Money, Banks and Finance in Economic Thought

The Friedman rule in today's perspective

Jens Reich, Dt. Bundesbank, University of Frankfurt

50 years ago Milton Friedman’s Optimum Quantity of Money was published. It contains his approach to determine the optimal rate of inflation. His approach, usually labelled the Friedman rule, is until today the common core of optimal inflation theory. He proposed to determine optimal inflation via the (opportunity) cost of currency. In contemporary literature this core approach is amended by “external effects”, e.g. the impact of monetary non-neutrality or “wage rigidities” and so on. However, even under consideration of external effects the standard literature contests a significant gap between actual inflation targets and optimal rates as suggested by theory. In this article, at its 50th birthday, the core Friedman rule is reflected against the background of institutional changes in these 50 years. Central banks like the Bank of England or the Bundesbank have highlighted recently that the supply of currency is achieved by means of granting credit. In contrast, the Friedman rule is based on the assumption of currency which is print and spent by a central authority at zero cost of production. From this perspective central banks’ inflation targets and optimal inflation targets are at odds with those suggested by economic theory. The supply by means of credit involves “costs of production”, i.e. the risks of losses which do not appear in Friedman’s approach: losses from defaults. Any rule for the optimal rate of inflation under an interest targeting central bank regime, needs to acknowledge risk in lending. Hence it is proposed to adjust the core Friedman rule by incorporating expected losses. This contributes significantly in aligning pursued central bank targets with economic theory and provides a new theory of optimal inflation for a credit currency.

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Keywords: Optimal inflation, monetary policy, central banking

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