Yellen, Optimal Control, and Dynamic Inconsistency

The Everyday Economist provides a well versed, well thought out look at Friedman’s k-percent rule, optimal control, and incoming Fed Chairman Janet Yellen. Please do yourself the favor of reading this to understand upcoming Fed expectations.

The Everyday Economist

For much of his career, Milton Friedman advocated a constant rate of money growth — the so-called k-percent rule. According to this rule, the central bank would increase the money supply at a constant rate, k, every year. In this case, there would be no need for an FOMC. A computer could conduct monetary policy.

The k-percent rule has often been derided as a sub-optimal policy. Suppose, for example, that there was an increase in money demand. Without a corresponding increase in the money supply, there would be excess money demand that even Friedman believed would cause a reduction in both nominal income and real economic activity. So why would Friedman advocate such a policy?

The reason Friedman advocated the k-percent rule was not because he believed that it was the optimal policy in the modern sense of phrase, but rather that it limited the damage done by activist monetary…

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