Friedman rule: Difference between revisions

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{{Short description|Monetary policy rule proposed by Milton Friedman}}

The '''Friedman rule''' is the term given for [[Milton Friedman]]'s policy regarding [[cash-in-advance]] models of [[monetary system]]s. Essentially, Friedman advocated a policy of zero [[nominal]] [[interest rate]]s - that is, it should seek a rate of [[deflation]] equal to the real rate on [[safe asset]]s in order to make the nominal rate zero.

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The '''Friedman rule''' is a [[monetary policy]] rule proposed by [[Milton Friedman]].<ref>M. Friedman (1969), ''The Optimum Quantity of Money,'' Macmillan</ref> Friedman advocated monetary policy that would result in the [[nominal interest rate]] being at or very near zero. His rationale was that the [[opportunity cost]] of holding [[money]] faced by private agents should equal the [[social cost]] of creating additional [[fiat money]]. Assuming that the [[marginal cost]] of creating additional money is zero (or approximated by zero), nominal rates of interest should also be zero. In practice, this means that a [[central bank]] should seek a rate of [[inflation]] or [[deflation]] equal to the [[real interest rate]] on [[government bond]]s and other safe assets, to make the nominal interest rate zero.

The result of this policy is that itthose iswho hold money do not costlysuffer toany thoseloss whoin havethe [[money]]value toof continuethat tomoney holddue itto [[inflation]]. The rule is motivated by [[long-run]] [[efficiency (economics)|efficiency]] considerations.

This is not to be confused with [[Friedman's k-percent rule]] which advocates a constant yearly expansion of the [[money supply|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 [[Optimization (mathematics)|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.

* With a positive nominal interest rate, people [[economize]] 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).

== Use in economic theory ==

** This is not socially [[Optimization (mathematics)|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.

The Friedman rule has been shown to be the welfare maximizing monetary policy in many [[economic model]]s of money. It has been shown to be optimal in [[monetary economy|monetary economies]] with [[monopolistic competition]] (Ireland, 1996) and, under certain circumstances, in a variety of monetary economies where the government levies other distorting taxes.<ref name="ChariChristianoKehoe1996">{{citation

* Thus, the Friedman Rule is designed to remove an [[inefficiency]], and by doing so, raise the mean of output.

| last1 = Chari

| first1 = V.V.

| last2 = Christiano

| first2 = Lawrence

| last3 = Kehoe

| first3 = Patrick

| year=1996

| title= Optimality of the Friedman rule in economies with distorting taxes

| journal = [[Journal of Monetary Economics]]

| volume = 37

| issue = 2–3

| pages = 203–23

| doi = 10.1016/0304-3932(96)01252-4| url = http://minneapolisfed.org/research/sr/sr158.pdf

}}</ref><ref name="Williamson1996">{{citation

| last1 = Williamson

| first1 = Stephen

| year=1996

| title= Sequential markets and the suboptimality of the Friedman rule

| journal = [[Journal of Monetary Economics]]

| volume = 37

| issue = 3

| pages = 549–72

| doi = 10.1016/0304-3932(96)01259-7}}</ref><ref name="Gahvari2007">{{citation

| last1 = Gahvari

| first1 = Firouz

| year=2007

| title= The Friedman rule: Old and new

| journal = [[Journal of Monetary Economics]]

| volume = 54

| issue = 2

| pages = 581–89

| doi = 10.1016/j.jmoneco.2006.06.008}}</ref><ref name="Ireland2003">{{citation

| last1 = Ireland

| first1 = Peter

| year=2003

| title= Implementing the Friedman Rule

| journal = [[Review of Economic Dynamics]]

| volume = 6

| pages = 120–34

| doi = 10.1016/s1094-2025(02)00011-x| url = http://www.nber.org/papers/w8821.pdf

}}</ref> However, there do exist several notable cases where deviation from the Friedman rule becomes optimal. These include economies with [[decreasing returns to scale]]; economies with imperfect [[Competition (economics)|competition]] where the government does not either fully tax [[monopoly profit]]s or set the tax equal to the labor [[income tax]]; economies with [[tax evasion]]; economies with [[sticky prices]]; and economies with downward nominal wage rigidity.<ref name="Opt2010">{{citation | last1 = Schmitt-Grohe | first1 = Stephanie | last2 = Uribe | first2 = Martin | year = 2010 | title = The Optimal Rate of Inflation | journal = Handbook of Monetary Economics | volume = 3 | pages = 653–722 | doi = 10.1016/B978-0-444-53454-5.00001-3 | isbn = 9780444534705 | s2cid = 12936645 }}</ref> While deviations from the Friedman rule are typically small, if there is a significant foreign demand for a nation's [[currency]], such as in the United States, the optimal rate of inflation is found to deviate significantly from what is called for by Friedman rule in order to extract [[seigniorage]] revenue from foreign residents.<ref name="Opt2010" /> In the case of the United States, where over half of all [[U.S. dollar]]s are held overseas, the optimal rate of inflation is found to be anywhere from 2 to 10%, whereas the Friedman rule would call for [[deflation]] of almost 4%.<ref name="Opt2010" />

Recent results have also suggested that in order to achieve the goal of the Friedman rule, namely to reduce the [[opportunity cost]] and monetary frictions associated with money, it may not be required that the nominal interest rate be set at zero.<ref name="Woodford">{{citation | last1 =Curdi | first1 = Vasco | last2 = Woodford | first2 = Michael | year = 2010 | title =The Central-Bank Balance Sheet as an Instrument of Monetary Policy | journal = NBER Working Paper No. 16208 }}</ref> When the effects of [[financial intermediary|financial intermediaries]] and [[credit spread (bond)|credit spreads]] are taken into account, the welfare optimality implied by the Friedman rule can instead be achieved by eliminating the interest rate differential between the policy nominal interest rate and the [[interest rate]] paid on [[Bank reserves|reserves]] by assuring that the rates are identical at all times.<ref name="Woodford" />

==Experimental evaluation==

While no central bank has explicitly implemented the Friedman rule, experimental economists have evaluated the Friedman rule in a laboratory setting with paid human subjects.<ref name="DuffyPuzzello2022">{{citation

| last1 = Duffy

| first1 = John

| last2 = Puzzello

| first2 = Daniela

| year=2022

| title= The Friedman Rule: Experimental Evidence

| journal = [[International Economic Review]]

| volume = 63

| issue = 2

| pages = 671–98

| doi = 10.1111/iere.12549

| url = https://doi.org/10.1111/iere.12549| url-access = subscription

}}</ref>

Contrary to theoretical predictions, the Friedman rule was not found to be welfare-improving, performing no better than a constant money supply regime. By one welfare measure, [[Friedman's k-percent rule]] performed best.

==See also==

* [[Welfare cost of inflation]]

* [[Zero interest-rate policy]]

* [[Negative interest on excess reserves|Negative interest rate policy]]

* [[Money creation]]

==References==

{{econ-stub}}

{{Reflist}}

{{Milton Friedman}}

[[Category:Macroeconomics]]

{{Central banks}}

[[Category:MacroeconomicsMilton Friedman]]

[[Category:Monetary policy]]

[[Category:Monetary economics]]

[[Category:International economics]]