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We explain why central banks rarely implement the Friedman rule by studying the properties of a simple New Keynesian dynamic macroeconomic model that is generalized to incorporate the zero lower bound on nominal interest rates. We show that two long-run equilibria exist, one stable and the other unstable, and we characterize the conditions under which the economy plunges into a deflation-induced depression following a contractionary demand shock. As long as the sum of the inflation rate and the natural real interest rate stays positive, the economy converges back to the long-run stable equilibrium, even when the zero lower bound is initially binding. On the other hand, a deflationary spiral starts when the sum of the inflation rate and the natural rate of interest becomes negative. The Friedman rule, which calls for a small dose of anticipated deflation, takes the sum of the inflation rate and the natural real interest rate uncomfortably close to zero and thereby raises the probability of the economy plunging into a depression. Our theoretical results also shed light onto the different correlation values between inflation and economic growth in the data.


This work was originally published in International Journal of Economics and Finance IJEF, available at doi:10.5539/ijef.v5n11p22

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