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K-Percent Rule

Definition

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.

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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. Milton Friedman coauthored a book with Anna Schwartz to summarise a historical analysis of monetary policy, called A Monetary History of the United States, 1867–1960. The book 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.

Definition

According to Friedman, "The stock of money 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

Economists and policy makers have modified Friedman's k-percent rule and have developed more sophisticated 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.


Additional Resources

  1. Taylor Rules [www2.econ.iastate.edu]
  2. Is The Taylor Rule The Same As The Friedman Rule? [web.stanford.edu]
  3. Determinacy And Indeterminacy In Monetary Policy Rules With Money [www2.ku.edu]
  4. Friedman's Money Supply Rule Vs. Optimal Interest Rate Policy [pages.uoregon.edu]
  5. Chapter 33 [spots.augusta.edu]