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Bank of Finland Research Discussion Papers, Bank of Finland

No 10/2003:
Friedman's money supply rule vs optimal interest rate policy

George W. Evans and Seppo Honkapohja

Abstract: Using New Keynesian models, we compare Friedmanís 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 Friedmanís 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 Friedmanís rule performs poorly compared to the optimal interest rate rule.

Keywords: monetary policy; determinacy; stability under learning; (follow links to similar papers)

JEL-Codes: E31; E52; (follow links to similar papers)

25 pages, April 14, 2003

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