Should We Be Afraid of Friedman's Rule?
Tilburg University, CentER Working Paper No. 2000-62
Posted: 19 Oct 2000
Date Written: July 2000
Should one think of zero nominal interest rates as an undesirable liquidity trap or as the desirable Friedman rule? I use three different frameworks to discuss this issue. First, I restate Cole and Kocherlakota's (1998) analysis of Friedman's rule: short run increases in the money stock - whether through issuing spending coupons, open market operations or foreign exchange intervention - change nothing as long as the money stock shrinks in the long run. Second, two simple "Keynesian" models of the inflationary process with a zero lower bound on nominal interest rates imply either that deflationary spirals should be common or that a policy close to the Friedman rule and thus some deflation is optimal. Finally, a formal "baby-sitting coop" model implies multiple equilibria, but does not support the injection of liquidity to restore the good equilibrium, in contrast to Krugman (1998).
Keywords: Friedman's rule, liquidity trap, cash in advance, baby sitting coop, zero lower bound on nominal interest rates, deflation, deflationary spiral, Japan, optimal monetary policy
JEL Classification: E31, E41, E50, E51, E52
Suggested Citation: Suggested Citation