Southern Economic Journal 2017, 83(3), 744–755

DOI: 10.1002/soej.12177

An Evaluation of Friedmans Monetary

Instability Hypothesis
Joshua R. Hendrickson*

In this article, I examine what I call Milton Friedmans Monetary Instability Hypothesis.
Drawing on Friedmans work, I argue that there are two main components to this view. The
first component is the idea that deviations between the publics 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 Friedmans work and a money growth rule, for a period from
1875 to 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 Friedmans view.

JEL Classification: E51, E32, E41

1. Introduction

In A Program for Monetary Stability (Friedman 1960) and later in his speech to the American
Economic Association (Friedman 1968), Milton Friedman advocated a constant-rate-of-money-
growth rule for monetary policy. Friedman saw the desirability of a constant money growth rule as
the result of two characteristics of monetary policy. First, unlike other variables for which mone-
tary policy could attempt to set a desired outcome, the monetary aggregates are to some degree
controllable by the monetary authority. Second, and most important was Friedmans view,
informed from his empirical work with Anna Schwartz, that sharp swings in monetary aggregates
were a significant source of economic fluctuations. Friedman attributed these large swings in mon-
etary aggregates to the propensity on the part of the Federal Reserve to overreact to fluctuations
in the economy because policymakers failed to consider the lag in the effect of policy.
To understand Friedmans advocacy of the constant money growth rule, it is important to
understand his underlying theoretical framework. At the core of Friedmans analysis is his restate-
ment of the quantity theory (Friedman 1956). Friedman argued that the quantity theory of money
was primarily a theory of money demand. According to this view, the real stock of money is deter-
mined by the holders of money whereas the nominal stock of money is determined by the mone-
tary authority or other financial institutions. Individuals are not capable of influencing the
nominal stock of money. As a result, deviations between the nominal stock of money and the

* Department of Economics, University of Mississippi, 229 North Hall, University, MS 38677, USA; E-mail:
jrhendr1@ olemiss.edu.
Received May 2016; accepted September 2016.

744 Ó 2016 by the Southern Economic Association

 Friedmans Monetary Instability Hypothesis 745

demand for real balances cause corresponding fluctuations in nominal spending and also real eco-
nomic activity. For example, if the nominal stock of money differs from the demand for real balan-
ces at the current price level, individuals will seek to adjust nominal money balances accordingly
and this is typically accomplished through changes in spending. However, while each individual
can reduce their own nominal balances, these nominal balances cannot be reduced collectively.
This process, therefore, continues until the price level adjusts such that the nominal money supply
is consistent with the demand for real balances. Furthermore, during this adjustment process,
changes in nominal spending also have an effect on real economic activity.1 As a result of his
empirical work with Anna Schwartz, Friedman viewed the deviations between the supply and the
demand for money to be a significant source of economic fluctuations and, in particular, argued
that changes in the money supply were the primary source of such deviations.
I refer to Friedmans view as the Monetary Instability Hypothesis and argue that there are
two main components of this hypothesis. In Friedmans view, there are three types of monetary
shocks. There are shocks to the monetary base, the money multiplier, and money demand. The
first component of the Monetary Instability Hypothesis is that monetary shocks are an important
source of economic fluctuations. The second component of Friedmans hypothesis is that shocks
to the money supply (i.e., shocks to the monetary base and/or the money multiplier) are much
more important than shocks to the demand for money.
The purpose of this article is to analyze Friedmans Monetary Instability Hypothesis within
the context of Friedmans own theoretical framework. Specifically, I amend an otherwise standard
New Keynesian model to include a money demand function in which money is a function of per-
manent income, as defined by Friedman, and estimate the model using U.S. data from 1875 to
1963. The use of this structural model is important because it allows for the isolation of money
demand shocks from money supply shocks. The model is, therefore, capable of addressing two
hypotheses. First, the model allows for a comparison of the magnitudes of shocks to the monetary
base and shocks to money demand. Second, conditional variance decompositions can be used to
address the relative importance of the shocks.
The evidence suggests that shocks to money demand were indeed quite small, as Friedman
argued. The variance decompositions suggest that shocks to the monetary base can explain 28%
of the fluctuations in output. Shocks to the money multiplier can explain an additional 2% of the
fluctuations in output. Thus, unexpected changes in broad measures of the money supply can
explain at most 30% of the fluctuations in output. Money demand shocks explain at most 0.5% of
the fluctuations in output. The results suggest that monetary shocks were not the predominant
cause of economic fluctuations over the sample period, but were nevertheless economically signifi-
cant. As a result, the evidence broadly supports Friedmans Monetary Instability Hypothesis.
This article is related to work by Christiano, Motto, and Rostagno (2003) and Belongia and
Ireland (2015). Christiano et al. estimate a DSGE model using data from the 1920s and 1930s and
then use the model to construct a counterfactual to determine whether the policy prescriptions
advocated by Friedman and Schwartz would have helped reduce the severity of the Great Depres-
sion. Their evidence supports the policy implications suggested by Friedman and Schwartz.
Belongia and Ireland (2015) test the implications of the Friedman-Schwartz hypothesis by exam-
ining both the correlations in the data and by estimating a structural vector autoregressive model.

