20.2 Friedman’s Modern Quantity Theory of Money

A simple money demand function is. (M/P) d =kY. Where k is a constant that tells us how much money people want to hold for every dollar of income. Equation states that the quantity of real money balances demanded is proportional to real income. The money demand function is like the demand function for a particular good. Here the.
Consider the money demand function that takes the form (M/P)d = kY, where M is the quantity of money, P is the price level, k is a constant, and Y is real output. If the money supply is growing at a 10 percent rate, real output is growing at a 3 percent rate, and k is constant, what is the average inflation rate in this economy?

Thus, given desired real money holdings, the nominal quantity of money demanded will vary in direct proportion with the price level and in inverse proportion with the nominal value of money. Since the public decides on a desired real money stock, M/P, the rectangular area under DD associated with each given level of M will be a constant equal.

Learning Objective

What is the quantity theory of money, and how was it improved by Milton Friedman?

Building on the work of earlier scholars, including Irving Fisher of Fisher Equation fame, Milton Friedman improved on Keynes’s liquidity preference theory by treating money like any other asset. He concluded that economic agents (individuals, firms, governments) want to hold a certain quantity of real, as opposed to nominal, money balances. If inflation erodes the purchasing power of the unit of account, economic agents will want to hold higher nominal balances to compensate, to keep their real money balances constant. The level of those real balances, Friedman argued, was a function of permanent income (the present discounted value of all expected future income), the relative expected return on bonds and stocks versus money, and expected inflation.

More formally,

M_{d} / P : f (Y p <+>, r_{b} - r_{m} <->, r_{s} - r_{m} <->, π^{e} - r_{m} <->)

where

M_d/P = demand for real money balances (M_d = money demand; P = price level)

f means “function of” (not equal to)

Y_p = permanent income

r_b − r_m = the expected return on bonds minus the expected return on money

r_s − r_m = the expected return on stocks (equities) minus the expected return on money

π^e − r_m = expected inflation minus the expected return on money

<+> = increases in

<−> = decreases in

So the demand for real money balances, according to Friedman, increases when permanent income increases and declines when the expected returns on bonds, stocks, or goods increases versus the expected returns on money, which includes both the interest paid on deposits and the services banks provide to depositors.

Stop and Think Box

As noted in the text, money demand is where the action is these days because, as we learned in previous chapters, the central bank determines what the money supply will be, so we can model it as a vertical line. Earlier monetary theorists, however, had no such luxury because, under a specie standard, money was supplied exogenously. What did the supply curve look like before the rise of modern central banking in the twentieth century?

The Quantity Of Real Money

The supply curve sloped upward, as most do. You can think of this in two ways, first, by thinking of interest on the vertical axis. Interest is literally the price of money. When interest is high, more people want to supply money to the system because seigniorage is higher. So more people want to form banks or find other ways of issuing money, extant bankers want to issue more money (notes and/or deposits), and so forth. You can also think of this in terms of the price of gold. When its price is low, there is not much incentive to go out and find more of it because you can earn just as much making cheesecake or whatever. When the price of gold is high, however, everybody wants to go out and prospect for new veins or for new ways of extracting gold atoms from what looks like plain old dirt. The point is that early monetary theorists did not have the luxury of concentrating on the nature of money demand; they also had to worry about the nature of money supply.

This all makes perfectly good sense when you think about it. If people suspect they are permanently more wealthy, they are going to want to hold more money, in real terms, so they can buy caviar and fancy golf clubs and what not. If the return on financial investments decreases vis-à-vis money, they will want to hold more money because its opportunity cost is lower. If inflation expectations increase, but the return on money doesn’t, people will want to hold less money, ceteris paribus, because the relative return on goods (land, gold, turnips) will increase. (In other words, expected inflation here proxies the expected return on nonfinancial goods.)

The modern quantity theory is generally thought superior to Keynes’s liquidity preference theory because it is more complex, specifying three types of assets (bonds, equities, goods) instead of just one (bonds). It also does not assume that the return on money is zero, or even a constant. In Friedman’s theory, velocity is no longer a constant; instead, it is highly predictable and, as in reality and Keynes’s formulation, pro-cyclical, rising during expansions and falling during recessions. Finally, unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand. The reason for this is that Friedman believed that the return on bonds, stocks, goods, and money would be positively correlated, leading to little change in r_b − r_m, r_s − r_m, or π^e − r_m because both sides would rise or fall about the same amount. That insight essentially reduces the modern quantity theory to M_d/P = f(Y_p <+>).

The Quantity Of Real Money Balances Demanded

Key Takeaways

Quantity Of Real Money Vs

According to Milton Friedman, demand for real money balances (M_d/P) is directly related to permanent income (Y_p)—the discounted present value of expected future income—and indirectly related to the expected differential returns from bonds, stocks (equities), and goods vis-à-vis money (r_b − r_m, r_s − r_m, π^e − r_m ), where inflation (π) proxies the return on goods.
Because he believed that the return on money would increase (decrease) as returns on bonds, stocks, and goods increased (decreased), Friedman did not think that interest rate changes mattered much.
Friedman’s modern quantity theory proved itself superior to Keynes’s liquidity preference theory because it was more complex, accounting for equities and goods as well as bonds.
Friedman allowed the return on money to vary and to increase above zero, making it more realistic than Keynes’s assumption of zero return.