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Milton Friedman: Economic Theories and Their Importance Research Paper

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Updated: Dec 20th, 2021

The 20th century abounded with notable economists who have made valuable contributions into the economic theory and once and for all changed the economic policies that the world countries have followed. Among all these people, Milton Friedman is fairly regarded as one of the most influential economists and political philosophers. His political and economic views were not only duly appreciated by the society and the government, but produced a great influence on the economic welfare of a range of countries.

His achievements have influenced much the economic science and “his advocacy of classical liberal views has influenced public opinion on the social role of Western governments. Friedman’s ideas … may have influenced the rise of free-maker economies in Asia and the decline of state socialism in Eastern Europe” (Friedman & Bordo, 2005, p. vii). The only fact that Friedman is a winner of a Nobel Prize in Economics testifies to the fact that he was not an ordinary person simply interested in economics; he made it a goal of his life to leave his mark in the world history, the goal that he was more than able to achieve.

Together with carrying out empirical and theoretical research, Milton Friedman was also a professor of the University of Chicago and an economic advisor to the 40th President of the United States, Ronald Reagan. Milton Friedman has advanced three major economic theories, namely, monetary theory, permanent income hypothesis and a theory of natural rate of unemployment; these theories have revealed important aspects of economics, have shown to be extremely helpful to the U.S. economics in particular, and could make the latter even more prosperous if their creator was still alive.

What should be mentioned above all is that monetary theory is the first thing that the name of Milton Friedman is associated with. Friedman’s monetary theory was largely influenced by the work that was performed by Irving Fisher on the quantitative theory of money, a theory proposing a view that there is a direct relation between a price level and money supply. Friedman did not totally support quantitative theory of money; he relied on it, but there were certain ideas in which he and Fisher did not agree. In general, monetary theory refers to macroeconomics because it deals with such issues as total employment, fluctuations in the total output, levels of prices, etc (Friedman, 2007).

In short, Friedman’s monetary theory, supporting the quantity theory, posited that a change in money supply is capable of changing the price level and nominal expenditures in the same direction. This presupposes that, in terms of its real value, a unit of money is a good that has a purchasing power over other goods: “This real purchasing power of money over commodities is reduced by inflation, so that the rate of inflation is the opportunity cost of holding real balances as against holding commodities.

Hence, money demand depends on the (expected) inflation rate” (Handa, 2008, p. 63). At the same time, the demand for money is characterized by the real income but, at this, the quantity of money that people wish to possess does not depend on their incomes only, as it was believed earlier. Instead, it is determined by the level of incomes and the level of prices, as well as by the cost of holding money (this cost is determined by the interest which those people who hold money obtain when lending them, as well as by the increase in the level of prices). The biggest importance on monetary theory proposed by Friedman lies in its giving a possibility to evaluate the effect of the monetary change on the course of the economic activity, as well as in showing that economic stability may be achieved by the monetary stability.

This policy also helped our economy much during 2007-2010 financial crisis when, following namely this theory, the U.S. Federal Reserve and a number of the banks around the world have expanded money supplies with a purpose of avoiding deflation. In this way, Friedman’s monetary policy has helped the USA to avoid the collapse of a number of financial institutions. Thus, one of the most famous Friedman’s theories is monetary theory that has had a positive impact on a number of world economies and proved to be effective for the USA in 2007-2010 financial crisis.

Another no less important theory advanced by Milton Friedman is permanent income hypothesis, or a theory of consumption. Friedman developed this theory together with his wife, Rose, and with Margareth Reid and Dorothy Brade, as well as he based this theory on Fisher’s theory of saving. Permanent income hypothesis is believed to be a theory of individual behavior. Snowdon & Vane (2002) state that Friedman’s theory consists in the following: “Consumer unit plans consumption with the objective of maximizing utility over the long term, subject to a wealth constraint. When this constrained optimization problem is solved, current-period consumption is seen to depend upon both wealth and the rate of interest” (p. 573).

