Friedman rule

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

The result of this policy is that it is not costly to those who have money to continue to hold it. The rule is motivated by long-run efficiency considerations.

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

[edit] 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 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).
  • 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.