K-Percent Rule

Posted in Finance, Accounting and Economics Terms, Total Reads: 409
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Definition: K-Percent Rule

K-percent Rule is theory of growth in money supply in economy which was first proposed by the Nobel Prize winner Milton Friedman. As per this theory, most effective way of controlling inflation (by central bank authorities) is by pumping in money into the economy with amount growing by a set percentage (say K percent) every year. This increase in money supply was fixed irrespective of the needs of cyclical state of the economy.


Friedman was of the view that any flexibility given to the government in terms of setting money growth would lead to inflation and hence central bank should follow a procyclical monetization policy and should expand money supply in the economy at a constant rate, usually equal to the growth in GDP. Since GDP usually ranges between 1-5%, K as a set percentage usually ranges between 2-5%.


K percent rule was designed in the context of US federal Reserves. Primary duty of Federal Reserve is to protect and stabilize the US economy, thus they need to ensure that economy grows at a constant pace, neither too slow nor too fast. Fast growth leads to high inflation, thus posing a threat to stability of economy.


A slight modification has also been proposed to K-percent rule, according to which the growth of money supply, i.e. K should be less than GDP growth when economy is performing well, so that central bank can keep a check on the amount of money in the economy and hence can control the increasing inflation. Similarly when K > GDP growth when economy is not performing well. This policy will help central bank to pump in more money into the economy and hence foster growth, thus stabilizing economy.

 

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