What it means
Friedman, a leading monetarist, argued that inflation is always a result of money growing faster than output. He therefore suggested that central banks stop trying to fine-tune the economy and instead pick a steady growth rate for the money supply, the "k" in the rule.
The reasoning draws on the quantity theory of money, which says that money supply times velocity (how often each unit of money is spent) equals prices times real output. If velocity is stable, then steady money growth should produce steady spending and low inflation.
The rule is a way of applying that idea in practice. To set k, Friedman suggested linking it to the long-run growth rate of the economy, plus an allowance for the inflation the central bank considers acceptable.
If real output grows 2% a year and the target is 2% inflation, money growth of about 4% would keep prices on course, assuming velocity does not change. Supporters say the rule removes guesswork and political pressure.
Businesses and lenders could plan with greater confidence, because policy would be predictable and central bankers could not make errors through mistimed decisions. Critics point out a weakness: velocity turned out to be unstable.
When financial innovation and changing habits altered how people hold money, the link between money growth and spending broke down, and rigid targets sometimes produced poor results. For this reason most central banks moved to targeting inflation and setting interest rates instead.
The rule remains valuable as a teaching tool and a benchmark. It shows the trade-off between rules and discretion, and it explains why modern central banks put so much effort into being clear about their goals.
Students of economics often meet it first, before moving on to more modern policy rules such as the Taylor Rule.
In practice
Real-world examples.
Example
An economics lecturer explains the K-Percent Rule to her students. She asks them to calculate k for a country with 3% real growth and 2% inflation, and they find it is 5%, which shows how the rule links money to growth. They then discuss what happens if velocity changes.
Example
A treasurer at a manufacturing company reads about a central bank that has committed to a steady money growth rule. He decides he can plan borrowing costs with more confidence, since policy will not change suddenly. Stable policy lowers the risk of surprise rate jumps.
Example
A financial journalist writes about why central banks dropped money supply targets. She quotes analysts who say that when velocity became unstable, the K-Percent Rule would have produced too little or too much money. The article concludes that rules need regular review.
Formula
Calculation
Money supply next year = Money supply this year x (1 + k)
A common way to choose k is: k = Real output growth + Target inflation - Change in velocity.
Suppose real output is expected to grow 2%, the inflation target is 2% and velocity is stable, so its change is 0%.
k = 2% + 2% - 0% = 4%
If the money supply is currently $20 trillion, next year's money supply = $20 trillion x (1 + 0.04) = $20 trillion x 1.04 = $20.8 trillion.
The central bank would therefore allow the money supply to grow by $0.8 trillion, whatever the state of the economy that year. If velocity fell by 1%, the same formula would call for k = 2% + 2% - (-1%) = 5%, showing how the rule depends on stable velocity.Case study
Seen in the real world.
This is an illustrative story about a fictional country. Northland, an invented economy, adopted a K-Percent Rule with a fixed money growth rate of 4% a year after a period of high inflation. The government hoped to rebuild trust in the currency.
At first, inflation fell and businesses welcomed the predictability. Then new payment technology changed how people held money, and velocity dropped sharply, so the same money growth produced less spending.
The economy slowed and unemployment rose. The central bank governor, Elena, argued that a rule that ignores changes in velocity is too rigid, and the bank moved to an inflation target with flexible interest rates, showing that rules need to fit how the economy actually works. Elena later said that clear communication mattered as much as the rule itself.
Watch out
Common mistakes.
- Thinking the rule keeps the economy perfectly stable. It only fixes money growth and does not control other shocks. Wars, oil price shocks and financial panics still affect the economy.
- Ignoring velocity. If velocity changes, a fixed money growth rate does not give stable spending. This was the main reason the rule fell out of favour.
- Assuming every central bank follows the rule. Most modern central banks use inflation targets and interest rates. Some still watch money growth as an indicator.
Questions
People also ask.
Who proposed the K-Percent Rule?
Milton Friedman proposed it as part of his monetarist approach. He argued for it in the mid-twentieth century.
What does k stand for?
It is the fixed percentage growth rate of the money supply chosen by the central bank. For example, k = 3% means money grows 3% a year.
Why did central banks stop using money targets?
The link between money growth and inflation proved unstable, so they turned to interest rate and inflation targets. Most also publish forecasts to guide expectations.
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