1
A discussion of the transmission mechanism of monetary policy can be found in Friedman and Schwartz (1963a) and
the transmission of the effects of deviations between the supply of and demand for money more generally can be found
in Friedman and Schwartz (1982).
746 Joshua R. Hendrickson

They find support for both the cross-correlation properties in the data as well as evidence of large
and persistent effects of money on output and prices. This article differs from this related work in
the sense that it looks at the broader period covered in Friedman and Schwartzs Monetary
History of the United States and uses Friedmans preferred model of money demand.

2. The Quantity Theory and the Permanent Income View of Money Demand

In Friedmans (1956) restatement of the quantity theory and in his subsequent writings on
the quantity theory (Friedman 1989), he describes the quantity theory of money as a theory of the
demand for money. According to this view, the demand for real money balances is determined by
individuals as a function of income and a spectrum of asset prices. The nominal supply of money
is determined by the central bank and/or the banking system. For a given price level, the nominal
money supply might be greater than or less than the quantity that individuals want to hold. Such
deviations between the publics demand for real money balances and the nominal supply of money
for a given price level ultimately result in reallocation. However, while individuals can succeed in
increasing or reducing their own money balances, this is not true of the public as a whole. The
reallocation process leads to changes in nominal spending, which is initially has an effect on
real economic activity, but ultimately results in changes in the price level until equilibrium is
restored.
What is unique about Friedmans view of money demand, however, is his emphasis on per-
manent income rather than real current income. In contrast to contemporary estimates of money
demand functions, which include a scale variable of real economic activity and an interest rate to
measure the opportunity cost of money, Friedman argued that the demand for money was primar-
ily a function of permanent income, rather than current income.2 Friedmans permanent income
theory of money demand was motivated by the observation that the correlation between the
income velocity of money and real income at business cycle frequencies differed from that
observed in the secular trend of the data. In particular, Friedman (1959) observed that the secular
trend in velocity was negatively correlated with that of real income, but that velocity was positively
correlated with real income at business cycle frequencies. The reason this finding was important
was because it contradicted the traditional transactions view of money demand. Under the trans-
actions view declines in income, associated with a recession for example, should result in corre-
sponding declines in real money balances as individuals draw down money balances to make
purchases. This decline in money demand implies an increase in velocity. This view, therefore, pre-
dicts that velocity should be negatively correlated with measured real income over the business
cycle. However, this is precisely the opposite of what was observed in the data.
Whereas others sought to incorporate additional variables into the money demand function,
Friedman offered an alternative explanation for the behavior of velocity. If economic agents adjust
their consumption path in accordance with their permanent level of income, as in Friedmans
(1957) Permanent Income Hypothesis, then the transactions demand for money should similarly
respond to permanent rather than measured income. The basis of this observation is the view that
money is a durable consumer good. The demand for money is, therefore, a demand for a flow of

2
For examples of the contemporary approach, see Hoffman, Rasche, and Tieslau (1995), Carlson et al. (2000), Ball
(2012), and Hendrickson (2014).
 Friedmans Monetary Instability Hypothesis 747

services proportional to the stock of money held. According to this view, money demand would
not be subject to the shock-absorber function typically attributed to it in the transaction view and
instead other items in the household balance sheet, like consumer debt, for example, would adjust
to transitory fluctuations in income. Given that most cyclical movements in measured income are
dominated by the transitory component, the permanent income view could potentially explain
why there was a positive correlation between velocity and measured real income.
Given Friedmans emphasis on both this permanent income view of money demand and the
deviations between the money supply and money demand as an important source of economic
fluctuations, it stands to reason that any evaluation of the Monetary Instability Hypothesis should
include Friedmans preferred money demand function. In the next section, I present a standard
New Keynesian model amended to included Friedmans view of money demand. I then use the
model to test Friedmans predictions.

