Question

Professor Milton Friedman argued that money was socially useful but essentially free to create. Society should therefore reduce the opportunity cost of holding money to zero, so that people would demand it up to the point at which its marginal benefit was zero. (a) Suppose the real interest rate on other assets is around 3 per cent. Is there any way society could arrange for cash to earn a similar real return? (b) Why don't governments do this?

Short answer

Cash could theoretically earn interest, but it's impractical; governments avoid it due to potential economic issues.

Step-by-step solution

Understanding the Context

Milton Friedman suggested that money is beneficial to society and can be created without much cost. Individuals should hold money until its additional benefit becomes zero. In this problem, we explore whether cash can yield a real interest comparable to that of other assets and why governments might not implement such a policy.

Analyzing Part (a): Real Return on Cash

The question asks whether cash can earn a real return like other assets with an interest rate of 3%. This would require cash to generate interest or provide returns. One theoretical way to achieve this is through mechanisms like indexation of cash or introducing interest on cash holdings. However, practically, cash does not earn interest; thus, its real return would need to be arranged through policy changes like monetary rewards for holding cash or savings schemes offering returns on cash balances.

Exploring Part (b): Government Perspective

Governments avoid implementing policies that provide real returns on cash similar to interest-yielding assets for several reasons. Primarily, offering returns on cash could complicate monetary policy, potentially lead to inflation, or exacerbate economic imbalances. Additionally, a system providing interest on cash could undermine traditional banking systems and the roles of banks in the economy.

Formulating the Conclusion

So, in theory, cash could be adjusted to earn a real interest similar to other assets, but practical and policy limitations make this challenging. Governments avoid such strategies due to potential negative impacts on the economy and monetary system.

Key concepts

Milton Friedman's Theory

Milton Friedman's theory, often associated with his well-known "Monetarism" concept, proposes that money is crucial for economic stability and growth. He emphasized the importance of controlling the money supply to manage inflation and maintain economic health. Friedman argued that money creation is nearly cost-free, implying that society could benefit by making money more accessible and cheaper to hold.

The idea is rooted in the marginal utility of money, where people should hold cash until the benefit of holding it becomes zero. This notion challenges conventional economic theory by suggesting a policy where holding money entails no opportunity cost.

• This would mean adjusting the real interest rates on money to match those of other assets, essentially reducing the cost of holding money.
• Such adjustments are purely theoretical, posing challenges in practice.

Friedman's theories often lead to discussions about how monetary policy can be used to stabilize the economy, making them central to debates on managing economic cycles.

Real Interest Rate

The real interest rate is a fundamental economic concept that represents the rate of interest an investor expects to receive after allowing for inflation. Real interest rates are crucial in decision-making processes of both consumers and investors as they reflect the true cost of borrowing or the real yield on investments.

In Friedman's context, he suggests society should make the opportunity cost of holding money zero. But by traditional standards, achieving a real interest rate on cash involves turning basic currency into interest-bearing assets.

• This could include mechanisms like indexation or policies where inflation adjustments apply directly to currency holdings.
• The challenge lies in maintaining monetary policy efficiency while allowing for cash to hold or gain relative value akin to interest-yielding securities.

Understanding real interest rates helps policymakers predict economic behavior and set strategies to encourage savings or spending as needed to achieve macroeconomic goals.

Government Economic Policy

Government economic policy involves a strategic approach to influence a nation's economic framework, primarily through fiscal and monetary tools. These policies are crucial for maintaining economic stability, growth, and output.

Regarding Friedman's proposition of erasing the opportunity cost of holding money, governments typically avoid such actions. Here's why:

• Traditional banking systems rely heavily on interest differentials for operation. Introducing real returns on cash could disrupt banking activities and fund flows.
• Monetary policy complications could arise, such as increased inflation risk, reducing the central bank's control over economic regulation.

While theoretically plausible, implementing such policies requires balancing multiple interests and outcomes. Policymakers must consider potential economic imbalances and impacts on financial stability, often opting for more conservative approaches to monetary strategy for broader economic security.