Friedman Rule - Friedman's Argument

Friedman's Argument

• The marginal benefit of holding additional money is the decrease in transaction costs represented by (for example) costs associated with the purchase of consumption goods.
• With a positive nominal interest rate, people economise on their cash balances to the point that the marginal benefit (social and private) is equal to the marginal private cost (i.e., the nominal interest rate).
  • This is not socially optimal, because the government can costlessly produce the cash until the supply is plentiful. A social optimum occurs when the nominal rate is zero (or deflation is at a rate equal to the real interest rate), so that the marginal social benefit and marginal social cost of holding money are equalized at zero.
• Thus, the Friedman Rule is designed to remove an inefficiency, and by doing so, raise the mean of output.