3. Structural Estimates

According to Friedmans Monetary Instability Hypothesis, monetary shocks are an impor-

tant source of economic fluctuations, where monetary shocks are defined as deviations between
the publics demand for real balances and the supply of nominal money balances given the price
level. For example, consider the following money demand function:

mt 2pt 5x0 1x1 yp;t 2x2 rt 1et

where m is nominal money balances, p is the price level, yp is permanent income, r is a nominal
interest rate, and e is a stationary error term. Given this money demand function, the series, fet g,
represents the monetary shocks to which Friedman is referring. In other words, for nonzero value
of et, the quantity of real money balances differs from the predicted value. If the money demand
function is stable, one could estimate a cointegrating vector within the context of a cointegrated
VAR (Juselius 2006) and obtain a stationary series for fet g and potentially consider the impor-
tance of these “shocks” for explaining economic fluctuations. The problem with this approach is
that Friedmans Monetary Instability Hypothesis actually consists of two components. Broadly,
the hypothesis is about the significance of monetary shocks for economic fluctuations. However,
more narrowly the hypothesis is about the relative significance of shocks to the money supply rela-
tive to shocks to money demand. Estimation of the money demand function and the recovery of
the stationary series fet g will not be able to distinguish between money demand shocks and money
supply shocks. For example, et could take on a positive value because the nominal money supply
unexpectedly increased and the price level has yet to adjust or et could take on a positive value
because of an exogenous increase in money demand.
Thus, in order to isolate the shocks to the money supply from the shocks to money demand,
one needs to posit a structural model. In this section, I append an otherwise standard New
Keynesian model to include a money demand function consistent with Friedmans permanent
income view of money demand and the standard interest rate feedback rule is replaced by a money
growth rule. I then estimate the model using a sample from 1875 to 1963. I can then use condition-
al variance decompositions to evaluate both the overall importance of monetary shocks and the
relative importance of shocks to money supply in comparison to shocks to money demand.
The complete modified model can be expressed in log-deviations around the zero inflation
steady state as
748 Joshua R. Hendrickson

1
~y t 5Et ~y t11 2 ðRt 2Et pt11 Þ1eyt (1)
r
pt 5bEt pt11 1j~y (2)
lt 5x1 yp;t 2x2 Rt 1elt (3)
~y t 5yt 2ynt (4)
ynt 5hat (5)
yp;t 5ayt21 1ð12aÞyp;t21 (6)
at 5qa at21 1eat (7)
Dmt 5lt 2lt21 1pt (8)
Dmbt 5qm Dmbt21 1em
t (9)
Dmt 5Dmbt 1Dmmt (10)
Dmmt 5emm
t (11)

where ~y is the output gap, R is the nominal interest rate, p is the rate of inflation, ‘t is real money
balances, yt is real output, yn is the natural level of output, yp;t is permanent income, a is produc-
tivity, Dm is the change in the broad measure of the money supply, Dmb is the change in the mone-
tary base, Dmm is the change in the money multiplier, ey is an IS shock, ea is a productivity shock,
el is a shock to money demand, em is a shock to the monetary base, emm t is a shock to the money
multiplier, and r, b, j, x1, x2, h, c, qa, qm are parameters. Equation 3 is the money demand func-
tion consistent with Friedmans view of money demand.3 Also, Equation 6 is the definition of per-
manent income consistent with Friedmans (1957) definition.4 Equations 1–11 are sufficient to
determine an equilibrium for ~y t, Rt, pt, yt, ynt , at, Dmt ; Dmbt ; Dmmt ; ‘t , and yp;t .
This model has a state-space solution:

