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The Friedman rule is a monetary policy rule proposed by Milton Friedman.[1] 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 bonds 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 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

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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.

Use in economic theory

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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.[2][3][4][5] 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 where the government does not either fully tax monopoly profits 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.[6] 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.[6] In the case of the United States, where over half of all U.S. dollars 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%.[6]

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.[7] When the effects of financial intermediaries 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 paid on reserves by assuring that the rates are identical at all times.[7]

Experimental evaluation

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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.[8] 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

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References

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Friedman rule

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The Friedman rule is a monetary policy prescription formulated by economist Milton Friedman, positing that the optimal quantity of money is achieved when a central bank engineers mild deflation at a rate equal to the real interest rate, thereby driving the nominal interest rate to zero and eliminating the opportunity cost of holding non-interest-bearing money. This approach, detailed in Friedman's 1969 essay collection The Optimum Quantity of Money, seeks to minimize the deadweight loss arising from the distortion between the private return on money (zero) and alternative assets, aligning the social and private incentives for money demand under first-principles assumptions of rational agents and frictionless markets absent nominal rigidities. In theoretical models incorporating in the utility function or cash-in-advance constraints, the rule emerges as welfare-maximizing by equating the marginal product of to that of capital, a result robust across various specifications when taxes are the primary distortion. distinguished this from his earlier k-percent rule—a steady growth targeting low positive —emphasizing the zero-nominal-rate variant as superior for efficiency, though both stem from quantity theory foundations prioritizing predictable monetary expansion over discretionary intervention. Empirical challenges include the on nominal rates, which complicates implementation without fiscal coordination or interest on reserves, and historical fears of deflationary spirals, despite model-based evidence showing stability under credible policy commitments. The rule's influence persists in modern debates on optimal targets, with New Keynesian analyses often approximating it via low positive (around 0-2%) to buffer against downside shocks, though purist interpretations critique deviations as yielding suboptimal welfare losses from persistent taxes. No major economy has fully adopted it, reflecting institutional inertia and aversion to rooted in interwar experiences, yet simulations indicate potential gains in efficiency if pursued with transparent rules.

Definition and Principles

Core Elements of the Rule

The Friedman rule prescribes a under which the adjusts the money supply to achieve a zero in . This target eliminates the opportunity cost of holding , as the return on money holdings would equal that on interest-bearing assets like bonds. articulated this in his 1969 essay collection The Optimum Quantity of Money, arguing that such a policy maximizes revenue while minimizing distortions from or away from the optimal point. To implement the rule, the money growth rate must offset the real on capital, typically implying mild equal to the real , around 1-3% annually in historical U.S. data from low- periods. For instance, if the real is 2%, the rate should be -2%, yielding a nominal rate of zero via the i=r+πi = r + \pi, where ii is the nominal rate, rr the real rate, and π\pi the rate. This steady-state condition assumes a cash-in-advance constraint or money-in-the-utility-function framework, where agents hold for transactions but face an otherwise. Central to the rule is the causal mechanism that zero nominal rates internalize the social benefit of by equating private and social marginal costs of provision. Friedman emphasized that deviations create deadweight losses: positive nominal rates impose an implicit tax on money balances, reducing velocity and output; excessive risks hoarding but is mitigated under the rule's calibrated growth path. Empirical calibration in overlapping-generations models confirms welfare gains from this policy over discretionary regimes, provided fiscal backing aligns with low debt levels to avoid issues.

Distinction from K-Percent Rule

The k-percent rule, proposed by Milton Friedman in his 1960 book A Program for Monetary Stability, advocates for the central bank to expand the money supply at a fixed annual rate—typically 3 to 5 percent—calibrated to the economy's long-run real output growth, thereby fostering predictable monetary conditions and minimizing inflationary or deflationary surprises from discretionary policy. This approach assumes stable money demand velocity over time and prioritizes operational simplicity to insulate monetary policy from short-term political influences or forecasting errors, with the goal of achieving approximate price level stability, often implying low positive inflation in practice. In distinction, the Friedman rule constitutes a normative prescription for optimal derived from welfare-theoretic models, under which the adjusts growth to equate the on to zero, thereby removing the distortionary of holding fiat currency and maximizing steady-state efficiency by equating the return on to that on other assets. This typically entails a contraction in the supply at a rate matching the real rate of (e.g., 2-3 percent annually if real rates are positive), financed through lump-sum taxation rather than , contrasting sharply with the k-percent rule's emphasis on positive, steady expansion. The rules diverge fundamentally in rationale and feasibility: the k-percent rule serves as a practical, rule-based to curb and stabilize cycles amid in or output, without requiring precise knowledge of real rates, whereas the Friedman rule hinges on first-best theoretical optimality in frictionless models but demands accurate of intertemporal preferences and risks implementation challenges like ary spirals or coordination with . Empirical applications of the k-percent rule, such as in 1970s-1980s monetary targeting regimes, tolerated deviations for instability, while the Friedman rule's zero-nominal-rate target has informed modern discussions of unconventional but remains aspirational due to positive real rates and institutional constraints on sustained .

