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Friedman’s money supply rule vs optimal interest rate policy

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  • George W. Evans

    (Faculty of Economics & ´Politics, University of Cambridge)

  • Seppo Honkapohja

    (Faculty of Economics & ´Politics, University of Cambridge)

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. We first 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 then show that Friedman’s rule also can generate equilibria that are determinate and stable under learning. However, in computing the mean quadratic welfare loss, we find that for calibrated models Friedman’s rule performs poorly compared to the optimal interest rate rule.

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Bibliographic Info

Paper provided by EconWPA in its series Macroeconomics with number 0405002.

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Date of creation: 03 May 2004
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Handle: RePEc:wpa:wuwpma:0405002

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Keywords: monetary policy; determinacy; stability under learning;

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  1. Kaushik Mitra & James Bullard, 2004. "Determinacy, Learnability, and Monetary Policy Inertia," Royal Holloway, University of London: Discussion Papers in Economics 04/14, Department of Economics, Royal Holloway University of London, revised Jul 2004.
  2. Svensson, Lars E.O., 1998. "Inflation Targeting as a Monetary Policy Rule," Seminar Papers 646, Stockholm University, Institute for International Economic Studies.
  3. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
  4. Evans, George W. & Honkapohja, Seppo, 2007. "Policy Interaction, Learning, And The Fiscal Theory Of Prices," Macroeconomic Dynamics, Cambridge University Press, vol. 11(05), pages 665-690, November.
  5. 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.
  6. Ben S. Bernanke & Michael Woodford, 1997. "Inflation forecasts and monetary policy," Proceedings, Federal Reserve Bank of Cleveland, pages 653-686.
  7. 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.
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Cited by:
  1. Schabert, Andreas & Stoltenberg, Christian, 2005. "Money Demand and Macroeconomic Stability Revisited," CEPR Discussion Papers 4974, C.E.P.R. Discussion Papers.
  2. Schabert, Andreas, 2005. "Money supply and the implementation of interest rate targets," Working Paper Series 0483, European Central Bank.
  3. Guender, Alfred V., 2003. "Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables," Research Discussion Papers 12/2003, Bank of Finland.
  4. Jukka Vauhkonen, 2004. "Financial contracts and contingent control rights," Finance 0404022, EconWPA.
  5. Andreas Schabert, 2005. "Discretionary Policy, Multiple Equilibria, and Monetary Instruments," Tinbergen Institute Discussion Papers 05-098/2, Tinbergen Institute.
  6. David T. Llewellyn & David G. Mayes, 2004. "The role of market discipline in handling problem banks," Finance 0404020, EconWPA.
  7. Jukka Vauhkonen, 2004. "Banks' equity stakes in borrowing firms: A corporate finance approach," Game Theory and Information 0404003, EconWPA.

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