For nearly two decades, Milton Friedman's monetarist framework dominated central banking discourse. The premise was elegantly simple: control the money supply's growth rate, and you control inflation. The Federal Reserve, Bundesbank, and Bank of England all adopted monetary aggregate targets during the 1970s and 1980s, promising to anchor expectations through transparent, rule-based policy. Yet by the mid-1990s, virtually every major central bank had quietly abandoned these targets.

This intellectual retreat represents one of the most significant paradigm shifts in modern monetary economics. It was not driven by ideological fashion or political pressure, but by a fundamental empirical failure: the relationships that monetarism required—stable velocity, predictable money demand, reliable transmission mechanisms—collapsed precisely when policymakers attempted to exploit them. Financial innovation systematically dismantled the structural parameters that made monetary targeting operationally feasible.

Understanding this transition illuminates deeper questions about how central banks navigate the tension between theoretical elegance and operational necessity. The lessons extend beyond historical curiosity. Contemporary debates about central bank digital currencies, narrow banking proposals, and the role of monetary aggregates in unconventional policy environments all require grappling with why the monetarist experiment failed and what constraints any successor framework must satisfy. The answer reveals how institutional evolution can invalidate even well-established theoretical relationships.

Milton Friedman's 1956 restatement of the quantity theory transformed monetary economics by grounding ancient intuitions in modern portfolio choice theory. Rather than treating the equation of exchange as a tautology, Friedman established money demand as a stable function of permanent income, expected returns on alternative assets, and anticipated inflation. This reformulation generated a testable proposition: if velocity exhibits predictable behavior, controlling monetary aggregates translates directly into controlling nominal income growth.

The policy implications crystallized in Friedman's famous k-percent rule. Central banks should expand the money supply at a constant rate approximating the economy's long-run real growth rate plus any desired inflation target. Activist discretionary policy was not merely unnecessary—it was actively destabilizing. Friedman and Schwartz's Monetary History of the United States provided historical evidence that monetary volatility preceded output volatility, suggesting the Federal Reserve's attempts at stabilization had amplified rather than dampened business cycle fluctuations.

The framework's theoretical elegance derived from its separation of real and nominal determination. Money was neutral in the long run, affecting only the price level, while short-run non-neutralities arose from expectational errors that systematic policy would eventually eliminate. This implied central banks faced no meaningful trade-off between inflation and unemployment beyond transitory adjustment periods. The natural rate hypothesis, independently developed by Friedman and Phelps, reinforced that attempting to exploit Phillips curve relationships would generate accelerating inflation without permanent employment gains.

Institutional adoption accelerated following the Great Inflation. The Bundesbank embraced monetary targeting in 1974, explicitly grounding policy credibility in announced growth rates for the central bank money stock. The Federal Reserve followed in 1975 with Congressional testimony requirements for monetary aggregate targets. The Bank of England's Medium-Term Financial Strategy of 1980 made sterling M3 growth the centerpiece of anti-inflation policy. Each institution recognized that rules-based frameworks could coordinate expectations more effectively than discretionary pronouncements.

The monetarist research program also generated substantial empirical work documenting money-income relationships across countries and time periods. Studies consistently found that monetary aggregates Granger-caused nominal GDP, with transmission lags of approximately 18-24 months. The St. Louis equation, estimating reduced-form relationships between money growth and nominal income growth, became standard pedagogical and forecasting apparatus. By the early 1980s, the intellectual foundations appeared secure and the policy framework operationally established.

Takeaway

Monetarism's policy prescription rested on an empirical claim that money demand functions were stable and predictable—when this failed, the entire operational framework became untenable regardless of the theory's logical consistency.

The monetarist framework began unraveling in the early 1980s when M1 velocity departed dramatically from its postwar trend. Between 1982 and 1986, M1 velocity declined by approximately 15 percent relative to trend projections—an unprecedented deviation that rendered money growth targets meaningless as guides to nominal income. The Federal Reserve's October 1982 decision to de-emphasize M1 targeting marked the beginning of monetarism's operational collapse, though intellectual retreat took longer.

Financial innovation systematically eroded the institutional features that had stabilized velocity. The Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St. Germain Act of 1982 transformed the U.S. financial landscape. Interest-bearing NOW accounts blurred distinctions between transactions and savings balances. Money market mutual funds created close substitutes for traditional monetary aggregates. Sweep accounts allowed banks to minimize required reserves by automatically transferring customer balances overnight.

The underlying problem was Goodhart's Law operating at the aggregate level: once the money supply became a formal policy target, financial institutions had powerful incentives to create substitutes that escaped regulatory definitions. Each redefinition of monetary aggregates—from M1 to M2 to M3 to L—encountered the same dynamic. Broader aggregates exhibited more stable velocity but weaker relationships to nominal income. Narrower aggregates maintained transmission relationships but became increasingly difficult to measure or control.

