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Milton friedman and the case for flexible exchange rates and monetary rules

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108666_03_Dellas-Tavlas.qxd:19016_Cato 4/18/18 7:55 PM Page 361

Milton Friedman and the Case for

Flexible Exchange Rates and
Monetary Rules
Harris Dellas and George S. Tavlas

Managed currency without definite, stable, legislative rules is

one of the most dangerous forms of “planning.” A free enter-
prise economy can function only within a legal framework of
rules; and no part of that framework is more important than
the rules which define the monetary system. In the past those
rules have been empty and inadequate; but there is no
tolerable solution to be found in resort to the wisdom of
“authorities.” No liberal can contemplate with equanimity
the prospect of an economy in which every investment and
business venture is largely a speculation in the future actions
of the Federal Reserve Board.

Henry C. Simons (1935: 558)

The institutional arrangements that constitute the global mone-

tary system have long occupied center stage of discussions in inter-
national economics. For many years, the discussions focused on the
choice of exchange rate regime, especially the relative merits of

Cato Journal, Vol. 38, No. 2 (Spring/Summer 2018). Copyright © Cato Institute.
All rights reserved.
Harris Dellas is Professor of Economics and Director of the Institute of
Economics at the University of Bern. George S. Tavlas is a Member of the Monetary
Policy Council of the Bank of Greece and the Alternate to the Bank of Greece’s
Governor on the Governing Council of the European Central Bank. The authors
thank Ed Nelson and Mike Ulan for their very helpful comments.

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fixed and floating exchange rates. Beginning in the 1980s, however,

the focus of the discussions shifted from arrangements among coun-
tries to the appropriate framework for national monetary policies.
With the widespread acceptance of monetary rules by the majority
of the profession, the debate has shifted to the evaluation of alter-
nate rules—most notably, the comparison between those that
involve a fixed exchange rate regime and those that involve only
domestic goals. Our objective is to contribute to this debate.
We pivot our discussion around the work of Milton Friedman,
whose views on the viability of alternative exchange rate regimes and
on national monetary rules in many ways presaged modern thinking
on these issues. In common with much of modern thinking,
Friedman favored a combination of flexible exchange rates and a
domestic monetary rule. As we will demonstrate, two key factors
underpinned Friedman’s views. First, in common with John Taylor
(2017), Friedman believed that this particular combination would
deliver superior economic performance, helping to avoid the major
policy mistakes of the past produced by fixed exchange rate regimes
cum discretionary monetary policies. Second, Friedman also
thought that the combination of flexible exchange rates and a
domestic monetary rule was more consistent with democratic prin-
ciples than a regime based on fixed exchange rates and discretionary
monetary policy.1
The remainder of this article is structured as follows. First, we
provide an overview of the three major international fixed exchange
rate systems that existed in the 20th century: the classical gold
standard (1880–1913), the interwar gold exchange standard
(1924–1936), and the Bretton Woods System (1944–1973). We
show that Friedman concluded that the classical gold standard,
whatever its virtues—and Friedman thought that its virtues had
been exaggerated by its adherents—would not be sustainable in
the world of the mid-20th century and after. The circumstances
that rendered the gold standard unsustainable, he believed, also
applied to other fixed exchange rate arrangements. Next, we discuss

1
Friedman (1953, 1960), of course, recognized that, in the absence of controls on
capital flows, the stance of domestic monetary policy would be determined by the
fixed exchange rate objective, especially for smaller countries. During the 1950s and
1960s, most countries maintained controls on capital movements, providing scope
for nationally oriented monetary policies in the presence of fixed exchange rates.

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Case for Flexible Exchange Rates

Friedman’s views on flexible exchange rates and the reasons under-

pinning his advocacy of a domestic monetary policy rule. We then
consider the case for a Taylor rule.

Fixed Exchange Rate Regimes

The basic case for fixed exchange rates is that fixed rates eliminate
exchange rate uncertainty, which is alleged to impede international
trade and investment.2 Monetary historians have argued that the
exchange rate stability of the period of the classical gold standard
helped create a global trade boom and increased investors’ confi-
dence in faraway places, giving rise to unprecedented levels of capi-
tal exports (Gallarotti 1995, Morys 2014).

