The Shortcomings of the Friedman Rule

My recent background reading on all things monetary economics has often led me to stumble on what is generally dubbed the Friedman rule for optimal monetary policy. As the name already implies, it is the result at which Friedman arrived when trying to derive how a central bank should set its nominal interest rate in order to achieve the best, most socially desirable outcome. The logic behind it is simple. Interestingly enough, even Friedman assumed that money was indeed not neutral, essentially for reasons similar to the mundell-Tobin effect: money always pays 0% nominal interest rates. Yet, people still both want and need to hold money, so the optimal policy in this world is one were the opportunity costs of holding cash is minimized, which means setting the nominal interest rate in the economy also to zero. This implies that the optimal inflation rate is should be negative – negative the real interest rate, to be precise. This finding seems odd, and is obviously very different from what central banks do in practice.

First of all, holding cash does indeed bring higher opportunity costs if the nominal interest rate set by the central bank is positive. Yet, of course, holding money also has benefits, the most important of which is liquidity. As such, it would seem that these benefits, that no other financial asset offers in the same degree, should seem to alter the optimality rule. Setting nominal interest rates to zero in this setting would seem to “unfairly” make money more attractive than comparable assets, and present a distortion in and of itself. The only way to argue that these benefits should not be taken into consideration would be if these private benefits were of the same magnitude as the social benefits they bring, which might but also might not be the case. Also, some have argued that inflation should be positive since it can be the only way to tax things that we would want to tax but often find hard to do (like tax evasion, for instance), but also for a whole slew of other reasons.

But, and more importantly, this “friction” from the demand of fiat money is the only friction entailed in the model. Yet probably one of the most vital things that Keynesianism taught us is that prices are sticky, particularly when it comes to the downside. This assymetry also means that the optimal inflation rate is not zero, but positive to take into consideration the natural “variance” of inflation. There is, of course, no way that a policy that calls for considerable negative inflation rates can be optimal in the real world, and even though the inflationary 70s did represent a major defeat of the type of Keynesianism found both in practice and in theory at the time, throwing all of it overboard, as evidently done by Friedman and others in coming up with this not-so-optimal monetary policy rule was a horrible idea that thankfully was never implemented. To be fair, even new Keynesian models find that the optimal inflation rate is considerably lower than the one used in practice, which is puzzling, but at least they include many of the real world issues we face to come to the conclusion.

3 thoughts on “The Shortcomings of the Friedman Rule

  1. Didn’t know that one 🙂 What I found interesting though, which is linked to your 4% inflation targeting post, is that apparently (according to what I have so far found in the 2011 handbook of monetary economics) there seems to be not a single model that finds even 2% inflation to be optimal, much less 4%. As in my post, there are plenty of things missing as these are only models, and the re-balancing issue is certainly one of them, but still interesting.

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