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Economics

Friedman was best known for reviving interest in the money supply as a determinant of the nominal value of output, that is, the quantity theory of money. Monetarism is the set of views associated with modern quantity theory. Its origins can be traced back to the 16th-century School of Salamanca or even further; however, Friedman's contribution is largely responsible for its modern popularization. He co-authored, with Anna Schwartz, A Monetary History of the United States, 1867–1960 (1963), which was an examination of the role of the money supply and economic activity in the U.S. history.

Friedman was the main proponent of the monetarist school of economics. He maintained that there is a close and stable association between inflation and the money supply, mainly that inflation could be avoided with proper regulation of the monetary base 's growth rate. He famously used the analogy of " dropping money out of a helicopter ", to avoid dealing with money injection mechanisms and other factors that would overcomplicate his models.

Friedman's arguments were designed to counter the popular concept of cost-push inflation, that the increased general price level at the time was the result of increases in the price of oil, or increases in wages; as he wrote:

Inflation is always and everywhere a monetary phenomenon.

Friedman rejected the use of fiscal policy as a tool of demand management; and he held that the government's role in the guidance of the economy should be restricted severely. Friedman wrote extensively on the Great Depression, and he termed the 1929–1933 period the Great Contraction. He argued that the Depression had been caused by an ordinary financial shock and the duration and seriousness of which were greatly increased by the subsequent contraction of the money supply caused by the misguided policies of the directors of the Federal Reserve.

The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933... Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government.

This theory was put forth in A Monetary History of the United States, and the chapter on the Great Depression was then published as a stand-alone book entitled The Great Contraction, 1929–1933. Both books are still in print from the Princeton University Press, and some editions include as an appendix a speech at a University of Chicago event honoring Friedman in which Ben Bernanke made this statement:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you're right. We did it. We're very sorry. But thanks to you, we won't do it again.

Friedman also argued for the removal of government intervention in currency markets, thereby spawning an enormous literature on the subject, as well as promoting the practice of freely floating exchange rates. His close friend George Stigler explained, "As is customary in science, he did not win a full victory, in part because research was directed along different lines by the theory of rational expectations, a newer approach developed by Robert Lucas, also at the University of Chicago." The relationship between Friedman and Lucas, or new classical macroeconomics as a whole, was highly complex. The Friedmanian Phillips curve was an interesting starting point for Lucas, but he soon realized that the solution provided by Friedman was not quite satisfactory. Lucas elaborated a new approach in which rational expectations were presumed instead of the Friedmanian adaptive expectations. Due to this reformulation, the story in which the theory of the new classical Phillips curve was embedded radically changed. This modification, however, had a significant effect on Friedman's own approach, so, as a result, the theory of the Friedmanian Phillips curve also changed. Moreover, new classical adherent Neil Wallace, who was a graduate student at the University of Chicago between 1960 and 1963, regarded Friedman's theoretical courses as a mess, highlighting the strained relationship between monetarism and new classical schools.

Friedman was also known for his work on the consumption function, the permanent income hypothesis (1957), which Friedman himself referred to as his best scientific work. This work contended that utility-maximizing consumers would spend a proportional amount of what they perceived to be their permanent income. Permanent Income refers to such factors like human capital. Windfall gains would mostly be saved because of the law of diminishing marginal utility.

Friedman's essay " The Methodology of Positive Economics " (1953) provided the epistemological pattern for his own subsequent research and to a degree that of the Chicago School. There he argued that economics as science should be free of value judgments for it to be objective. Moreover, a useful economic theory should be judged not by its descriptive realism but by its simplicity and fruitfulness as an engine of prediction. That is, students should measure the accuracy of its predictions, rather than the 'soundness of its assumptions'. His argument was part of an ongoing debate among such statisticians as Jerzy Neyman, Leonard Savage, and Ronald Fisher.

While being an advocate of the free market, Friedman believed that the government had two crucial roles. In an interview with Phil Donahue, Friedman argued that "the two basic functions of a government are to protect the nation against foreign enemy, and to protect citizens against its fellows". He also admitted that although privatization of national defense could reduce the overall cost, he has not yet thought of a way to make this privatization possible.