Oxford, MS 38677
United States

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