Xt 5CSt (12)
St 5XSt21 1Wt (13)

where X is a vector of control variables, S is a vector of state variables, and  is a vector of shocks.
In order to estimate the model, Equations 12 and 13 can be re-written as

Zt 5AZt21 1Bt
Wt 5C1DZt 1ut

where A and B are functions of C, X, and W, C is a vector to match the means of the variables, Wt
" #
Xt
are the observable variables, Zt 5 , and ut is a vector of measurement errors. This new state-
St

3
Note that I have included the nominal interest rate in the money demand function. The interest rate is not included in
Friedmans (1959) estimates of money demand. Also, after the publication of Friedman and Schwartzs Monetary His-
tory, one criticism was their exclusion of the interest rate from the discussion of money demand. Friedman (1966) dis-
cusses such criticisms and asserts that the neglect of the nominal interest rate is due to its small estimated elasticity. I
have chosen to include the nominal interest rate in the money demand function as an additional empirical test of
Friedmans views.
4
For more details, see the Appendix.
 Friedmans Monetary Instability Hypothesis 749

space representation can be used to estimate the parameters of the model. I estimate the model
using Bayesian estimation techniques.5 Specifically, the posterior distribution is estimated using
the Metropolis-Hastings algorithm.6
The observable variables of the system are real GNP, the log-difference of the monetary
base, the log-difference of M2, real money balances as measured by the logarithm of M2 minus
the logarithm of the GNP deflator, inflation (measured by the log-difference of the GNP deflator),
the yield on commercial paper, and permanent income, as defined by Friedman (1957).7 The data
is from Balke and Gordon (1986) and the sample ranges from 1875:Q1 to 1963:Q4. One cannot
reject the hypothesis of a unit root for real GNP, real money balances, permanent income, and the
yield on commercial paper. As a result, these variables are de-trended using the Christiano-
Fitzgerald (2003) filter.
Two parameters in the model are calibrated. The discount factor, b, is set to 0.99, which is a
standard value in the literature for quarterly data. The parameter, a, that determines the relative
weight given to last periods income in the calculation of permanent income is set to 0.2. This
parameter is chosen to ensure that there is a unique rational expectations equilibrium. The
remaining parameters are estimated. The prior distribution of the parameters is shown in Table 1.
The standard errors of the model are assumed to follow an inverse gamma distribution with a
mean of 0.01. Given the way that the variables are measured, this value implies a prior belief that
the standard deviation (SD) of the shocks relative to the steady-state is 1%. The persistence of the
AR(1) processes are assumed to follow a beta distribution with a mean of 0.5 and a SD of 0.25.
The inverse intertemporal elasticity of substitution is assumed to follow a gamma distribution
with mean 1 and SD of 0.25, which is consistent with the assumption of log-utility. The parameter,
h, measures the marginal effect of a technology shock on the natural level of output. This is
assumed to follow a gamma distribution with mean 1 and SD of 0.15. This prior is chosen to be
consistent with the parameterization of the model in Gali (2008). The permanent income elasticity
is assumed to follow a gamma distribution with a mean of 1.0 and a SD of 0.25. The (absolute val-
ue of the) interest elasticity of money demand is assumed to follow a gamma distribution with a
mean of 0.1 and a SD of 0.025. Finally, j is assumed to follow a beta distribution with mean 0.10.
This is chosen to coincide with standard calibrations of the New Keynesian model, such Gali
(2008) who calibrates j50:1275.
Table 1 also provides the means and the 10th and 90th percentiles of the posterior distribution
of the parameters obtained using the Metropolis-Hastings algorithm. As shown in Table 1, the per-
manent income elasticity of money demand is 0.12, which is small. In addition, the absolute value
of the interest elasticity of money demand is 0.23. Friedmans estimate of the permanent income
elasticity was greater than one. Friedman (1959, 1966) also suggests that interest elasticities of mon-