Classical Gold Standard, 1880–1913

The classical gold standard was a rules-based monetary policy
regime. The basic rule for each monetary authority was the commit-
ment to convert its domestic (paper) currency into a fixed quantity
of gold at a fixed nominal price. This rule required the subordina-
tion of domestic policy considerations to the external, fixed gold
price, constraint.
Under the gold standard, if a country faced a balance-of-
payments deficit—for example, capital account inflows that were
not sufficient to finance a current account deficit—it needed an
adjustment mechanism to reverse the resulting outflow of gold
(O’Rourke and Taylor 2013: 172). The gold standard mechanism
was essentially automatic. It included a reduction of the domestic
money supply—because the money stock was tied directly to the
quantity of domestic gold holdings—and the consequent reduction
of prices of domestic goods and services relative to those of foreign
goods and services. The resulting depreciation of the real exchange
rate would help restore external balance.
Modern monetary historians, citing the durability of the system,
have a benign view of the workings of the classical gold standard, at
least for the countries at the system’s core3 (Eichengreen 1992,

2
For a contrary argument, see Bailey, Tavlas, and Ulan (1987).
3
The core countries were Belgium, France, Germany, the Netherlands, the
United Kingdom, and the United States.

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O’Rourke and Taylor 2013, Bordo and Schenk 2017). Friedman’s

view was more nuanced. He believed that if an automatic gold stan-
dard were feasible, “It would provide an excellent solution to the lib-
eral’s dilemma: a stable monetary framework without the danger of
the irresponsible exercise of monetary powers” (Friedman 1962a:
40–41). Nevertheless, he noted that “even during the so-called great
days of the gold standard in the nineteenth century, when the Bank
of England was supposedly running the gold standard skilfully . . . it
was a highly managed system” (p. 42). Underlying this circumstance
was the fact that, historically, an automatic commodity system
always tended to develop toward a mixed system, containing, in
addition to the monetary commodity, fiduciary elements, such as
bank notes and deposits, and government notes: “And once fiduci-
ary elements have been introduced, it has proved difficult to avoid
government control over them” (p. 41). For example, Friedman esti-
mated that gold coins and gold certificates constituted only
10–20 percent of the money stock in the United States during the
late 19th century (p. 42).
Friedman’s assessment of the performance of the gold standard in
the United States was as follows: “In retrospect, the system may seem
to us to have worked reasonably well. To Americans of the time, it
clearly did not” (p. 42). As an example, he pointed out that the “agi-
tation” to monetize silver in the 1880s and 1890s, culminating in
William Jennings Bryan’s “Cross-of-Gold” speech during the 1896
presidential election “was one sign of dissatisfaction. In turn, the agi-
tation was largely responsible for the [economically] depressed years
of the early-1890s. . . . [The agitation] led to a flight from the dollar
and a capital outflow that forced deflation at home” (pp. 42–43).
More importantly, Friedman did not believe that the gold stan-
dard, even if fully automatic, would be viable in the world of the mid-
20th century and after. To the extent that the gold standard operated
as intended, it did so because of special circumstances. First, the
late 19th and early 20th centuries made up a world in which “the
countries of the Western world placed much heavier emphasis on
freedom from government interference at home . . . than on domes-
tic stability; thus they were willing to allow domestic economic policy
to be dominated by the requirements of fixed exchange rates”
(Friedman 1953: 166–67). Second, wages and prices were relatively
flexible during the gold standard period (pp. 172–73). As a result,
the adjustment toward balance-of-payment equilibrium could

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Case for Flexible Exchange Rates

take place with relatively minor effects on domestic output and

employment.
The world of the mid-20th century, Friedman observed, was very
different from that of the gold standard period. The Great
Depression of 1929 to 1933 encouraged the view that a capitalist
economy is inherently unstable and that it is the government’s
responsibility to stabilize the economy.4 As a result, the role of gov-
ernment in economic affairs expanded greatly, and the pursuit of
full employment became the overriding goal of economic policy.
The spread of unionization led to a more rigid wage and price struc-
ture, increasing the unemployment costs of deflationary policies. In
these circumstances, Friedman believed that governments of dem-
ocratic nations would no longer be willing to submit themselves to
what he called “the harsh discipline of the gold standard” (Friedman
1953: 179).5

