Milton Friedman, one of the greatest economists in the 20th century, stated his theory of monetary policy in his book The Optimum Quantity of Money (1969) as follows: “Our final rule for the optimum quantity of money is that it will be attained by a rate of price deflation that makes the nominal rate of interest equal to zero.” Friedman suggested that the opportunity cost for people to hold money should be equal to the social marginal cost of creating additional fiat money. Given that the cost of creating money today is practically zero, the opportunity cost, or the nominal interest rate, should also be zero. This implies a deflation equal to the rate of the real interest rate.

Zero interest rate means zero cost when people invest, so one can argue that Friedman’s rule can raise the level of output by stimulating investment. But there is another side of this investment argument. By having the nominal interest rate at zero, money becomes a more valuable asset, and agents such as banks and private loaners would preferably hold excess reserve in hand. A low nominal interest rate can discourage investment, which lowers the level of investment. In an endogenous growth model, this decrease in investment would lead to low economic growth. In practice, countries with zero or nearly zero interest rates are often associated with long-term recessions and not considered as performing well but rather as performing poorly. For example, Japan in the past decade and the United States after the financial crisis have experienced nearly zero interest after recession.

In fact, Japan is experiencing a negative interest rate. Similarly, central banks of Demark, Sweden, Switzerland have targeted a negative interest rate in the past few years, which means borrowers get paid and savers get penalized. These efforts to stimulate economies almost forces everyone to consume; the banks need to pay for their reserves and same for the individuals. Great news for investors: they are rewarded for investing. This negative interest rate serves a similar purpose as the zero interest rate, and may be even better. But the truth is, by forcing households to pay in order to save, people might store the money somewhere other than banks. And since banks would also need to pay the negative interest rate when holding reserves, which could potentially shrink their profit margin and can make them even less willing to lend. More importantly, there is no significant increase in those countries’ GDP.

Another missing part of Friedman’s rule is that he ignored the fact that inflation is sometimes a way for the government to generate revenue. This is because inflation can act as a tax on consumption, which allows the government to collect revenue on all types of consumption. The working paper done by Schmitt-Grohe and Uribe, “The Optimal Rate of Inflation,” found that there is incomplete taxation because the government cannot generate tax at the optimal rate. In practice, inflation targets around the world range from two percent in the developed countries and three and half percent in the developing countries. Akerlof, Dickens, Perry, Gordon and Mankiw argued in “The Macroeconomics of Low Inflation” that “the optimal inflation target is not zero”; rather, a low inflation is more preferable when stabilizing the economy, and is the appropriate target for monetary policy.

In conclusion, Friedman’s rule is a good attempt in trying to stabilize the economy, and it has its pros. However, real world evidence suggests that targeting a zero percent interest rate may not be the optimal monetary policy to follow.




Will the Nominal Interest Rate at Zero Lead to an Optimal Monetary System? Maybe, Not Quite