ON THE FRIEDMAN RULE WITH LABOR MARKET FRICTIONS

This paper uses a cash-in-advance model to study whether the optimality of a nominal interest rate equal to zero holds in the presence of labor market frictions. Results show that labor market frictions may break the equality between the marginal rate of substitution and the marginal rate of transformation, thereby inducing households to supply a suboptimal amount of labor. A non-zero nominal interest rate may correct the inefficient labor market decisions and improve efficiency. Numerical evaluations of the model quantify the inefficiencies generated by labor market frictions. Finally, the paper shows that an appropriate fiscal policy stance may restore the optimality of a nominal interest rate equal to zero.