Friedman’S K-Percent Rule

Published Mar 22, 2024

Definition of Friedman’s k-percent Rule

Friedman’s k-percent rule is a monetary policy proposal recommended by economist Milton Friedman, which suggests that the central bank should increase the money supply at a constant annual rate. This rate should be equal to the long-term growth rate of the real GDP, typically around 2% to 3%. According to Friedman, this policy would provide the necessary liquidity for economic growth while preventing the inflation and deflation that can result from discretionary monetary policy.

Example

Let’s consider an economy with an average real GDP growth rate of 2.5% per year. According to Friedman’s k-percent rule, the country’s central bank should aim to increase the money supply by 2.5% each year. This approach assumes that such an increase in the money supply would match the economy’s natural growth rate, thereby maintaining stable prices and avoiding the boom and bust cycles associated with more active monetary interventions.

Imagine the central bank decides to increase the money supply by exactly 2.5% annually over a decade. In theory, if the real GDP also grows at an average rate of 2.5% per year during this period, the economy should experience nominal stability, with low and stable inflation rates, assuming velocity remains constant and there are no significant external shocks.

Why Friedman’s k-percent Rule Matters

Friedman’s k-percent rule emphasizes the importance of rule-based monetary policy over discretionary actions by central banks. The argument is that by adhering to a simple, predictable rule, central banks can avoid the informational lags and politically motivated decisions that often lead to economic instability. This proposal underscores the significance of monetary stability for achieving long-term economic growth and low inflation rates. It suggests that the predictability in monetary policy can help manage people’s expectations about inflation, contributing to economic stability. 

Furthermore, the k-percent rule serves as a critique of discretionary monetary policy, where central banks respond to economic indicators in a more subjective and often reactive manner. By following a set rule, central banks could ostensibly reduce uncertainty in the financial markets and encourage more consistent economic planning and investment.

Frequently Asked Questions (FAQ)

How would a central bank implement Friedman’s k-percent rule in practice?

To implement the k-percent rule, a central bank would first determine the long-term growth rate of the real GDP of its economy. Once established, the bank would adjust its monetary policy tools, such as the reserve requirement, discount rate, and open market operations, to ensure that the money supply grows at this predetermined rate each year. This approach requires discipline and a commitment to avoid responding to short-term economic fluctuations with substantial changes in monetary policy.

What are the criticisms of Friedman’s k-percent rule?

Criticisms of Friedman’s k-percent rule center around its rigidity and the challenge of accurately identifying the appropriate growth rate for the money supply. Critics argue that economic conditions are complex and vary over time, making a one-size-fits-all rule impractical. For instance, in the event of a financial crisis or an external economic shock, adhering strictly to a k-percent rule could prevent central banks from responding effectively to stabilize the economy. Furthermore, the rule assumes a stable velocity of money and a clear understanding of the potential output of an economy, both of which can fluctuate.

Has any central bank successfully followed Friedman’s k-percent rule?

No central bank has strictly implemented Friedman’s k-percent rule over a long period, primarily due to the criticisms mentioned and the complexities of managing an economy in real time. While some central banks have adopted policy guidelines inspired by the principles of the k-percent rule—focusing on low, stable inflation targets and predictable policy actions—none have committed to a strict, invariant rate of money supply growth. This reflects the broader shift towards inflation targeting and away from strict monetary aggregates as the primary tool for monetary policy in many economies.