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Friedman's Money Supply Rule vs. Optimal Interest Rate Policy

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  • George W. Evans
  • Seppo Honkapohja

Abstract

Using New Keynesian models, we compare Friedman's "k"-percent money supply rule to optimal interest rate setting, with respect to determinacy, stability under learning and optimality. First we review the recent literature: open-loop interest rate rules are subject to indeterminacy and instability problems, but a properly chosen expectations-based rule yields determinacy and stability under learning, and implements optimal policy. We show that Friedman's rule also can generate equilibria that are determinate and stable under learning. However, computing the mean quadratic welfare loss, we find for calibrated models that Friedman's rule performs poorly when compared to the optimal interest rate rule. Copyright (c) Scottish Economic Society 2003.

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Bibliographic Info

Article provided by Scottish Economic Society in its journal Scottish Journal of Political Economy.

Volume (Year): 50 (2003)
Issue (Month): 5 (November)
Pages: 550-566

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Handle: RePEc:bla:scotjp:v:50:y:2003:i:5:p:550-566

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  1. Ben S. Bernanke & Michael Woodford, 1997. "Inflation Forecasts and Monetary Policy," NBER Working Papers 6157, National Bureau of Economic Research, Inc.
  2. Svensson, L.E.O., 1998. "Inflation Targeting as a Monetary Policy Rule," Papers 646, Stockholm - International Economic Studies.
  3. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  4. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 277-316.
  5. James Bullard & Kaushik Mitra, 2003. "Determinacy, learnability, and monetary policy inertia," Working Papers 2000-030, Federal Reserve Bank of St. Louis.
  6. Evans, G W & Honkapohja, Seppo, 2002. "Policy Interaction, Learning and the Fiscal Theory of Prices," CEPR Discussion Papers 3564, C.E.P.R. Discussion Papers.
  7. Howitt, Peter, 1992. "Interest Rate Control and Nonconvergence to Rational Expectations," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 776-800, August.
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Cited by:
  1. Andreas Schabert, 2005. "Money Supply and the Implementation of Interest Rate Targets," Tinbergen Institute Discussion Papers 05-059/2, Tinbergen Institute.
  2. Andreas Schabert, 2005. "Discretionary Policy, Multiple Equilibria, and Monetary Instruments," Tinbergen Institute Discussion Papers 05-098/2, Tinbergen Institute.
  3. Andreas Schabert & Christian Stoltenberg, 2005. "Money Demand and Macroeconomic Stability Revisited," SFB 649 Discussion Papers SFB649DP2005-027, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany, revised Aug 2005.
  4. Llewellyn, David T. & Mayes , David G., 2003. "The role of market discipline in handling problem banks," Research Discussion Papers 21/2003, Bank of Finland.
  5. Alfred V. Guender, 2004. "Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables," Macroeconomics 0404038, EconWPA.
  6. Jukka Vauhkonen, 2004. "Banks' equity stakes in borrowing firms: A corporate finance approach," Game Theory and Information 0404003, EconWPA.
  7. Jukka Vauhkonen, 2004. "Financial contracts and contingent control rights," Finance 0404022, EconWPA.

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