Interwar Gold Exchange Standard, 1924–36

The classical gold standard ended with the outbreak of World
War I. In light of policymakers’ high regard for the classical gold
standard, after the war policymakers from the United Kingdom,
France, the United States, and other countries sought to resurrect
it, but failed to realize that its basic underpinnings were no longer
present in the changed circumstances of the interwar period
(Morys 2014: 730).6

4
The view that a capitalist economy is inherently unstable is typically traced back
to Keynes’s (1936) General Theory. In fact, Keynes put forward that view earlier—
in 1931 during his participation at a conference at the University of Chicago. In
response to a question whether depressions are inevitable in a capitalist economy,
Keynes replied: “I should agree that the capitalist society as we now run it is essen-
tially unstable. The question in my mind is whether one could preserve the stabil-
ity by the injection of a moderate degree of management; whether in practice it is
beyond our power to do this, and that we will have to have some further plan of
control” (Harris Foundation 1931: 93).
5
Friedman (1962a: 40) was also critical of commodity standards because of the
real resources required to add to the stock of money: “People must work hard to
dig gold out of the ground in South Africa—in order to rebury it in Fort Knox or
some similar place.”
6
Germany and Sweden returned to gold in 1924, and the United Kingdom
returned to gold in 1925. With the departure of France, the last major country to
cling to the gold standard, from gold in October 1936, the interwar gold standard
came to an end.

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Like its prewar predecessor, the interwar gold standard was based
on a convertibility rule, but the rule was more susceptible to evasion.
One key difference between the classical gold standard and the inter-
war gold standard was the change in domestic environments in which
policymakers operated. As Friedman (1953) inferred, after the war
the spread of unionization contributed to reduced wage and price
flexibility, increasing the output costs of deflationary policies. The
extension of voting rights and the growth of organized labor greatly
loosened governments’ commitment to subordinate domestic eco-
nomic objectives to the fixed exchange rate rule. This circumstance
can be clearly seen in the pivotal case of the United Kingdom, the
“center country” in the prewar system. As Crafts (2014: 717)
reported, the electorate in the 1910 election numbered 7.7 million;
in the 1929 election, when the Labor Party won 47 percent of the
seats in parliament, the electorate numbered 29 million; the exten-
sion of voting rights made political parties increasingly sensitive to
domestic economic conditions.
Concerned that the existing global gold stock would produce
deflation, policymakers actively encouraged the use of key
currencies—the pound sterling, the U.S. dollar, and the French
franc—as international reserves (Morys 2014: 731), loosening the
link between gold flows and domestic monetary conditions.
Friedman’s assessment of the interwar gold standard was as
follows:

Already during the 1920s, the United States . . . refused to

allow its [balance-of-payments] surplus, which took the form
of gold imports, to raise domestic prices in the way the sup-
posed rules of the gold standard demanded; instead, it “ster-
ilized” gold imports. Especially after the Great Depression
completed the elevation of full employment to the primary
goal of economic policy, nations have been unwilling to allow
deficits to exert any deflationary effect [Friedman 1953: 171].

In light of the above factors, considerable central bank coordina-

tion was required to maintain the system (Bordo and Schenk 2017:
221). Much of that cooperation centered on the personal relation-
ships among Montagu Norman, governor of the Bank of England;
Benjamin Strong, governor of the Federal Reserve Bank of New
York; Hjalmar Schacht, president of the Reichsbank; and Emile

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Case for Flexible Exchange Rates

