The Friedman rule is a monetary policy rule proposed by Milton Friedman

Milton Friedman

Milton Friedman was an American economist, statistician, academic, and author who taught at the University of Chicago for more than three decades...

. Essentially, Friedman advocated setting the nominal interest rate

Nominal interest rate

In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation ; or, for interest rates "as stated" without adjustment for the full effect of compounding...

 at zero. According to the logic of the Friedman rule, the opportunity cost

Opportunity cost

Opportunity cost is the cost of any activity measured in terms of the value of the best alternative that is not chosen . It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the...

 of holding money faced by private agents should equal the social cost of creating additional fiat money

Fiat money

Fiat money is money that has value only because of government regulation or law. The term derives from the Latin fiat, meaning "let it be done", as such money is established by government decree. Where fiat money is used as currency, the term fiat currency is used.Fiat money originated in 11th...

. It is assumed that the marginal cost

Marginal cost

In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good...

 of creating additional money is zero (or approximated by zero). Therefore, nominal rates of interest should be zero. In practice, this means that the central bank should seek a rate of deflation equal to the real interest rate

Real interest rate

The "real interest rate" is the rate of interest an investor 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 approximately the nominal interest rate minus the inflation rate...

 on government bond

Government bond

A government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...

s and other safe assets, to make the nominal interest rate zero.

The result of this policy is that those who hold money

Money

Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

 don't suffer any loss in the value of that money due to inflation. The rule is motivated by long-run

Long-run

In macroeconomics, the long run is the conceptual time period in which there are no fixed factors of production as to changing the output level by changing the capital stock or by entering or leaving an industry. The long run contrasts with the short run, in which some factors are variable and...

 efficiency

Efficiency (economics)

In economics, the term economic efficiency refers to the use of resources so as to maximize the production of goods and services. An economic system is said to be more efficient than another if it can provide more goods and services for society without using more resources...

 considerations.

This is not to be confused with Friedman's k-percent rule

Friedman's k-percent rule

Friedman's k-percent rule 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....

 which advocates a constant yearly expansion of the monetary base

Money supply

In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...

.

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 optimal
    Optimization (mathematics)
    In mathematics, computational science, or management science, mathematical optimization refers to the selection of a best element from some set of available alternatives....
    
    , because the government
    Government
    Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...
    
     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
  Inefficiency
  The term inefficiency has several meanings depending on the context in which its used:*Algorithmic inefficiency - refers to less than optimum computer programs that might exhibit one of more of the symptoms of:** slow execution...
  
  , and by doing so, raise the mean of output.

The Friedman Rule in Economic Theory

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. 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 . While normally deviations from the Friedman Rule are typically small, if there is a significant foreign demand for a nations 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 . 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%.

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. . 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 .