Historical Context

Milton Friedman's Original Formulation

Milton Friedman articulated the Friedman rule in his 1969 essay "The Optimum Quantity of Money," published as the title essay in a collection by Aldine Publishing Company. Drawing on microeconomic principles applied to monetary holdings, Friedman identified the opportunity cost of money—embodied in the nominal interest rate foregone by holding non-interest-bearing currency—as a key distortion in resource allocation. In a frictionless economy, individuals would hold money up to the point where its marginal productivity equals that of other assets, but positive nominal rates lead to excessive economization on cash balances, wasting real resources on inventory management and velocity-increasing efforts. The rule's core prescription is for the monetary authority to engineer a steady-state policy where the nominal interest rate equals zero, thereby aligning private incentives with social optimality by removing the wedge between money and alternative stores of value. Friedman derived this by considering an economy starting from an initial money stock; optimality requires adjusting the money supply growth such that expected deflation offsets the real rate of return on capital, per the Fisher equation i=r+πi = r + \pi, where ii is the nominal rate, rr the real rate, and π\pi the inflation rate (negative for deflation). Thus, π=−r\pi = -r yields i=0i = 0, typically implying deflation around 2-4% annually if rr approximates historical real returns of 3%. He explicitly stated: "Our final rule for the optimum quantity of money... is that it will be attained by a rate of price deflation that makes the nominal rate of interest equal to zero." For transition to this regime, Friedman advocated a one-time, unanticipated doubling (or proportional increase) of the supply to instantly lower the and eliminate accumulated distortions from past , avoiding gradual adjustment costs like or relative price variability. Thereafter, growth should match real output expansion minus the rate to maintain the zero nominal rate , preventing further or excess . This formulation assumes no taxes on holdings and , focusing on minimizing deadweight losses from 's liquidity premium without addressing fiscal-monetary interactions.

Intellectual Influences and Early Discussions

The intellectual foundations of the Friedman rule trace back to the quantity theory of money, which Friedman restated in 1956 as emphasizing the long-run proportionality between money supply growth and price level changes, independent of real output fluctuations. This framework, originally articulated by Irving Fisher in his 1911 Purchasing Power of Money, underscored the inefficiency of positive nominal interest rates as an implicit tax on money holdings, a concept central to the rule's rationale for minimizing "shoe-leather" costs associated with inflation. Friedman's analysis built on this by positing that optimal policy equates the money growth rate to real output growth minus the real interest rate, yielding zero nominal rates and deflation to eliminate the opportunity cost of liquidity. Key influences within included Henry Simons' 1936 essay "Rules versus Authorities in ," which argued for binding rules to curb discretionary biases in central banking, favoring steady expansion over activist interventions. Simons' advocacy for 100% reserve requirements and fixed growth rates prefigured Friedman's emphasis on predictability to stabilize expectations, though Simons prioritized without explicitly targeting zero nominal rates. Similarly, Lloyd Mints' 1945 of Fixed Fiduciary Issue explored constant money issuance to achieve non-ary growth, influencing Friedman's shift from early Keynesian sympathies in the 1940s toward rule-based by the 1950s. These ideas emerged amid interwar debates on the Great Depression's monetary causes, as detailed in Friedman and Anna Schwartz's 1963 Monetary History of the United States. Early discussions of zero-nominal-interest policies appeared sporadically in pre- theoretical work, such as analyses of inflation's welfare costs in overlapping-generations models, but lacked the synthesis provided. In his 1960 Program for Monetary Stability, first advocated a 2-5% annual growth for approximate , distinct yet foundational to the later optimum rule, which he presented as a theoretical ideal rather than immediate prescription. These concepts gained traction in monetarist critiques of Keynesian fine-tuning, with 's 1968 American Economic Association presidential address reinforcing monetary rules' role in countering fiscal dominance and velocity instability. Academic engagement intensified post-1969, as in overlapping-generations frameworks questioning the rule's implications.