Moreau, governor of the Banque de France (Ahamed 2009, James

2016, Bordo and Schenk 2017). Bordo and Schenk (2017: 215)
argued that the coordination of monetary policies “contributed to the
interwar gold standard’s problems by propping up a flawed system
and possibly even helping to fuel the 1920s asset price boom.”
The cooperation ultimately failed, and the gold exchange standard
collapsed. Some historians (Temin 1989, Eichengreen 1992) argued
that the gold standard constraint caused the Great Depression
because national monetary authorities were not allowed to follow
lender-of-last-resort policies. Friedman and Schwartz (1963) pointed
out that the gold standard’s fixed exchange rate served as the key
channel through which a decline in the U.S. money supply, a result
of the Fed’s tightening in 1928 and 1929—aimed at stemming the
boom in stock prices—was transmitted to the rest of the world.
Friedman’s assessment of the cooperation among the central bankers
was highly critical:

The impression left with me . . . is that Norman and Schacht

were contemptuous both of the masses—of “vulgar”
democracy—and of the classes—of the, to them, equally vul-
gar plutocracy. They viewed themselves as exercising control
in the interests of both groups but free from the pressures of
either. In Norman’s view, if the major central bankers of the
world would only cooperate with one another—and he had in
mind not only himself and Schacht but also Moreau and
Benjamin Strong—they could jointly wield enough power to
control the basic economic destinies of the Western world in
accordance with rational ends and objectives rather than with
the irrational processes of either parliamentary democracy or
laissez-faire capitalism. Though of course stated in obviously
benevolent terms of doing the “right thing” and avoiding
distrust and uncertainty, the implicit doctrine is clearly
thoroughly dictatorial and totalitarian [Friedman 1962b:
181–82].

Bretton Woods System, 1944–73

The Bretton Woods Agreement of 1944 reestablished a system of
pegged exchange rates. The gold convertibility rule was preserved
with the U.S. Treasury, which entered the Bretton Woods period
holding three-fourths of the global monetary gold stock, pegging the

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price of the dollar at $35 per ounce of gold by freely buying and sell-
ing gold to foreign official bodies at that price. Other countries inter-
vened to keep their currencies within 1 percent of parity against the
dollar by buying and selling dollars (Bordo 1993: 35). Convertibility
of major European currencies on current-account transactions was
not put in place until the end of 1958.7 Under certain conditions,
countries had access to International Monetary Fund (IMF) credit
to cover temporary balance-of-payments deficits. A key objective of
the system was to create a framework for cooperation and coordina-
tion underpinned by credible rules (Giovannini 1993).
Two key innovations were introduced to make the system durable.
First, controls on short-term capital flows were permitted to provide
domestic monetary policy sovereignty. Second, the system was an
adjustable peg, meaning that occasional, discrete changes in
exchange rates were permitted to help attain equilibrium in coun-
tries’ balance of payments and to discourage destabilizing speculation
in foreign exchange markets. Parities could be changed with IMF
approval if a member faced a “fundamental disequilibrium” on its
external accounts.8
During the heyday of Bretton Woods, Friedman accurately pre-
saged both the frailty of the capital controls and the destabilizing
properties of the fixed-but-adjustable regime. Regarding capital
controls, he stated: “There are political and administrative limits to
the extent to which it is possible to impose and enforce such
controls. These limits are narrower in some countries than in others,
but they are present in all. Given sufficient incentive to do so, ways
will be found to evade or avoid the controls” (Friedman 1953: 169).
And, with regard to the durability of the adjustable-peg system,
he argued:

This system practically insures the maximum of destabiliz-

ing speculation. Because the exchange rate is changed
infrequently and only to meet substantial difficulties, a
change tends to come well after the onset of difficulty, to
be postponed as long as possible, and to be made only after

7
The Japanese yen became convertible on current account in 1964.
8
The term “fundamental equilibrium” was never defined. The IMF could not dis-
approve a change in parity, however, if the change was less than 10 percent
(Bordo 1993: 35).

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substantial pressure on the exchange rate has accumulated.

In consequence, there is seldom any doubt about the direc-
tion in which exchange rate will be changed [Friedman
1953: 164].