Theoretical reinterpretation accompanied empirical deterioration. Research by Poole, Goldfeld, and others demonstrated that the case for money supply targeting versus interest rate targeting depended on the relative stability of money demand and IS curve disturbances. If money demand shocks were large relative to goods market shocks, interest rate targeting would deliver superior stabilization. The velocity instability of the 1980s provided dramatic evidence that money demand functions had become unstable precisely when policymakers attempted to exploit them.

International evidence reinforced domestic findings. The Bank of England's sterling M3 targets proved similarly ungovernable, leading to the 1985 suspension of formal targeting. Even the Bundesbank, often cited as monetarism's success story, systematically undershot its announced targets when doing so conflicted with other objectives, suggesting that monetary aggregates functioned more as communication devices than operational constraints. The Swiss National Bank's experience with monetary base targeting demonstrated that even the most controllable aggregates exhibited velocity movements that complicated nominal income stabilization.

Takeaway

Financial systems adapt to exploit any targeted variable, making structural relationships between that variable and policy objectives inherently unstable—this insight applies beyond monetarism to any framework that assumes fixed behavioral parameters.

The transition from monetary aggregate targeting proceeded through intermediate frameworks before settling on inflation targeting. Exchange rate targeting offered an alternative nominal anchor, with the European Monetary System's Exchange Rate Mechanism and various developing country currency boards demonstrating that external commitment could substitute for domestic rules. However, the 1992 ERM crisis and subsequent Asian financial turbulence exposed how exchange rate targets could generate destabilizing capital flows when markets questioned sustainability.

Inflation targeting emerged from New Zealand's 1990 reform as a synthesis addressing monetarism's operational failures while preserving its intellectual insights. The framework retained the monetarist emphasis on nominal anchoring and long-run neutrality while abandoning intermediate targeting in favor of direct focus on the ultimate objective. Svensson's theoretical formalization demonstrated that inflation targeting could be understood as flexible inflation targeting, where the central bank minimized a loss function in inflation and output gap deviations subject to a model of the transmission mechanism.

The operational advantages were substantial. Inflation targeting required no stable velocity relationship because the central bank adjusted its instruments directly in response to inflation forecasts rather than intermediate aggregates. The framework accommodated uncertainty about transmission mechanisms through its emphasis on forecasting and continual reassessment. Communication strategies evolved accordingly, with inflation reports, fan charts, and forward guidance replacing money supply announcements as the primary coordination devices.

New Keynesian models provided theoretical foundations that incorporated monetarist insights into a framework suited to modern financial systems. The canonical three-equation model—IS curve, Phillips curve, and monetary policy rule—specified interest rate transmission without requiring assumptions about money supply control or velocity stability. Money demand remained theoretically relevant but operationally peripheral; central banks set interest rates and allowed the money supply to adjust endogenously to satisfy whatever money demand materialized at that rate.

Contemporary debates about the monetarist legacy continue within the inflation targeting framework. Quantitative easing revived questions about whether monetary aggregates contain information relevant for inflation forecasting. Research on the credit channel and bank lending capacity suggests that aggregate measures of liquidity may matter even when velocity relationships have broken down. Central bank digital currency proposals implicitly engage monetarist concerns about controlling the payments system. The transition from monetary targeting was less an intellectual refutation than a recognition that operational frameworks must accommodate institutional evolution rather than assuming it away.

Takeaway

Successful policy frameworks target ultimate objectives directly rather than intermediate variables, building in mechanisms for continuous adaptation as the economic environment evolves—flexibility is not weakness but operational necessity.

The abandonment of monetary aggregate targeting illustrates a broader principle in policy design: theoretical relationships that hold under passive observation may collapse under active exploitation. Friedman's quantity theory revival generated genuine insights about long-run monetary neutrality and the dangers of discretionary activism. What it could not accommodate was the financial system's endogenous response to being targeted.

Contemporary central banking inherited monetarism's emphasis on nominal anchoring, transparent communication, and rules-based frameworks while recognizing that operational targets must adapt to institutional change. The question is not whether money matters—it does—but whether controllable monetary aggregates provide useful intermediate targets given modern financial architecture.

For researchers and policymakers, the monetarist episode demonstrates that parameter stability cannot be assumed when policy attempts to exploit structural relationships. Any framework that treats behavioral coefficients as invariant to the policy regime itself faces similar vulnerability. The successful central banks of the inflation targeting era learned this lesson; the challenge now is ensuring it is not forgotten as new targeting proposals emerge.