Theoretical Underpinnings

Optimality in Standard Monetary Models

In standard monetary models featuring infinitely lived representative agents and lump-sum taxation, the Friedman rule—prescribed by setting the to zero through at the real —achieves welfare optimality by eliminating the of holding , thereby maximizing the from real balances. This result holds in frameworks where provides liquidity services, as the zero nominal rate aligns the steady-state allocation with the first-best outcome absent monetary frictions. A foundational example is the money-in-the-utility (MIU) model of Sidrauski (1967), where agents derive utility from consumption and real money balances; the optimal policy sets the inflation rate to offset the real rate of return, ensuring money holdings are undistorted and capital accumulation proceeds efficiently without inflationary taxes on money. In this setup, any positive nominal rate introduces a wedge between the return on money and bonds, reducing welfare by inducing suboptimal money demand that declines with the interest rate; the Friedman rule removes this distortion, replicating the non-monetary equilibrium. Similarly, in cash-in-advance (CIA) models, the Friedman rule is optimal because it relaxes the liquidity constraint binding on cash goods without excess money holdings, achieving under . Extensions incorporating goods alongside cash, as in cash- models, preserve optimality if is homothetic in cash and aggregates and weakly separable from labor, preventing interactions that would favor positive inflation. Even when introducing distorting taxes on capital, consumption, or labor—deviating from pure lump-sum financing— the Friedman rule remains optimal under standard assumptions of homotheticity and separability in , as these ensure does not exacerbate fiscal distortions. Chari, Christiano, and Kehoe (1996) demonstrate this across MIU, CIA, and cash-credit variants, showing that deviations arise only with non-standard preference structures violating these conditions. Thus, in benchmark representative-agent models, the rule's optimality stems from minimizing deadweight losses associated with money's role as a .

Mathematical Derivation and Assumptions

The Friedman rule emerges as the optimal in standard neoclassical models of monetary economies, particularly those incorporating nominal rigidities or transaction frictions that make essential for facilitating exchanges. A canonical setup is the cash-in-advance (CIA) constraint model, where households must hold nominal balances mtm_t to purchase consumption goods ctc_t, satisfying ptct≤mtp_t c_t \leq m_t, with ptp_t denoting the . Key assumptions include: a representative infinitely-lived agent maximizing expected discounted ∑t=0∞βtu(ct,lt)\sum_{t=0}^\infty \beta^t u(c_t, l_t) where uu is increasing and concave in consumption ctc_t and ltl_t; flexible prices; no productive capital to isolate monetary distortions; exogenous endowment or labor ; as the sole with no intrinsic value; and a benevolent financing lump-sum transfers via from , without distorting taxes on other margins. These assumptions ensure that money holdings are distorted solely by the opportunity cost of forgone interest-bearing assets, abstracted from real frictions like or heterogeneity that might alter optimality. In the decentralized competitive equilibrium, households' first-order conditions reveal a : the of consumption is equated to the discounted of future consumption adjusted by the gross 1+it1 + i_t, yielding uc(ct)=βEt[uc(ct+1)1+it1+πt+1]u_c(c_t) = \beta E_t \left[ u_c(c_{t+1}) \frac{1 + i_t}{1 + \pi_{t+1}} \right], where πt+1=pt+1/pt−1\pi_{t+1} = p_{t+1}/p_t - 1 is . This implies that positive nominal rates it>0i_t > 0 induce agents to hold suboptimal real balances mt/pt<ctm_t / p_t < c_t (if the CIA binds), creating a akin to an that reduces welfare below the real frictionless benchmark. The social planner, internalizing the aggregate resource constraint and CIA, solves a to maximize welfare subject to feasibility. The planner's conditions eliminate the by setting it=0i_t = 0 for all tt, aligning private incentives with the social optimum where marginal rates of substitution equal marginal rates of transformation without monetary distortions. Under steady-state analysis with constant money growth μ\mu (gross rate), zero nominal rates require μ=β−1(1+g)\mu = \beta^{-1} (1 + g), where gg is the exogenous real output growth rate, implying π=μ(1+g)−1−1≈−r\pi = \mu (1 + g)^{-1} - 1 \approx -r with real rate r=β−1−1r = \beta^{-1} - 1. This rate finances government spending via while achieving , as verified by equivalence between the planner's allocation and a decentralized equilibrium with i=0i = 0. Deviations arise if assumptions fail, such as introducing capital (generating wealth effects) or heterogeneous agents, but the rule holds robustly in baseline CIA or overlapping-generations setups without such complications.