5
For an overview, see An and Schorfheide (2007).
6
Let H denote the vector of model parameters. The Metropolis-Hastings algorithm begins with an initial parameter vec-
tor H0 to obtain an estimate of the models likelihood function. This parameter vector is then updated following the
law of motion H1 5H0 1xw‹1 , where H1 is the updated parameter vector, x is the “jump” scalar, w is the Choleski
decomposition of the variance-covariance matrix of H, and ‹ is a normally-distributed error. The updated parameter
vector is used to calculate the likelihood of the model. The Metropolis-Hastings decision rule is used to determine
whether to accept the initial vector of the proposed update. This process is carried out N times to generate a distribu-
tion pðHjWT Þ. In the present analysis, a sample of 250,000 draws was created and the first 50,000 draws were dis-
carded. The “jump” scalar is chosen such that the acceptance rate is approximately 25%.
7
For details, see the Appendix.
750 Joshua R. Hendrickson

Table 1. Prior and Posterior Distribution of the Parameters—Full Sample: 1875–1963

Prior Posterior
Parameter Distribution Mean Standard Error Mean 90% Interval

j Beta 0.10 0.025 0.09 [0.07, 0.11]

r Gamma 1.00 0.25 1.25 [1.10, 1.36]
x1 Gamma 1.00 0.25 0.12 [0.11, 0.12]
x2 Gamma 0.10 0.025 0.23 [0.21, 0.25]
h Gamma 1.00 0.15 1.33 [1.23, 1.41]
qa Beta 0.50 0.25 0.90 [0.86, 0.94]
qm Beta 0.50 0.25 0.78 [0.75, 0.81]
Standard deviationðey Þ Inverse Gamma 0.01 Inf. 0.0044 [0.0024, 0.0064]
Stdandard deviationðel Þ Inverse Gamma 0.01 Inf. 0.0012 [0.0012, 0.0012]
Stdandard deviationðea Þ Inverse Gamma 0.01 Inf. 0.0274 [0.0243, 0.0302]
Stdandard deviationðem Þ Inverse Gamma 0.01 Inf. 0.0081 [0.0072, 0.0090]
Stdandard deviationðemm Þ Inverse Gamma 0.01 Inf. 0.0021 [0.0018, 0.0024]

ey demand are small in absolute value.8 However, it is important to note the difference in estima-
tion techniques. Friedmans sample was constructed using cycle averages. As a result, Friedmans
sample size was small and of a reduced form. This might explain the discrepancy in estimates.
As noted above, by estimating the money demand equation within a general equilibrium con-
text it is also possible to isolate shocks to money demand and shock to the money supply directly
in the model. This characteristic is important because it allows one to test the relative importance
of each shock for economic fluctuations. This can be done comparing the magnitude of the shocks
and estimating conditional variance decompositions. The SD of shocks to money demand is
approximately 0.1% relative to the steady state. By contrast, the SDs of shocks to the monetary
base and the money multiplier are 0.8% and 0.2%, respectively, relative to the steady state. The
magnitudes of the SD of the shock to the monetary base in comparison to the shock to money
demand supports for Friedmans view that shocks to the money supply are of more economic sig-
nificance than shocks to money demand.
Estimates of the conditional variance decompositions are shown in Table 2. According to the
table, shocks to the monetary base account for up to 28% of the forecast error variance in real out-
put. In addition, shocks to the money multiplier can account for up to 2% of fluctuations in real
output. This suggests that shocks to the broad measure of the money supply account for up to
30% of the fluctuations in real output. By contrast, shocks to money demand can only account for
at most 2% of the forecast error variance of real GNP. Nonetheless, the majority of the forecast
error variance is accounted for by shocks to productivity. Thus, the conditional variance decom-
positions provide support for both Friedmans view that monetary shocks are an important
source of economic fluctuations and that shocks to the money supply were of greater economic
importance than shocks to money demand. Nonetheless, monetary shocks are not the predomi-
nant source of economic fluctuations.
To put the shocks into context, consider that Friedman and Schwartz (1963a,b) attribute the
severe recessions in 1920–1921 and 1929–1933 to changes in the monetary base. For example, they
argue that during 1920 and 1921 the Federal Reserve significantly increased the discount rate,

8
Friedman (1966) argued that while interest rates likely played a role in money demand decisions, in his experience the
estimated elasticities are small in magnitude. He also argued that the magnitude of interest elasticities mattered little
for macroeconomic fluctuations.
 Friedmans Monetary Instability Hypothesis 751

