K-Percent Rule

What is the K-Percent Rule?

The K-percent rule, proposed by economist and Nobel Prize winner Milton Friedman, is a monetary policy rule that requires central banks to increase the money supply irrespective of the condition of the economy. Friedman proposed that central banks should boost the money circulating in the economy by a certain percentage (“k” variable) every year for controlling inflation in the long term.

The K-percent rule suggests fixing the growth rate of money supply at the growth rate of actual GDP. Usually, the GDP growth ranges between 1% and 4%.

How the K-Percent Rule Works

The primary objective of a central bank is to keep an economy steady and monitor growth rates to ensure that the economy does not grow too quickly or too slowly. In the case of a cyclically weak economy, central banks set the rate of the growth of money supply higher than the rate required by the K-percent rule. It implies that the total money circulating in the economy grows faster than the value of the economy.

On the contrary, central banks limit the rise of money supply in a well-performing economy since rapid economic growth, in particular, results in inflation. This will slow down economic activity. Thus, the K-percent rule is utilized by central banks to protect the economy from deflation or hyperinflation.

Significance of the K-Percent Rule

According to Friedman, banks act as greater sources of cyclic fluctuations than the sources of stability. He believed that letting the money supply grow at a reasonable rate would help avoid extreme deflationary pressure and avoid substantial inflation. It would allow the economy to manage through business fluctuations.

Friedman asserted using the K-percent rule for stabilizing the price level and restrained the interference of central banks for framing monetary policies. He argued that a rule allowing the banks to make the price level stable would grant them excessive discretion in decision making.

However, policymakers and economists attempt to frame policies using rules while allowing a choice of adjusting the policies according to the economic situation to increase the effectiveness of the monetary policies. K-percent rule does not provide any discretion to banks while framing monetary policies, leading many economists to criticize the rule.

Since the K-percent rule does not allow the central banks to interfere, several policymakers and economists modify the K-percent rule and used it as a base to develop other rules, which are used to frame monetary policies. Moreover, the K-percent rule is a no feedback rule and is not effective for the short term, as it does not allow for any modifications in monetary policies to adjust to the prevailing economic situations.

Monetary Policy

It is the macroeconomic policy that involves managing interest rates and money supply. It is a demand-side policy laid down by central banks and used by a country’s government to promote stability and growth and to strive for low unemployment and stable prices. The central banks implement monetary policies through instruments such as bank rate policy, open market operations, and credit control policy.

The use of such instruments will lead to variations in the stock of money circulating in an economy or cause the interest rate to change. Monetary policy can either be expansionary or contractionary. When the monetary policy leads to an increase in the supply of money and a decrease in interest rate, it is referred to as expansionary. When the money supply decreases and interest rate increases on account of any monetary policy, it is called a contractionary monetary policy.

As it is important to maintain a balance among various economic variables, formulating monetary policies becomes very difficult. Monetary rules such as the K-percent rule are used to design effective policies keeping a trade-off between economic variables.

Related Readings

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

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