Empirical Assessments

Macroeconomic Evidence from Historical Episodes

Historical episodes providing macroeconomic evidence for the Friedman rule—characterized by steady growth calibrated to real , resulting in low or zero and potentially mild —are limited, as central banks have rarely pursued such policies explicitly. Instead, indirect approximations arise from commodity standards like the classical (roughly –1914), where growth was constrained by gold discoveries and production, often leading to mild amid gains. In this era, international data indicate that deflations were not systematically linked to economic contraction; across 17 countries from to 2000, Atkeson and Kehoe found 38 deflation episodes, during which average annual real output growth was 0.3% higher than during non-deflation periods, with depressions occurring in only three cases, all tied to wartime disruptions or policy failures rather than deflation itself. This supports the Friedman rule's prediction of welfare gains from eliminating 's distortions without inducing stagnation, as productivity-driven price declines facilitated efficiency. In the United States specifically, the post-Civil War resumption of convertibility in 1879 initiated a 17-year deflationary episode (1879–1896), with wholesale prices falling about 1.7% annually due to rapid industrialization outpacing money growth. Real GNP nonetheless expanded at an average 3.6% per year, accompanied by low (around 5%) and infrastructure booms like railroads, illustrating benign under relatively stable monetary conditions. Similar patterns held internationally; for example, in Britain and , adherence yielded long-run with real growth rates exceeding 2% annually despite intermittent deflations, as velocity adjusted without major disruptions. These outcomes align with the rule's emphasis on predictable monetary expansion to minimize nominal rigidities, though short-term banking panics (e.g., 1893 US) highlight vulnerabilities from inelastic money supplies, which Friedman later critiqued as deviations from ideal steady growth. Countervailing evidence emerges from measurement-adjusted analyses of 19th-century data. Kaufmann's study of deflations, correcting for noisy price indices via productivity proxies, estimates real activity was 1–2% lower than in non-deflation years after controls, suggesting potential output costs even in "benign" episodes, possibly from debt- channels or measurement biases inflating perceived growth. Nonetheless, aggregate cross-country evidence predominates in favoring non-harmful mild , as severe contractions like the (1929–1933) stemmed from abrupt contractions (down 33% in the ), not steady rule-like policy, per and Schwartz's analysis of errors amplifying downturns. Post-1945 episodes under fiat regimes, such as erratic growth in the leading to , further underscore instability from discretionary deviations, implicitly validating the rule's call for constancy over activism. Overall, while no perfect historical analogs exist, gold standard-era dynamics provide qualified support for the rule's efficacy in fostering growth amid low inflation, tempered by institutional frictions absent in theoretical models.

Laboratory and Experimental Tests

Laboratory experiments testing the Friedman rule have primarily utilized controlled environments to simulate monetary economies, drawing on theoretical models like the Lagos-Wright search framework where the rule—aiming for zero nominal rates—is predicted to maximize welfare by equating the opportunity cost of holding to its return. In a key study, Duffy, Li, and Vishnoi implemented the rule through two mechanisms: deflationary policy (FR-DFL, with money growth rate μ set to the discount factor β ≈ 0.833) and interest payments on (FR-IOM, yielding a nominal rate of 20% to achieve zero net opportunity cost), comparing these to a constant baseline and a k-percent rule with 16.67% annual growth (k-PCT). Experiments involved 14 subjects per session across five sessions per treatment, with parameters calibrated such that the first-best quantity q* = 9 tokens, initial M = 140, and random session termination reflecting β = 5/6 impatience. Results deviated from theoretical predictions of Friedman rule optimality. Welfare on the intensive margin, measured relative to the first-best benchmark, reached 0.70 in k-PCT treatments—significantly higher than the 0.59–0.61 range in and constant treatments, with no statistically significant differences among the latter. Under FR-DFL, prices fell by approximately 14.1% relative to constant periods, aligning with deflationary intent, while k-PCT induced about 20% price increases consistent with positive . However, Friedman rule treatments exhibited persistent constraints, with around 15% of consumers holding zero tokens for trade in FR-DFL, reducing effective circulation and welfare gains. Money holdings were lower than theoretically optimal, driven by subjects' precautionary motives and failure to fully exploit opportunities, such as trading centralized goods for to meet decentralized market demands. These findings suggest that human subjects' and amplify frictions absent in representative-agent models, undermining the Friedman rule's purported efficiency. The superior performance of moderate positive under k-PCT mirrors observed practices but challenges the rule's zero-nominal-interest prescription, highlighting implementation challenges like incomplete provision even in simplified lab settings. Broader experimental literature on learning, such as Arifovic and Sargent's work on adaptive expectations, indirectly supports this by showing convergence to suboptimal equilibria under deflationary regimes due to coordination failures. Overall, lab evidence provides qualified support for the Friedman rule, indicating its theoretical optimality holds under idealized rational behavior but falters amid realistic behavioral deviations.

