The Friedman rule is a

monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...

rule proposed by

Milton Friedman Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...

.M. Friedman (1969), ''The Optimum Quantity of Money,'' Macmillan Friedman advocated monetary policy that would result in the

nominal interest rate In finance and economics, the nominal interest rate or nominal rate of interest is the rate of interest stated on a loan or investment, without any adjustments or fees. Examples of adjustments or fees # An adjustment for inflation(in contrast with ...

being at or very near zero. His rationale was that the

opportunity cost In microeconomic theory, the opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More effective it means if you chose one activity (for example ...

of holding

money Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...

faced by private agents should equal the

social cost Social cost in neoclassical economics is the sum of the private costs resulting from a transaction and the costs imposed on the consumers as a consequence of being exposed to the transaction for which they are not compensated or charged. In other w ...

of creating additional

fiat money Fiat money (from la, fiat, "let it be done") is a type of currency that is not backed by any commodity such as gold or silver. It is typically designated by the issuing government to be legal tender. Throughout history, fiat money was sometime ...

. Assuming that the

marginal cost In economics, the marginal cost is the change in the total cost that arises when the quantity produced is incremented, the cost of producing additional quantity. In some contexts, it refers to an increment of one unit of output, and in others it r ...

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 A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...

should seek a rate of

inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...

deflation In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflation ...

equal to the

real interest rate The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approx ...

government bond A government bond or sovereign bond is a form of bond issued by a government to support public spending. It generally includes a commitment to pay periodic interest, called coupon payments'','' and to repay the face value on the maturity date ...

s and other safe assets, to make the nominal interest rate zero. The result of this policy is that those who hold money do not suffer any loss in the value of that money due to

. The rule is motivated by

long-run In economics, the long-run is a theoretical concept in which all markets are in equilibrium, and all prices and quantities have fully adjusted and are in equilibrium. The long-run contrasts with the short-run, in which there are some constraints an ...

efficiency Efficiency is the often measurable ability to avoid wasting materials, energy, efforts, money, and time in doing something or in producing a desired result. In a more general sense, it is the ability to do things well, successfully, and without ...

considerations. This is not to be confused with

Friedman's k-percent rule In macroeconomics, Friedman's k-percent rule (named for Milton Friedman) is the monetarist proposal that the money supply should be increased by the central bank by a constant percentage rate every year, irrespective of business cycles. Definit ...

which advocates a constant yearly expansion of the

monetary base In economics, the monetary base (also base money, money base, high-powered money, reserve money, outside money, central bank money or, in the UK, narrow money) in a country is the total amount of money created by the central bank. This include ...

Friedman's argument

The

marginal benefit In economics, utility is the satisfaction or benefit derived by consuming a product. The marginal utility of a good or service describes how much pleasure or satisfaction is gained by consumers as a result of the increase or decrease in consump ...

of holding additional money is the decrease in transaction costs represented by (for example) costs associated with the purchase of

consumption goods A final good or consumer good is a final product ready for sale that is used by the consumer to satisfy current wants or needs, unlike a intermediate good, which is used to produce other goods. A microwave oven or a bicycle is a final good, but ...

. With a positive nominal interest rate, people economise on their cash balances to the point that the

(social and private) is equal to the marginal private cost (i.e., the nominal interest rate). This is not socially

optimal Mathematical optimization (alternatively spelled ''optimisation'') or mathematical programming is the selection of a best element, with regard to some criterion, from some set of available alternatives. It is generally divided into two subfi ...

, because the

government A government is the system or group of people governing an organized community, generally a state. In the case of its broad associative definition, government normally consists of legislature, executive, and judiciary. Government is a ...

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 Efficiency is the often measurable ability to avoid wasting materials, energy, efforts, money, and time in doing something or in producing a desired result. In a more general sense, it is the ability to do things well, successfully, and without ...

, and by doing so, raise the mean of output.

Use in economic theory

The Friedman rule has been shown to be the welfare maximizing monetary policy in many

economic model In economics, a model is a theoretical construct representing economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified, often mathematical, framework desig ...

s of money. It has been shown to be optimal in monetary economies with

monopolistic competition Monopolistic competition is a type of imperfect competition such that there are many producers competing against each other, but selling products that are differentiated from one another (e.g. by branding or quality) and hence are not perfect ...

(Ireland, 1996) and, under certain circumstances, in a variety of monetary economies where the government levies other distorting taxes. However, there do exist several notable cases where deviation from the Friedman rule becomes optimal. These include economies with

decreasing returns to scale In economics, returns to scale describe what happens to long-run returns as the scale of production increases, when all input levels including physical capital usage are variable (able to be set by the firm). The concept of returns to scale arise ...

; economies with imperfect

competition Competition is a rivalry where two or more parties strive for a common goal which cannot be shared: where one's gain is the other's loss (an example of which is a zero-sum game). Competition can arise between entities such as organisms, indivi ...

where the government does not either fully tax

monopoly profit Monopoly profit is an inflated level of profit due to the monopolistic practices of an enterprise.Bradley R. Chiller, "Essentials of Economics", New York: McGraw-Hill, Inc., 1991. Basic classical and neoclassical theory Traditional economics sta ...

s or set the tax equal to the labor

income tax An income tax is a tax imposed on individuals or entities (taxpayers) in respect of the income or profits earned by them (commonly called taxable income). Income tax generally is computed as the product of a tax rate times the taxable income. Tax ...

; economies with

tax evasion Tax evasion is an illegal attempt to defeat the imposition of taxes by individuals, corporations, trusts, and others. Tax evasion often entails the deliberate misrepresentation of the taxpayer's affairs to the tax authorities to reduce the taxp ...

; economies with

sticky prices Nominal rigidity, also known as price-stickiness or wage-stickiness, is a situation in which a nominal price is resistant to change. Complete nominal rigidity occurs when a price is fixed in nominal terms for a relevant period of time. For exampl ...

; and economies with downward nominal wage rigidity. While deviations from the Friedman rule are typically small, if there is a significant foreign demand for a nation's

currency A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general def ...

, 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 Seigniorage , also spelled seignorage or seigneurage (from the Old French ''seigneuriage'', "right of the lord (''seigneur'') to mint money"), is the difference between the value of money and the cost to produce and distribute it. The term can be ...

revenue from foreign residents. In the case of the United States, where over half of all

U.S. dollar The United States dollar ( symbol: $; code: USD; also abbreviated US$ or U.S. Dollar, to distinguish it from other dollar-denominated currencies; referred to as the dollar, U.S. dollar, American dollar, or colloquially buck) is the officia ...

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

of almost 4%. Recent results have also suggested that in order to achieve the goal of the Friedman rule, namely to reduce the

and monetary frictions associated with money, it may not be required that the nominal interest rate be set at zero. When the effects of

financial intermediaries A financial intermediary is an institution or individual that serves as a middleman among diverse parties in order to facilitate financial transactions. Common types include commercial banks, investment banks, stockbrokers, pooled investment funds ...

and 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 An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...

paid on reserves by assuring that the rates are identical at all times.

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. 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,

performed best.

References

{{Milton Friedman Milton Friedman Monetary policy

Friedman's argument

Use in economic theory

Experimental evaluation

See also

References