ANNALS OF ECONOMICS AND FINANCE 14-2(B), 893–930 (2013) The Sub-Optimality of the Friedman Rule and the Optimum Quantity of Money

According to the logic of the Friedman rule, the opportunity cost of holding money faced by private agents should equal the social cost of creating addi-tional fiat money. Thus nominal rates of interest should be zero. This logic has been shown to be correct in a number of contexts, with and without various distortions. In practice, however, economies that have confronted very low nominal rates of interest over extended periods have been viewed as performing very poorly rather than as performing very well. Examples include the U.S. during the Great Depression, or Japan during the last decade. Indeed economies experi-encing low nominal interest rates have often suffered severe and long-lasting recessions. This observation suggests that the logic of the Friedman rule needs to be reassessed. We consider the possibility that low nominal rates of interest imply that fiat money is a good asset. As a result, agents are induced to hold an excessive amount of savings in the form of money, and a sub-optimal amount of saving