What Is the K-Percent Rule?
Let me explain the K-Percent Rule directly: it's a proposal from economist Milton Friedman that central banks should boost the money supply by a fixed percentage every year, no matter what's happening in the economy.
Key Takeaways
- The K-Percent Rule is Milton Friedman's idea for central banks to increase the money supply by a constant percentage annually.
- It sets money supply growth to match the annual GDP growth rate.
- In the US, this would usually be 2-4%, drawing from historical data.
Understanding the K-Percent Rule
You need to know that the K-Percent Rule ties money supply growth directly to the economy's growth rate each year. GDP measures the percentage increase in all goods and services produced, and in the US, it historically averages 2-4%. This rule lets the money supply expand in line with that GDP rate.
Friedman argued this approach brings long-term stability by having central banks automatically increase the money supply by a set percentage—the 'K' variable—every year, ignoring short-term economic ups and downs.
He suggested an annual rise between 3% and 5%. Importantly, this rule gives no room for Fed officials to make judgment calls on monetary policy. Friedman thought a rules-based system makes monetary policy more effective, as discretionary actions can lead to errors and overreactions.
As you know, the Federal Reserve manages the US money supply. If growth slows, the Fed can expand it through tools like cutting interest rates, which encourages borrowing for things like homes and cars, stimulating spending and jobs.
Beyond this rule, Friedman won a Nobel Prize in economics and founded monetarism, which emphasizes monetary growth as the key driver of inflation. Inflation tracks rising prices, and if it spikes, workers' wages buy less.
Friedman saw monetary policy as a big cause of economic cycles. Fine-tuning via varying policies is risky because we don't fully understand the effects. His rule aims to stop Fed mistakes, like shrinking the money supply in the 1930s, which worsened the Great Depression.
Discretionary Monetary Policy
While the Fed understands the K-Percent Rule's benefits, in reality, most advanced economies adjust monetary policy based on economic conditions. When the economy weakens, they grow the money supply faster than the rule suggests.
When things are strong, they slow it down. But US policy isn't strictly rules-based or triggered only by conditions—it's discretionary, focused on growth and price stability.
This flexibility lets the Fed tackle shocks and crises. For instance, in the 2007-2008 crisis, they slashed rates to near zero and bought Treasuries and securities, injecting massive cash into banks to revive growth.
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