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Federal Reserve and monetary policy

Although Friedman concluded the government does have a role in the monetary system he was critical of the Federal Reserve due to its poor performance and felt it should be abolished. He was opposed to Federal Reserve policies, even during the so-called " Volcker shock " that was labeled " monetarist ". Friedman believed the Federal Reserve System should ultimately be replaced with a computer program. He favored a system that would automatically buy and sell securities in response to changes in the money supply.

The proposal to constantly grow the money supply at a certain predetermined amount every year has become known as Friedman's k-percent rule. There is debate about the effectiveness of a theoretical money supply targeting regime. The Fed's inability to meet its money supply targets from 1978 to 1982 led some to conclude it is not a feasible alternative to more conventional inflation and interest rate targeting. Towards the end of his life, Friedman expressed doubt about the validity of targeting the quantity of money. To date, most countries have adopted inflation targeting instead of the k-percent rule.

Idealistically, Friedman actually favored the principles of the 1930s Chicago plan, which would have ended fractional reserve banking and, thus, private money creation. It would force banks to have 100% reserves backing deposits, and instead place money creation powers solely in the hands of the US Government. This would make targeting money growth more possible, as endogenous money created by fractional reserve lending would no longer be a major issue.

Friedman was a strong advocate for floating exchange rates throughout the entire Bretton-Woods period (1944–1971). He argued that a flexible exchange rate would make external adjustment possible and allow countries to avoid balance of payments crises. He saw fixed exchange rates as an undesirable form of government intervention. The case was articulated in an influential 1953 paper, "The Case for Flexible Exchange Rates", at a time when most commentators regarded the possibility of floating exchange rates as an unrealistic policy proposal.