Table 2. Conditional Variance Decompositions—Full Sample: 1875–1963

Variable Periods Ahead Output Inflation

Monetary base shock 1 0.28 0.98

2 0.25 0.98
3 0.24 0.99
4 0.22 0.99
Money multiplier shock 1 0.02 0.01
2 0.02 0.01
3 0.01 0.01
4 0.01 0.01
Money demand shock 1 0.005 0.00
2 0.003 0.00
3 0.002 0.00
4 0.002 0.00
Productivity shock 1 0.69 0.00
2 0.73 0.00
3 0.75 0.00
4 0.76 0.00
IS shock 1 0.003 0.003
2 0.002 0.005
3 0.002 0.005
4 0.001 0.005

reducing the central banks credit outstanding and therefore the monetary base. They also argue that
the Federal Reserve contracted the monetary base during 1929 and 1930 and that the Federal
Reserve again undertook a deflationary policy following Englands decision to go off the gold
standard.
Figure 1 plots the monetary shocks estimated from the model. As shown, the largest negative
shock to the monetary base occurs precisely during the period 1920–1921. In addition, note that
the period from 1929–1933 is characterized by a series of negative shocks to the monetary base.
This would seem to provide strong support for the view that unexpected changes in the monetary
base were a significant source of economic fluctuations during these periods.
Overall, the evidence suggests that (i) monetary shocks can account for an economically sig-
nificant fraction of output fluctuations, (ii) money demand shocks were of little significance, and
(iii) the estimated monetary shocks are consistent with the description of significance in Friedman
and Schwartz (1963a,b). I interpret this as evidence broadly in support of the Monetary Instability
Hypothesis.

4. Robustness of the Results

As shown in Figure 1, the largest monetary shocks appear to occur prior to 1935. To examine
the robustness of the results, I estimate conditional variance decompositions for the subperiods
1875–1935 and 1936–1963. The results for these subperiods are shown in Tables 3 and 4, respec-
tively. The results shown in Table 3 have the same general pattern as those in Table 2. However,
shocks to the monetary base account for up to 35% of the fluctuations in real output in this
subsample compared to 28% for the overall sample. In contrast, as shown in Table 4, shocks to the
monetary base only account for 10% of the fluctuations in real output in the 1936–1963
subsample.
752 Joshua R. Hendrickson

.03
.02
Shocks to the Monetary Base
.01
0
-.01
-.02

1875q1 1880q1 1885q1 1890q1 1895q1 1900q1 1905q1 1910q1 1915q1 1920q1 1925q1 1930q1 1935q1 1940q1 1945q1 1950q1 1955q1 1960q1 1965q1

Figure 1. Estimated Shocks to the Monetary Base.

These results suggest that monetary shocks were substantially more important during the
first subsample than the second. Nonetheless, these results are consistent with the empirical work
of Friedman and Schwartz (1963a,b). For example, Friedman and Schwartz (1963a) are careful to
distinguish between major economic fluctuations and minor economic fluctuations. They list six

Table 3. Conditional Variance Decompositions—Sample: 1875–1935

Variable Periods Ahead Output Inflation

Monetary base shock 1 0.35 0.98

2 0.34 0.98
3 0.33 0.99
4 0.32 0.99
Money multiplier shock 1 0.03 0.02
2 0.03 0.01
3 0.02 0.01
4 0.02 0.01
Money demand shock 1 0.002 0.00
2 0.001 0.00
3 0.001 0.00
4 0.000 0.00
Productivity shock 1 0.61 0.00
2 0.63 0.00
3 0.64 0.00
4 0.65 0.00
IS shock 1 0.01 0.00
2 0.01 0.00
3 0.01 0.00
4 0.004 0.00
 Friedmans Monetary Instability Hypothesis 753

Table 4. Conditional Variance Decompositions—Sample: 1936–1963

Variable Periods Ahead Output Inflation

Monetary base shock 1 0.10 0.96

2 0.10 0.96
3 0.10 0.97
4 0.10 0.97
Money multiplier shock 1 0.01 0.02
2 0.01 0.01
3 0.01 0.01
4 0.01 0.01
Money demand shock 1 0.001 0.00
2 0.00 0.00
3 0.00 0.00
4 0.00 0.00
Productivity shock 1 0.88 0.02
2 0.89 0.02
3 0.89 0.02
4 0.90 0.02
IS shock 1 0.004 0.00
2 0.003 0.00
3 0.002 0.00
4 0.002 0.00