And so it turned out. The Bretton Woods years became increas-

ingly characterized by the evasion of capital controls, and the credi-
bility of the system was undermined by a series of speculative attacks
against nondollar currencies, and repeated parity adjustments against
the dollar throughout the 1950s and 1960s. By the late 1960s, the
attacks had spread to the U.S. dollar, the center of the system, as the
United States undertook inflationary policies to finance the Vietnam
War and the Great Society program of the Johnson administration
(Bordo and Schenk 2017: 224). Following a series of measures in the
late 1960s and early 1970s that loosened the link between the dollar
and gold, the effect of which was essentially to demonetize gold, and
several ad hoc arrangements that aimed to sustain the system, most
countries abandoned their dollar pegs in the early 1970s, beginning
with the floating of sterling in June 1972, followed by the floating of
the deutsche mark and yen in early 1973.

Flexible Exchange Rates and Domestic Rules

As a classical liberal, Friedman (1962a: 38–39) was fearful of con-
centrated power. He was suspicious of assigning any functions that
could be performed through the market to government because
doing so would substitute coercion for voluntary cooperation and
because, by giving the government an increased role, it would
threaten freedom in other areas. Power, he believed, needed to
be dispersed. But the need of dispersal of power raised an especially
difficult problem in the field of money. Since money can be a pow-
erful force for controlling and shaping the economy, Friedman
believed that the government needed to have some responsibility
in monetary matters. Too much control over money, however,
could be dangerous; Friedman (1962a: 39) quoted Lenin’s famous
dictum that the most effective way to destroy a society is to destroy
its money.
In Friedman’s view, one of the great attractions of a floating
exchange rate system is that it decentralizes policymaking to
the national level, allowing each country’s policymakers to take

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responsibility for managing their own economy. Floating exchange

rates, he argued, would help insulate the domestic economy from
external shocks and would provide national policy authorities the
ability to satisfy domestic goals (Friedman 1953).9 Consequently,
national authorities could be held democratically accountable to their
citizens (Friedman 1962a).10 Flexible exchange rates, he believed,
would be stable exchange rates provided that the underlying eco-
nomic structure, including policy structure, was stable.
Two key arguments underpinned Friedman’s belief that flexible
exchange rates need to be accompanied by domestic monetary rules.
First, a system based on discretion would be inconsistent with dem-
ocratic principles: “Any system which gives so much power and so
much discretion to a few men . . . is a bad system to believers in
freedom just because it gives a few men such power without any
effective check by the body politic . . . this is the key political
argument” against discretionary monetary policy11 (Friedman 1962a:
50, italics added).
Second, the power given to monetary authorities under a discre-
tionary regime subjects policy actions to political pressures and to
the accidents of personality and fads in economic thinking.
Friedman (1962a) saw this as “the key technical argument” against
such discretion. With regard to susceptibility of central banks to
political pressures, Friedman (1967: 277) believed that even
supposedly independent central banks would be subjected to such
pressures: “Truly independent central banks are fair-weather insti-
tutions. When there is any serious conflict between the policies
they favor and policies strongly favored by the central political
authorities—generally reflected through Treasury policy—the polit-
ical authorities have inevitably had their way, though at times only
after some delay.” For this reason, Friedman favored monetary rules

9
Recently, Rey (2016) has argued that a floating exchange rate does not secure
monetary policy autonomy for inflation-targeting countries. Nelson (2017b) pro-
vides a forceful critique of Rey’s thesis.
10
Friedman’s argument that a floating exchange rate system allows national poli-
cymakers to be democratically accountable is almost always overlooked in the lit-
erature on exchange rate regimes. A major exception is Frankel (2016: 16).
11
In the above quotation, Friedman referred to the case of an independent cen-
tral bank, operating under discretion, that was not subject to legislative rules.

