13 Pages Posted: 25 Oct 2016 Last revised: 7 Nov 2016
Date Written: October 22, 2016
Friedrich August von Hayek suggested that price level stability might not be consistent with neutrality of money. In the economy with permanently increasing natural output, price level stabilization requires a steadily rising money supply. This permanent injection of liquidity might be the true source of the business cycle, regardless of the behaviour of the general price level. Instead of stability of prices, smooth economic growth could be achieved by a constant stream of money, represented by the MV term in the quantity equation, and a resulting decline in the price level. This paper examines the Hayek rule of constant MV. Shifts in aggregate demand caused by LM shocks and IS shocks test robustness of the MV-rule along with the AS-shocks. It is demonstrated that in the economy with expanding natural output, the MVrule is passive only under very specific circumstances. Thus, Hayek recommendations for a stable money supply in a growing economy might not be consistent with stable MV. Secular deflation provoked by this rule may also depress the nominal interest rate to very low levels. It is examined what conditions under the MV-rule decrease the nominal interest rate to the zero lower bound. A close resemblance to Friedman rule of optimum quantity of money is studied, as both rules imply very low nominal rates of interest. The two rules coincide if the economy is at the golden rule level of capital accumulation. It is proved that the Hayek rule is less deflationary compared to the Friedman rule if the economy is dynamically efficient.
Keywords: Hayek Rule, Zero Interest, Dynamic Efficiency
JEL Classification: E14, B22, B53
Suggested Citation: Suggested Citation