ABSTRACT OF PAPER

Title: Hayek MV-rule: A modern approach
Author: Potuzak Pavel


In the interwar period, Friedrich August von Hayek concluded that price level stability might not be consistent with a stable economy. In the economy with permanently increasing natural output, price level stabilization requires a steadily rising money supply. According to Hayek, this permanent injection of liquidity might be the true source of the business cycle, regardless of the behaviour of the general price level. Instead of the stability of some index of prices, smooth economic growth could be achieved by a constant stream of money, represented by the MV term in the quantity equation. Hayek implied that in such a case, the economy with expanding natural output should experience a secular decline in prices. Thus, a declining price level, rather than its stabilization, is more consistent with a smooth economic growth. This paper will examine the Hayek rule of constant MV. It will focus on its resemblance with modern nominal income targeting. Shifts in aggregate demand caused by the LM or IS shocks will be introduced, and the robustness of the MV-rule will be assessed. It will be shown that shocks to aggregate supply may result in changes in the money supply even under the MV-rule unless the AD curve is unit elastic. The next section will clarify that in the economy with expanding natural output, the MV-rule is passive only under very specific circumstances. In other words, Hayek recommendations for a stable money supply in a growing economy might not be consistent with the stable MV term. If real money balances are a luxury good, the MV-rule leads to monetary expansion. Furthermore, a secular deflation provoked by this rule may depress the nominal interest rate to very low levels. It will be examined under what circumstances the nominal interest rate could reach the zero lower bound, making the Hayek rule non-operational. A close resemblance to Friedman rule of optimum quantity of money will be discussed, as both rules imply very low nominal rates of interest. Conditions under which both rules coincide will be examined as well as rates of price deflation resulting from both rules. It will be shown that the Hayek rule is less deflationary compared with the Friedman rule only if the economy is dynamically efficient.

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