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embedded in legislation so that central bankers could be held

accountable for their actions.
With regard to personal attributes, Friedman’s research during
the 1950s, especially that with Anna Schwartz, culminating in their
A Monetary History of the United States (1963) convinced him
that such attributes, including ethnic prejudices, had contributed
to the Great Depression in two ways.12 First, Fed officials, aiming
to stem speculation in the stock market, had inappropriately tight-
ened monetary policy in 1928 and 1929, thereby initiating a
decline in economic activity. Second, in late 1930, a private bank
called the Bank of United States, with over 400,000 depositors—
more than any other bank in the country—found itself in trouble
as depositors rushed to convert their deposits into currency. It was
a sound bank; its troubles stemmed from rumors that produced a
run on it. Friedman and Schwartz believed that in a financial cri-
sis the monetary authorities should follow a well-established rule:
if a bank was sound, but was facing a run on deposits, the mone-
tary authorities needed to lend freely to the bank in order to
quench the panic. New York State banking officials, however,
refused to provide liquidity to the financial institution, and in
December 1930, the bank was forced to close. That single event
dramatically changed the character of the downturn, converting a
rather normal cyclical contraction into what has become known as
the Great Depression.
Friedman and Schwartz (1963) asserted that there were two rea-
sons for this turn of events. First, the Bank of United States was the
largest U.S. commercial bank ever to have failed at that time. Second,
although it was an ordinary commercial bank, its name had led many
at home and abroad to regard it as an official bank. Hence, its failure
undermined confidence more than the fall of a bank with a less dis-
tinctive name. They also hinted that anti-Semitism may have played
a role in the failure to provide liquidity to the bank; its stakeholders
and officers were mainly Jewish. Subsequently, Friedman (1974)
confirmed that he believed that anti-Semitism among some New
York state officials played a role in the closing of the bank.

12
Nelson (2017a) and Lothian and Tavlas (2018) provide discussions of Friedman
and Schwartz’s research.

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What Kind of Rule?

Friedman’s research led him to favor a rule under which the M2
(currency plus demand and time deposits) measure of money supply
would grow in the range of 3 to 5 percent annually. That research
included empirical estimations showing that the demand for M2 was
stable (Friedman 1959), a key requirement for effective monetary
targeting. In proposing the rule, he noted: “I do not regard my par-
ticular proposal as a be-all and end-all of monetary management, as
a rule which is somehow to be written in tablets of gold and
enshrined for all future time. . . . I would hope that . . . we might be
able to devise still better rules” (Friedman 1962a: 55).13
During the 1980s, a consensus emerged within the profession
about the superiority of a domestic monetary rule.14 Several contri-
butions led to this consensus. First, Friedman (1968) and Phelps
(1968) showed that, analytically, the steady-state unemployment rate
is not related to the steady-state inflation rate when the long-run
Phillips curve relationship is augmented with a variable representing
the expected inflation rate. An implication of the natural-rate hypoth-
esis is that the best that macroeconomic policy can hope to achieve is
price stability in the medium term. Second, Kydland and Prescott
(1977) showed that attempts to “reoptimize” (i.e., renege on previous
commitments) by authorities under a discretionary regime are likely
to lead to worse outcomes than those in which the authorities are
constrained to follow through on previous commitments.
The experience of the past 40 years has confirmed the superiority
of domestic rules-based regimes. The decade of the 1970s featured
discretionary policies accompanied by high unemployment in associ-
ation with rising inflation. The period from the mid-1980s until the
early 2000s, under which monetary policy was well characterized by
a Taylor rule, produced the Great Moderation of low unemployment
and low inflation.

13
Beginning in the 1970s, most empirical money demand functions exhibited insta-
bility in light of financial innovation and deregulation of the financial system. In the
1980s, Friedman changed his preferred aggregate from M2 to M1 (currency plus
demand deposits). Toward the latter part of his life, he expressed admiration of the
conduct of monetary policy during the period from the mid-1980s to the late1990s,
a period during which the Fed’s policy was well represented by the Taylor rule.
On these issues, see Nelson (2008).
14
Dorn (2018) provides a thorough analysis of the case for monetary rules.