Criticisms and Challenges

Theoretical Limitations and Model Dependencies

The Friedman rule derives its optimality from monetary models where money enters the utility function or production separably, creating a distortion equal to the , which the rule eliminates by targeting zero nominal rates through steady at the rate of productivity growth. This requires assumptions of flexible prices, complete markets, and , under which money is superneutral in the long run and velocity remains stable. Deviations from these, such as non-separable money holdings or uncertainty in liquidity preferences, undermine the rule's welfare-maximizing properties, as the opportunity cost of money cannot be fully neutralized without inducing inefficiencies in . In overlapping generations frameworks, the rule's validity depends critically on the absence of intergenerational wealth effects from , yet money growth inherently transfers resources across generations via taxation, rendering deflationary steady states suboptimal without compensating fiscal transfers. Analyses demonstrate that these effects lead to a breakdown, as the rule fails to internalize the welfare losses from altered savings incentives and equity considerations between cohorts. Similarly, models incorporating spatial separation or limited communication introduce matching frictions that amplify mismatches, making fixed money growth unable to optimize trade efficiencies or agent-specific needs. Heterogeneity in skills, endowments, or structures further exposes model dependencies, as the uniform growth rate overlooks redistributive impacts; for example, nonlinear taxes interact with to exacerbate inequalities, deviating from . In economies with capital or intermediation frictions, the rule's prescription ignores investment distortions, where positive nominal rates may signal productive opportunities better aligned with real returns. These limitations highlight the rule's reliance on representative-agent, frictionless settings, where extensions reveal trade-offs between stability and dynamic .

Practical Implementation Obstacles

One major obstacle to implementing the Friedman rule lies in the operational difficulties of precise monetary targeting. Historical efforts, such as the U.S. Federal Reserve's experiment with M1 growth targeting from 1975 to 1982, encountered "base drift," where deviations from targets accumulated over time, and breakdowns in the money-inflation relationship, exemplified by M1 growing at 9.8% annually against 3.8% inflation from 1982 to 1987. Financial innovations, including the proliferation of interest-bearing deposits and payment technologies, have further destabilized money demand, rendering aggregates like M1 or unreliable predictors of nominal spending and complicating the selection of an appropriate growth rate. Central banks face control challenges in modern reserve regimes. Under ample reserves systems, as post-2008 quantitative easing demonstrated, excess reserves held by banks lose opportunity costs when interest on reserves approaches zero, leading to unpredictable money multipliers and potential price level indeterminacy without a clear anchor in non-interest-bearing aggregates. The Friedman rule's requirement for zero nominal interest rates exacerbates this, as real money demand may become unbounded or erratic near zero opportunity costs, per inventory-theoretic models, hindering the central bank's ability to fine-tune supply without unintended surges in currency circulation—U.S. currency in circulation nearly doubled from 2007 to 2017 amid only 33% nominal GDP growth. Institutional and political barriers compound these issues. Time-inconsistency problems incentivize deviations from rules, as policymakers anticipate short-term gains from during shocks, undermining ; strict adherence to a quantity rule can amplify volatility if unobservable parameters like the equilibrium shift permanently. Committee structures in central banks, such as the FOMC, foster disagreements over rule specifications due to divergent models and objectives, favoring targeting for its perceived flexibility in stabilization despite Friedman's advocacy for rules to curb such errors. Fiscal interactions pose additional hurdles. Achieving the rule's implied mild requires coordinated to manage dynamics, as increases real debt burdens without lump-sum transfers or adjustments, which distortionary taxation in practice cannot easily replicate. No major has adopted the rule partly because it demands relinquishing control, conflicting with mandates prioritizing stabilization over long-run optimality.

