Financial Policy Working Papers
The Friedman Rule Meets the Zero Interest Rate Bound
Banking and Policy Working Paper 6-04
Published April 1, 2004
This paper is an attempt to determine the relative importance of the efficiency and stability effects of monetary policy. The method is to find the policy that maximizes welfare in a general equilibrium model that generates both effects. It is found that the steady-state inflation rate under the optimal policy is significantly above the rate required for maximal efficiency and significantly below that required for maximal stability. Thus, both effects play important roles in determining the optimal rate of inflation. In addition, it is found that if a typical macroeconomic objective function is maximized as a substitute for welfare-maximization, the resultant policy rule puts too much weight on stability. It generates too much inflation and causes the policy instrument to respond too much to new information.