Money Mischief_ Episodes in Monetary History - Milton Friedman [87]
Any such requirement should be accompanied by definite sanctions—such as removal from office or a reduction in compensation—for failure to conform.
A Case Study
Japan's recent experience is almost a textbook illustration of how to cure inflation. Before 1973, Japan had been following a monetary policy of pegging the exchange rate of the yen in terms of the dollar. In 1971, following President Nixon's closing of the gold window and the floating of the dollar, there developed strong upward pressure on the yen. To counter the pressure, the Japanese central bank bought dollars with newly created money, which added to the money supply. In principle the Japanese could have sterilized the additions to the money supply by selling yen-denominated obligations, but they did not do so. As a result, the quantity of money began growing at higher and higher rates. By mid-1973 it was growing at more than 25 percent a year.* As Figure 6 shows, inflation did not respond until about two years later. But in early 1973 it started to rise rapidly, and by 1975 it was proceeding at a rate of more than 20 percent a year.
Figure 6
Effect of Change in Japanese Monetary Policy on Inflation Two Years Later (Quarterly data: 1960.1–1990.4)
Note: Dates for money are two years earlier than dates for inflation.
This dramatic rise in inflation produced a fundamental change in monetary policy. Emphasis shifted from the external value of the yen—the exchange rate—to its internal value—inflation. Monetary growth was reduced sharply, from more than 25 percent a year to between 10 percent and 15 percent. It was kept there, with minor exceptions, for five years. (Because of Japan's high rate of economic growth at the time, monetary growth in this range was consistent with roughly stable prices. The comparable rate for the United States is 3 percent to 5 percent.)
About eighteen months after monetary growth started to decline, inflation followed suit, but it took two and a half years before the inflation rate fell below double digits. Inflation held roughly constant for about two years, despite a mild upturn in monetary growth, and then started moving rapidly toward zero in response to a new decline in monetary growth.
The numbers on inflation in the chart are for the deflator, that is, a price index for output as a whole. The outlook for wholesale prices was even better. They actually declined after mid-1977. The postwar shift of workers in Japan from low-productivity sectors to high-productivity sectors, such as automobiles and electronics, has meant that the prices of services have risen sharply relative to the prices of commodities. As a result, consumer prices have risen relative to wholesale prices.
Two things are worth noting in Figure 6. First, monetary growth was not only higher but also much more variable before the policy change than after. Second, with a two-year lag, inflation tended to mimic even the minor wiggles in monetary growth after the policy change. Like money growth, inflation was both lower and less variable after the policy change. Although not shown in the chart, output was also less variable after the policy change than before.
Japan did not escape the side effects of its cure. It experienced lower growth in output and higher unemployment after the slowing of monetary growth, particularly during 1974, before inflation had started to respond appreciably