DP3883 Freidman's Money Supply Rule versus Optimal Interest Rate Policy

Author(s): George W Evans , Seppo Honkapohja

Publication Date: May 2003

Keyword(s): monetary policy , determinacy , stability under learning

JEL(s): E31 , E52

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3883.asp

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. Computing the mean quadratic welfare loss, however, we find for calibrated models that Friedman’s rule performs poorly when compared to the optimal interest rate rule.