Friedman rule

The Friedman rule is a monetary policy rule proposed by Milton Friedman^[1]. Essentially, Friedman advocated setting the nominal interest rate at zero. According to the logic of the Friedman rule, the opportunity cost of holding money faced by private agents should equal the social cost of creating additional fiat money. It is assumed that the marginal cost of creating additional money is zero (or approximated by zero). Therefore, nominal rates of interest should be zero. In practice, this means that the central bank should seek a rate of deflation equal to the real interest rate on government bonds and other safe assets, in order to make the nominal interest rate zero.

The result of this policy is that those who hold money don't suffer any loss in the value of that money due to inflation. The rule is motivated by long-run efficiency considerations.

This is not to be confused with Friedman's k-percent rule which advocates a constant yearly expansion of the monetary base.

Friedman's argument

• The marginal benefit of holding additional money is the decrease in transaction costs represented by (for example) costs associated with the purchase of consumption goods.
• With a positive nominal interest rate, people economise on their cash balances to the point that the marginal benefit (social and private) is equal to the marginal private cost (i.e., the nominal interest rate).
  • This is not socially optimal, because the government can costlessly produce the cash until the supply is plentiful. A social optimum occurs when the nominal rate is zero (or deflation is at a rate equal to the real interest rate), so that the marginal social benefit and marginal social cost of holding money are equalized at zero.
• Thus, the Friedman Rule is designed to remove an inefficiency, and by doing so, raise the mean of output.

The Friedman Rule in Economic Theory

The Friedman rule has been shown to be the welfare maximizing monetary policy in many economic models of money. It has been shown to be optimal in monetary economies with monopolistic competition (Ireland, 1996) and, under certain circumstances, in a variety of monetary economies where the government levies other distorting taxes.

References

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