For a long time, it has been considered that the consumption patterns and choices of the consumers are largely determined by the level of their income. Friedman’s theory, however, refutes this idea arguing instead that these choices and patterns are determined by the consumers’ long-term income expectations. This is why a change in the current income of population can only influence the current consumption through altering wealth, both human (labor income) and non-human (property and financial assets) (Snowdon & Vane, 2002). So, the key component of Friedman’s theory is the permanent income, or the amount that can be consumed with the wealth of a particular consumption unit maintained intact.

This means that disposable income of a consumer does not have any effect on the consumption patterns; it is the real wealth of the individual that does because individual’s wealth determines the ability of a consumer to earn future income. In this way, individualism is characteristic for Friedman’s permanent income hypothesis. The importance of this hypothesis consists in its making the economists able to properly trace changes in consumption patterns and change these patterns in a way that not only current, but future income of the population is changed.

In particular, permanent income hypothesis has long been helpful for the U.S. economy because the American economists have always used this theory to make economic forecasts; this model has proven to improve forecasts for personal and labor income. Therefore, Friedman’s permanent income hypothesis is important and helpful for the world countries’ economies because it helps to trace changes in consumption patterns and make economic forecasts.

Furthermore, one of the most important theories advanced by Friedman is natural rate of unemployment that is used for tracing the relationship between unemployment and inflation. Until Friedman came up with his theory, it was believed that there was certain negative relationship between unemployment and inflation. The implication of this belief was that higher inflation had a power to reduce unemployment.

Friedman opposed such theory because he believed that a more serous variable in economy needed to be changed for unemployment to become lower. This was when Friedman coined the term ‘natural rate of unemployment” which was to mean “the unemployment rate toward which the economy gravitates in the long run” (Mankiw, 2007, p. 803). This rate is not necessarily socially desirable, nor is it constant all the time; its naturalness lies not in its being good for the society, but in its being unavoidable because, as Friedman stated, it could not be affected by the monetary policy.

Nevertheless, there are other policies that can affect the natural rate of unemployment; according to Friedman, these are the policies that influence the economy’s supply side. The importance of the theory of natural rate of unemployment is hard to overestimate. Without it, policymakers would use monetary policies to reduce the unemployment; this would lead to a temporary lower rate of unemployment that with time would return to the natural rate, thus, only leading to higher inflation.

The theory also proved to be helpful for the U.S. economy because the American economists have stopped studying how exactly wage demands are able to cause inflation and focused more on the relations between inflation and prices rates. Additionally, this theory helped to discredit the myth that full employment may serve as a measure of the workers’ well-being because, with unemployment rates falling for the past several years, no income rates have been registered. With the help of this theory, the American economists were able to reduce the unemployment rates without increasing the rates of inflation. In this way, Friedman’s theory of the natural rate of unemployment was helpful for the U.S. economy.

Finally, if Milton Friedman were alive today, he would be able to predict and help to avoid the financial crisis that the country faced in 2009. As an economic plan for our economy, he would suggest to focus on the free market and the private property as the means for the U.S. economy to achieve effectiveness and efficiency. It is hard to state whether he would agree or disagree with current policies; it seems that instead he would simply propose the policies of his own and show why exactly these policies could be beneficial for the country. Lastly, Friedman could object to some economists calling him an ‘extremist’ and explain to them where they have applied his theories incorrectly.

In conclusion, Friedman’s contribution into the theory of economics is huge and his three main theories, monetary theory, permanent income hypothesis and a theory of natural rate of unemployment have helped the economists of the late 20th century to explain certain economic phenomena that remained a riddle until Friedman had formulated his theories and supported them with corresponding evidence. All these three theories are still used by the U.S. economists to deal with economic difficulties and make economic forecasts. This means that Milton Friedman is deservedly called one of the best and most influential economists of the 20st century.

Reference List

Friedman, M. & Bordo, M. (2005). The optimum quantity of money. New Jersey: Transaction Publishers.

Friedman, M. (2007). Price theory. New Jersey: Transaction Publishers.

Handa, J. (2008). Monetary economics. New York: Taylor & Francis.

Mankiw, N.G. (2007). Principles of economics. Mason: Cengage Learning.

Snowdon, B. & Vane, H.R. (2002). An encyclopedia of macroeconomics. Cheltenham: Edward Elgar Publishing.

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