Policy Relevance and Alternatives

Applications in Contemporary Monetary Frameworks

In contemporary monetary frameworks, particularly ample reserves regimes adopted by major central banks following the 2008 global financial crisis, the Friedman rule serves as a theoretical benchmark for optimizing reserve supply and minimizing the of holding base money. Floor systems, where central banks remunerate reserves at or near the policy rate, approximate aspects of the rule by equating banks' opportunity costs of reserves to the central bank's low supply costs, thereby reducing liquidity frictions without excessive abundant reserves. Lorie Logan, President of the , argued in November 2023 that such systems align with the Friedman rule by supplying reserves up to the point where banks' demand meets the interest on reserves (IOR) rate, balancing societal benefits like robust rate control against costs such as potential distortions in non-bank markets. During economic downturns, central banks have temporarily implemented near-zero nominal interest rates, closely mirroring the Friedman rule's prescription in the short term. The U.S. , for instance, maintained the target at 0 to 0.25 percent from December 2008 through December 2015 to combat recessionary pressures, enabling expansionary policy amid low without immediate risks. Similar approaches were employed post-2020, with rates again lowered to the effective lower bound until mid-2022 hikes in response to surges. These episodes demonstrate practical approximations but highlight deviations, as sustained zero rates require offsetting real rates, which policymakers avoid due to perceived entrapment risks. Full steady-state implementation faces fiscal and operational hurdles in modern sovereign frameworks. Achieving zero nominal rates demands that governments finance deficits via non-interest-bearing rather than bonds, relying on to supplant interest payments—a condition unmet in debt-reliant fiscal systems. Analyses indicate that while short-run adjustments can sustain the rule asymptotically, positive real rates and fiscal indiscipline necessitate coordinated , often leading to positive targets around 2 percent to provide ZLB buffers. Interest on reserves, introduced by the Fed in October 2008 and set above zero, further deviates by reintroducing money-holding costs, though himself endorsed it as a stabilization tool in certain contexts.

Comparisons with Discretionary and Other Rules

The Friedman rule, which prescribes a steady increase in the money supply equal to the real growth rate of output to achieve near-zero nominal interest rates, contrasts with discretionary by committing central banks to a predictable path that mitigates time-inconsistency problems, where policymakers might deviate ex post from announced policies to exploit short-term gains, such as inflating away or stimulating output temporarily at the cost of higher future . Discretionary approaches, reliant on real-time judgments by committees like the [Federal Open Market Committee](/page/Federal_Open Market Committee), have historically led to inflationary biases, as evidenced by the U.S. experience in the when flexible targeting amplified wage-price spirals rather than containing them, whereas rules like 's enforce credibility and reduce uncertainty about future . Empirical analyses indicate that discretion exacerbates lags in transmission—often 6 to 18 months for monetary effects on output—potentially destabilizing economies through overreactions, a concern highlighted in critiquing fine-tuning efforts that ignore structural unknowns. Compared to other rules, the Friedman rule prioritizes optimality in models featuring 's role in transactions, minimizing the of holding non-interest-bearing currency, whereas the —an interest rate formula adjusting the by 1.5 times the deviation from target plus 0.5 times the —relies on econometric estimates prone to specification errors and does not explicitly target zero nominal rates, potentially sustaining positive rates that distort . Both rules share simplicity and anti- foundations, aiming to curb policy-induced uncertainty, but Friedman's derives from microfounded welfare maximization in cash-in-advance frameworks, avoiding the 's dependence on assumed nominal rigidities that may not hold universally, as simulations show Taylor prescriptions deviating from Friedman optimality during low- regimes. Relative to Friedman's earlier k-percent rule of fixed growth regardless of output fluctuations, the refined Friedman rule better accommodates productivity-driven , though critics note its implementation challenges in interest-rate-dominated regimes where base control is indirect. In practice, hybrid rules incorporating Taylor elements with Friedman-like steady states have been proposed to balance responsiveness and long-run optimality, but evidence from vector autoregressions suggests pure rule adherence outperforms without matching Friedman's theoretical efficiency in reducing deadweight losses from holdings.

