Money Growth Rule The Money Growth Rule is based upon a theory originally set forth by Milton Friedman as a solution to keep the United States economy on a controlled course of growth. The revolves around the premise that the best monetary policy that the Federal Reserve can follow is to establish a constant growth rate of the money supply independent of current economic fluctuations. The reasoning is that as the economy experiences changes in relative output, the money supply can have dramatic effects upon the economy. Additionally, by establishing a money growth rule, Friedman believed that this would eliminate the possibility of short-run mismanagement and, in the end, be more beneficial for the economy. The problem with balancing an economy is that human judgment and evaluation of economic situations enter into the equation.
Establishing a constant growth level in the money supply would eliminate the decision making process of the central banker. The problem with human intervention is the short-sided nature of many of the policies designed to aid the economy. Such interventions, which yields unintended negative consequences, is the result of the time inconsistency problem. This problem is understood through situations during which central bankers conduct monetary policy in a discretionary way and pursue expansionary policies that are attractive in the short-run, but lead to detrimental long-run outcomes. Friedman believes that by leaving money growth decisions to an individual, the results are poor long-run management and eventually high inflation rates, an obvious detriment to the economy. The idea of the money growth rule is contingent upon the relationship between the money supply and inflation.
Therefore, the question arises whether there even is a relationship between money supply and inflation. As stated earlier, one can see a relation between money and inflation. Presented above is series data that displays this relationship between money supply and the inflation rate over the previous decades. The problem is that there are fluctuations within the data and therefore a broader definition of the money supply must be utilized. Based on the research of Dr.
Terry J. Fitzgerald, an economist at the Cleveland Federal Reserve Bank, if one defines money supply as M 2, when examining the data over a multiple year progression, a pattern begins to present itself. Further, by graphing the difference between adjusted money growth and inflation, the link becomes evident. These graphs show the weight that changes to the money supply can have upon an economy's inflation rate.
Fine-tuning the money supply can be detrimental. Clearly, becoming too involved with tinkering with the economy will do more harm than good. The problem is that the full effect of an action does not become realized because of a time lag. Corrective actions will require a few fiscal quarters in order to evaluate whether it has been effective. The private sector is relatively stable; therefore the government should not become too involved, but rather follow some semblance or a constant growth policy.
A more liberal view of the money growth rule would be not to target a specific rate, but rather target a certain range of values. This more liberal theory still follows the same central idea that the private sector is relatively stable and government intervention can be detrimental. However, the goal is now to opt for a more flexible interpretation of Friedman's rule. By establishing a target range, one receives the benefit of constant growth rule. The range essentially serves as boundaries for individual decision-making and prevents policy makers from taking action that will increase the money supply and inflation. However, the range has the ability to compensate for dramatic events such as September 11, 2001, where immediate and dramatic action becomes necessary.
"As one economist from the Bank of Canada stated, "Our goal is to avoid disasters, like the inflation of the 1970 s. Anything else is a bonus." Eliminating the ability to adjust the rate simply ties the Fed's hands and removes the ability of monetary policy to serve as a cushion to the economy. Adopting a more liberal Money Growth Rule seems to offer the best of both worlds by allowing for prudent and bounded discretionary action. Ideally, the Federal Reserve is in place to curtail inflation and help guide the economy. This is not to say that the goal of low inflation is undesirable, but rather that the Federal Reserve should approach the situation from a 5 year perspective, rather than eliminating the control of the money supply all together. In doing so, this will allow flexibility within the economy, while still preserving the idea of controlling growth over a time frame to reduce inflation.