periods that they classify as major economic fluctuations. Of those six periods, only one (1937–
1938) occurs during second subsample. Further, Friedman and Schwartz (1963a, p. 55) acknowl-
edge that “[t]he case for a monetary explanation is not nearly so strong for the minor U.S. econom-
ic fluctuations that we have classified as mild depression cycles as the case is for the major
economic fluctuations.” One would therefore expect, a priori, to find that monetary shocks were
of greater importance in the first subsample given the concentration of major economic fluctua-
tions during this time period and the weaker empirical link between monetary shocks and minor
economic fluctuations.
On a related note, Friedman and Schwartz (1963a, p. 55) note that the failure to identify such
a strong connection between money and minor economic fluctuations raises two possibilities.
First, it is possible that monetary factors have much the same effect during minor fluctuations as
major fluctuations, but are harder to identify using their methods. Second, it is possible that non-
monetary factors have a more important role in explaining minor economic fluctuations. To dis-
tinguish between these alternatives

“would require an explicit and rigorously stated theory, which could take the form of a series of
simultaneous differential equations describing the reaction mechanism of the economy, togeth-
er with a specification of the joint distribution function of the random disturbances impinging
on it, and a specification of the systematic disturbances that could be introduced into it”
(Friedman and Schwartz, 1963a, p. 55).

The model I use in this article is an opportunity to answer that challenge. There is an element
of each of Friedman and Schwartzs explanations for minor economic fluctuations evident in the
results from the estimation over each subsample. The results suggest that nonmonetary factors
explain the vast majority of fluctuations in this latter subsample, but shocks to the monetary base
remain an economically significant source of business cycle fluctuations.
754 Joshua R. Hendrickson

5. Conclusion

Milton Friedmans support for a k-percent rule for money growth was based on his under-
standing of the quantity theory of money and his interpretation of the empirical evidence on mon-
ey and the business cycle. Specifically, he emphasized two testable empirical hypotheses: (i) that
monetary shocks were an important source of business cycle fluctuations, and (ii) that shocks to
the money supply were more important than shocks to the money demand. By establishing a k-
percent rule, central banks could eliminate shocks to the money supply. For this to be welfare-
improving would require that shocks to money demand were of little significance. Otherwise,
shocks to the demand for money would create a new source of instability since the money supply
would not be able to adjust accordingly.
In this article, I have tested each of these hypotheses within the context of a structural macro-
economic model. The benefit of using this approach is that it allows me to separately estimate
shocks to the monetary base, the money multiplier, and to money demand. Conditional variance
decompositions can then be used to assess the relative importance of the shocks. This approach is
therefore immune to earlier critiques of Friedmans own empirical work (Tobin 1970). The results
suggest that monetary shocks are indeed an important source of economic fluctuations during the
period covered by Friedmans (together with Anna Schwartz) own empirical work. In addition,
shocks to the monetary base account for up to 28% of the fluctuations in output whereas shocks
to money demand are of very little importance. One must be careful to draw conclusions about
what fraction of fluctuations in output could have been avoided during this period with a k-
percent rule since this would have implied a completely different monetary regime. Nonetheless,
the empirical evidence provides some support for Friedmans view.

Appendix

Friedmans definition of permanent income is based on the following assumption about the evolution of per-
manent income over time:

dyp
5cy1a½y2yp 
dt

Thus, permanent income changes over time with the secular growth of the economy and is also revised in accordance
with the difference between current income and the current estimate permanent income.
A discrete time representation is given as

yp;t11 2yp;t 5ðc1aÞyt 2ayp;t

where c; a 2 ð0; 1Þ. or

yp;t 5ðc1aÞyt21 1ð12aÞyp;t21

We can re-write this as

½12ð12aÞLyp;t 5ðc1aÞyt21

or,

yt21
yp;t 5ðc1aÞ
12ð12aÞL

Since b 2 ð0; 1Þ, we know from the properties of the lag operator that
 Friedmans Monetary Instability Hypothesis 755

1
511ð12aÞL1ð12aÞ2 L2 1ð12aÞ3 L3 1 . . .
12ð12aÞL

Thus,

X
1
yp;t 5ðc1aÞ ð12aÞi yt212i
i50

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