The aim of Monetarism?

Milton Freidman’s greatest contribution to economics and the real point of inflation targeting, have Monetarists’ misunderstood Monetarism?

http://morganisteconomics.blogspot.com/2011/02/milton-freidmans-greatest-contribution.html

If you discuss economics with a Monetarist they often, in fact almost always, claim the reason they intervene with aggregate demand is to achieve slow economic growth. Whether you believe this action to be virtuous or not it has other benefits which most Monetarists’ do not seem to understand. My personal view on inflation targeting has changed over the years, originally I deposed the concept due to the negative attributes, the main one being the inflexibility it can create in free markets. Now I have come to appreciate what I think Milton Freidman was noticing when he pushed the concept of monetary control, in the shape of Monetarism, in the 1970’s. This revelation comes in the form of the benefits that a constant level of inflation creates for the transparency of financial products and in particular the consistency and accuracy of return, which in turn enable risk (in particular long term risk) to be estimated more accurately.

I think the reason why Freidman advocated inflation targeting was not as the Monetarists’ claim, to achieve slow economic growth, but rather to enable the effective functioning of the investment market. I have come to this view point from my own re-modelling of the valuation and risk calculations, which I have been developing to provide a solution to what I think the real route of the banking crisis is. During this I found it was extremely beneficial when estimating future returns and in turn the risk, to make the variable rate of inflation constant. For example if you are attempting to estimate the return on an investment over four or five years the rate of inflation will depreciate that return. When inflation is variable the estimation is almost impossible, although there are models that can provide questionably accurate results it is not a constant result which inflation targeting provides. With a constant rate of inflation over a long period of time I can make the calculations reflect the expected return with a much greater level of accuracy. The longer the investment the more beneficial this function of inflation targeting becomes and the greater the transparency of risk and the desirability of investment becomes.

As Freidman was a statistician he would have appreciated the financial modelling aspect of long term economics, I believe this is what he was really trying to achieve with Monetarism rather than the mainstream view that it is an effort to control the business cycle. Although I agree with the idea of inflation targeting I do not think the target has to be a static number and that it is not required to achieve this aim. If the rate of inflation is planned in advance, even if it is variable it can enable accurate prediction. The main benefit is the pre-event information that enables investors to accurately compute the reducing factor that inflation has on return. For example the inflation target could be two percent one quarter, then three percent the next quarter, then four percent the next quarter etc. As long as the target has been set in advance and it is met the ability to estimate the expected return is retained. This brings me to the conclusion that although I agree with inflation targeting I do not necessarily believe the inflation target should be a constant percentage of GDP.

 

Since inflation targeting has little to do with realized inflation, how is knowledge of an arbitrary target more beneficial to the investor than simply using some variation of historic long-term inflation?

IMO, neither are at all accurate in forecasting real future inflation, so using either to calculate risk curves is somewhat pointless. The best one can hope for is to simply utilize present CPI with some historic standard deviation variable factored in. This is almost certainly more accurate than an arbitrary inflation target.

 

About 25 years ago, I saw Friedman on "Wall Street Week" tell Louis Rukeyser, "... The Fed should be abolished... and be replaced by a computer... which increases the money supply enough to keep up with population growth... about 2% per year".

 

I take it you are not a fan of inflation targeting in general?

You have to account for the diminishing effect of inflation somehow when calculating return setting a constant is a better way of doing it in my opinion.

 

So you are saying that the inflation target is merely there to show the natural growth. The flaw in that in my opinion is that inflation is not just the rise in the money supply. It is the increase of price of certain goods so that does not factor in the increase in output which is the real growth. If you had an equal growth of money supply and output there would be no inflation as the purchasing power of one monetary unit would still be equal to one output unit, assuming they were in equilibrium to start with.