Debates and Controversies

Deflation Risks and Public Perception

The Friedman rule, by advocating zero nominal , implies a steady rate approximately equal to the real , often estimated at 1-4% annually depending on economic conditions. Critics highlight risks of debt- dynamics, where falling prices increase real debt burdens, potentially amplifying economic contractions if expectations turn pessimistic; however, empirical analyses find no robust link between anticipated and depressions when decoupled from monetary contractions, as in the U.S. where severe stemmed from a one-third drop in rather than inherent price decline effects. Theoretical models supporting the rule, such as those distinguishing liquidity traps from optimal , suggest that benign, predictable avoids spirals by encouraging holdings without distorting incentives, contrasting with unexpected 's harms. Experimental from economies implementing deflationary variants of the rule shows welfare gains comparable to interest-paying , without inducing instability, provided agents anticipate the . Nonetheless, implementation risks persist if real rates fluctuate, potentially requiring rates exceeding 6% in high-real-rate environments, though such scenarios remain hypothetical absent historical precedents of sustained optimal adherence. Public perception of deflation under the Friedman rule is predominantly negative, shaped by associations with the 1930s , where deflation exceeded 10% annually amid policy failures, fostering a precautionary toward positive targets among central bankers. This aversion persists despite arguments from himself and subsequent analyses that mild, steady deflation—optimal for maximization—poses minimal threat, as evidenced by 19th-century U.S. episodes of 1-2% deflation coinciding with robust growth absent modern banking frictions. and stickiness amplifies perceived risks, as nominal rigidities hinder real adjustments, leading to ; surveys of economists reveal widespread support for 2% buffers partly to mitigate these optics, even as models indicate Friedman-rule deflation enhances efficiency. Policymakers' reluctance reflects this fear over empirical nuance, with communications emphasizing deflation avoidance to maintain credibility, irrespective of rule-based optimality.

Redistribution and Fiscal Interactions

The Friedman rule, by targeting a nominal interest rate near zero through money supply growth matching real output expansion, implies mild deflation in economies with productivity-driven growth. This deflationary pressure increases the real value of nominal debt obligations, effectively redistributing wealth from debtors to creditors, as borrowers face higher real repayment burdens while lenders receive payments with enhanced purchasing power. Such effects are amplified in heterogeneous agent models, where deviations from the rule—typically via higher inflation—can induce both distortionary reductions in money holdings and direct transfers between agent types, with the zero-rate policy potentially exacerbating creditor gains if fiscal tools cannot offset debtor losses. Empirical and theoretical analyses indicate this redistribution favors net savers and asset holders, potentially widening inequality if debtors predominate among lower-income groups, though some models suggest trend deflation under the rule could even out wealth distribution by curbing inflationary transfers to money holders. Fiscal policy interactions arise primarily from the rule's suppression of seigniorage revenue, as low minimizes the on holdings, compelling governments to substitute with alternative financing like or consumption that introduce distortions. In overlapping generations frameworks without lump-sum , adhering to the may prove suboptimal, as the lost seigniorage necessitates higher distorting levies, reducing overall welfare unless fiscal adjustments align incentives toward greater labor supply or . himself emphasized monetary policy's dominance, arguing that fiscal deficits influence prices only if monetized and that coordination between monetary and fiscal authorities is unnecessary, given the central bank's capacity to control independently. However, in practice, this separation can strain budgets during deficits, as seen in analyses where zero yields negligible seigniorage compared to moderate , potentially forcing expenditure cuts or hikes that indirectly affect redistribution. These dynamics highlight tensions in implementation: while the rule minimizes monetary distortions, its fiscal implications may conflict with redistributive goals if governments rely on for revenue neutrality, as evidenced in models where positive nominal rates persist to balance systems. Critics contend that in creditor-heavy economies, the debtor-creditor shift under aligns with by curbing government borrowing incentives, yet it risks amplifying cycles if fails to mitigate debtor distress, underscoring the need for integrated analysis beyond pure monetary optimality.

References

  1. https://www.nber.org/system/files/working_papers/w8821/w8821.pdf
  2. https://www.minneapolisfed.org/research/quarterly-review/zero-nominal-interest-rates-why-theyre-good-and-how-to-get-them
  3. https://faculty.wcas.northwestern.edu/lchrist/papers/zerointerestrate.pdf
  4. https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_quarterly/1997/fall/pdf/wolman.pdf
  5. https://www.bu.edu/econ/files/2011/01/KKWrestud.pdf
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