Friedman's k-percent rule is a monetary policy rule that the money supply should be increased by the central bank by a constant percentage rate every year, irrespective of business cycles. In A Monetary History of the United States, 1867–1960, monetarist economists Milton Friedman and Anna Schwartz
attributed inflation to excess money supply generated by a central
bank. It attributed deflationary spirals to the reverse effect of a
failure of a central bank to support the money supply during a liquidity
crunch. Friedman proposed a fixed monetary rule, called Friedman's
k-percent rule, where the money supply would be calculated by known
macroeconomic and financial factors, targeting a specific level or range
of inflation.
Under this rule, there would be no leeway for the central reserve bank, as money supply increases could be determined "by a computer" and therefore business could anticipate all monetary policy decisions.
Under this rule, there would be no leeway for the central reserve bank, as money supply increases could be determined "by a computer" and therefore business could anticipate all monetary policy decisions.
Definition
According
to Friedman, "The stock of money [should be] increased at a fixed rate
year-in and year-out without any variation in the rate of increase to
meet cyclical needs" (Friedman, 1960). Friedman was of the view that the main policy to be avoided is countercyclical monetary policy, the standard Keynesian
policy recommendation at the time. He believed giving governments any
flexibility in setting money growth would lead to inflation and
therefore, the central bank should follow an acyclical monetary policy
and expand the money supply at a constant rate, equivalent to the rate
of growth of real GDP.
Monetary policy
Monetary policy
is the process by which the monetary authority of a country controls
the supply of money, often targeting a rate of interest for the purpose
of promoting economic growth and stability. The official goals usually
include relatively stable prices and low unemployment.
Framing the monetary policy is a very complicated and difficult
task as balance has to be maintained between different economic
variables. A tradeoff usually has to be made between these economic
variables. Policymakers often make use of monetary rules like Friedman's
k-percent rule or the Taylor rule to design more effective monetary policies.
Rules vs. discretion in monetary policies
Many economists have argued whether using preset rules in framing monetary policies is better than the discretion of the policy maker
or not. The rules vs. discretion debate was the mainstream argument of
monetary policy framing in the 1960s to the 1980s and there is still no
single opinion on what is better. However, some economists like John B. Taylor
are inclined towards using rules rather than discretion. Taylor said,
"You do not prevent bailouts by giving the government more power to
intervene in a discretionary manner. You prevent bailouts by requiring
adequate capital based on simple, enforceable rules and by making it
possible for failing firms to go through bankruptcy without causing
disruption to the financial system and the economy," indicating a clear preference for rules rather than discretion in monetary policies.
Economists and policy makers strive to formulate monetary
policies using Rules but allowing scope for discretion so as to adjust
the policies appropriate to the current economic situation so as to make
these policies more effective.
The Friedman's k-percent rule, however, does not allow any
interference from central banks in framing the monetary policy, as
Friedman believed that discretion would be counterproductive and could
lead to increased levels of inflation instead of controlling it. The
k-percent rule does not allow any discretion in framing of monetary
policies and believes in strict adherence to the proposed rule. This has
caused many economists to criticize Friedman's k-percent rule.
Modified k-percent rule
Some economists and policy makers have modified Friedman's k-percent
rule and have developed other rules for framing monetary policy, using
the k-percent rule as a base. Joachim Scheide, head of the Forecasting
Center at the Kiel Institute for the World Economy in Germany, has
modified the k-percent rule to make it more applicable in context of
Germany's economy. He uses three new variables "nominal domestic
demand," "central bank money," and "error term with the standard
characteristics" to give a more suitable model.
The k-percent rule is considered a no feedback rule, which does
not allow central banks to alter monetary policy to adjust to current
economic situations; thus, it is not effective in the short term.