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The Taylor rule, under which the monetary authorities target the
short-term policy rate so that it responds to divergences of actual
inflation rates from target inflation rates, and to deviations of actual
gross domestic product (GDP) from potential GDP, and Friedman’s
money-supply growth rule share several important attributes.
1. Both rules are simple and easy to understand. Therefore, they
make monetary policy transparent and predictable.
2. Both rules prescribe a path for a policy instrument. For
Friedman, the path of the money supply is set exogenously—it
does not depend on economic conditions. For Taylor, the path
of the policy interest rate is endogenous—it responds to infla-
tion and the output gap.
3. In marked contrast to discretion, both the Friedman rule and
the original version of the Taylor rule exclude reliance on per-
ceptions and interpretations about future economic variables to
shape the conduct of monetary policy. By excluding such per-
ceptions and interpretations about future variables from policy
formation, both rules further limit discretion.
4. By limiting the amount of discretion, both rules also contain the
potential political influence that can be exerted on monetary
authorities;15 it is easier to influence policy formation if the
monetary authorities exercise judgment than it is if they are
bound by a rule.
5. Both rules limit the possibility that monetary policy may fall
prey to the influence of fads in economic thinking.
6. Both rules draw a clear separation of monetary policy from fis-
cal policy, thus further insulating the monetary authorities from
political pressures.
7. Both rules clearly place price stability at the heart of monetary
policy. Friedman (1960: 91) specifically proposed his rule for
the following reason: “a rate of increase [of the money supply]
of 3 to 5 percent per year might be expected to correspond with
a roughly stable price level.” The Taylor rule explicitly targets a
low and stable inflation rate.

15
Friedman (1960: 85) argued that reliance on discretion leads to “continual
exposure of the authorities to political and economic pressures.” Taylor (2012:
1024) argued that “[rules] help policymakers avoid pressures from special inter-
est groups and instead take actions consistent with long-run goals.”

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In addition, both Friedman and Taylor specified that their respec-

tive rules should be embodied in legislation in order to ensure
accountability of the monetary authorities in line with democratic
principles.
In today’s world, the Taylor rule, which has been shown to be
robust to widely different views about how monetary policy works
(Taylor and Williams 2011), would help produce the goals that
Friedman wanted to achieve while not having to confront the insta-
bility exhibited by monetary aggregates. As Taylor (2017) argued, an
international setting, in which the major countries followed Taylor
rules geared to their specific setting, would provide harmonization of
policies and optimal economic conditions domestically.
While we see substantial merits in a Taylor-type rule, our view is
tempered with the following cautionary observations. First, the
Taylor rule has been formulated so that it operates in normal circum-
stances in which the natural rate of interest is positive. What happens
when normal circumstances do not apply and the natural rate is
close to zero (as it apparently was in recent years)? Correspondingly,
how is harmonization measured when interest rates are near the
zero bound? The point is that, when interest rates are near the
zero bound, even if the authorities aim to follow a Taylor rule they
will be unable to do so. And harmonization of policies will therefore
not be measurable.16 Second, in periods of crisis, such as during
2007–08, monetary authorities will be tempted to resort to unortho-
dox policies, deviating sharply from rules-based policies, as evi-
denced during and after that crisis. In the late 1980s and the 1990s,
by contrast, the Taylor rule characterized the Fed’s behavior well
because there was no conflict between its domestic objectives and
the outcome that would prevail through the rule. These episodes
lead to the question: Under a rules-based policy, when the going gets
tough will the authorities stick to the rule? Third, Taylor, as men-
tioned, suggests that each country specify its own, individualized,
Taylor-type rule. What happens if some countries (e.g., China)
include an exchange rate objective in their policy rule while others
(e.g., the United States) do not? Will the differentiated rules be
consistent with harmonization of policies? Or will they lead to accu-
sations of currency manipulation?

16
For example, how is harmonization measured when quantitative easing operations
have increased central banks’ balance sheets by vastly different percentages?

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Case for Flexible Exchange Rates

Conclusion
To conclude, the Taylor rule has proved to be both a practical and
a preferable alternative to Friedman’s constant money-growth rule.
If embedded in legislation, and if it can address the above-mentioned
issues, the Taylor rule would be a worthy successor to Friedman’s
search for a rule that simultaneous achieves full employment, price
stability, and democratic accountability.

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