On the Friedman Rule
or, the one time Hayek > Friedman (economically)
A couple weeks ago, I posted some commentary about the Friedman Rule.
I want to consider more thoroughly what sort of conditions make the Friedman Rule “suboptimal” in practice and what scenarios cause it to be a poor tool to judge policy by (and these indeed are different things). However, before getting in to its flaws, I need to expound upon its value.
The Friedman Rule, in effect, performs something I like to call a “monetary counterspell.” If money illusion can disrupt an economy, then the Friedman Rule can temper its effects, like a stronger version of making price level stable. Its something like George Selgin’s proposal in Less Than Zero, where a falling price level communicates the growth of the economy, instead having the falling price level remove nominal incentives and provide the necessary amount of cash to keep calm the “fluttering veil.”
Removing the effects of money illusion during times of stability has an indelibly positive effect. A more pure allocation (based on market forces) is more easily reached, and it is a strong, but well-evidenced assumption that during times of boom such allocation is optimal.
It is important to note that the Friedman Rule does function much like price level targeting during demand-side recessions, and can even escape the flaws of price level targeting during supply-side recessions.
Nominal Friedman Targeting (NFT)
The inflexibility of the Friedman Rule, however, leads it to be suboptimal when the economy is hit by serious shocks. During severe shocks to the business cycle, the force of money illusion is beneficial, and assuming the long-run real interest rate is above zero, inflation does not take place. In general, inflation during a business cycle shock is necessary to restore labour markets.
I usually think its alright to assume that the economy is at or near capacity However, during times of higher economic stress, involving capacity frictions, labour shocks, and monetary disequilibrium, a higher nominal spending level can bring an economy back to work faster. The Friedman Rule does not do this.
Lastly, but perhaps most importantly, the Friedman Rule discounts the role that price plays. Both the price level manipulation and interest rate manipulation can interrupt the essential transfer of information those mechanisms provide. As F.A. Hayek outlined in 1945, prices carry information of scarcity that enables better economic decisions. The Friedman Rule instead merely treats prices as branches of the nominal tree.
The Friedman Rule is an interesting way of judging models light on frictions, but a serious accounting of the world we live in shows that is likely to be quite useless.
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If the equilibrium real interest rate decreases because of a supply shock, deflation will want to increase as well, so the Friedman Rule counters this.