Fed policy makers are of the view that if there is the need to tighten the interest rate stance the tightening should be gradual as to not destabilize the economy.
The gradual approach gives individuals plenty of time to adjust to the tighter monetary stance. This adjustment in turn will neutralize the possible harmful effect that such a tighter stance may have on the economy.
But is it possible by means of a gradual monetary policy to undo the damage inflicted to the economy by previous loose monetary policies? According to mainstream economic thinking, it would appear that this is the case.
In his various writings, the champion of the monetarist school of thinking, Milton Friedman, has argued that there is a variable lag between changes in money supply and its effect on real output and prices. Friedman holds that in the short run changes in money supply will be followed by changes in real output. In the long run, according to Friedman, changes in money will only have an effect on prices.
It follows then that changes in money with respect to real economic activity tend to be neutral in the long run and non-neutral in the short run. Thus according to Friedman,
In the short-run, which may be as much as five or ten years, monetary changes affect primarily output. Over decades, on the other hand, the rate of monetary growth affects primarily prices.1
According to Friedman, the effect of the change in money supply shows up first in output and hardly at all in prices. It is only after a longer time lag that changes in money start to have an effect on prices. This is the reason, according to Friedman, why in the short run money can grow the economy, while in the long run it has no effect on the real output.
According to Friedman, the main reason for the non-neutrality of money in the short run is the variability in the time lag between money and the economy. Consequently, he believes that if the central bank were to follow a constant money rate of growth rule this would eliminate fluctuations caused by variable changes in the money supply rate of growth. The constant money growth rule could also make money neutral in the short run and the only effect that money would have is on general prices.
Thus according to Friedman,
On the average, there is a close relation between changes in the quantity of money and the subsequent course of national income. But economic policy must deal with the individual case, not the average. In any case, there is much slippage. It is precisely this leeway, this looseness in the relation, this lack of mechanical one-to-one correspondence between changes in money and in income that is the primary reason why I have long favoured for the USA a quasi-automatic monetary policy under which the quantity of money would grow at a steady rate of 4 or 5 per cent per year, month-in, month-out.2
