Lesson 18

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Friedman’s Restatement of the Quantity theory
Objectives: After studying this lesson, you will be able to understood, • • • The definition of demand for money given by Friedman The different forms of wealth The meaning of Restatement of theory

18.1 Introduction 18.2. Reformulation of theory 18.3 Critical evaluation 18.4 Summary 18.5 Check your progress 18.6 Key concepts 18.7 Self Assessment questions 18.8 Answers to check your progress 18.9 Suggested Readings 18.1 Introduction The Keynesians discarded traditional quantity theory of money, which specified a proportionate relationship between money and prices, after publication of the general theory by Keynes. But it was only in the later 1950’s that the theory underwent a revival and re-emerged under the leadership of Milton Friedman. In his book, “Studies in the Quantity Theory of Money” in 1956, Friedman contributed an article, ‘The quantity theory of money- A restatement’ that heralded the re-emergence of the quantity theory. Friedman points out that the approach of Chicago economists is a theoretical one. The essence of it lies in its insistence that money does matter and that any interpretation of short term movements in economic activity is seriously at fault and is often misleading. 18.2.1 Reformulation of Quantity Theory: Friedman in his reformulation of the theory, he asserts “ the quantity theory is in the first instance a theory of demand for money. It is not a theory of output, or of money income,

or of the price level”. Further, his analysis is based on the general theory of demand. It is more in conformity with the real life situation. According to him, the demand for money depends on three factors: a) Total wealth to be held in the form of different assets b) Relative price of and return on one from of wealth as compared to other forms and, c) Tastes and preferences of the wealth holders. The cost of holding cash balances is influenced by the rate of interest, and expected rate of change in the price level. Friedman in his demand function of money analysis, used various forms of wealth, which are presented below: Total wealth: Total wealth comprises of different assets possessed by an individual. In actual life estimates of total wealth are not available and therefore Friedman says that income maybe taken as a proxy for total wealth. Friedman has therefore, substituted permanent income for wealth. Human & Nan-Human wealth: Total wealth comprises of both human and non-human wealth, but there are certain legal and institutional constraints in converting human wealth into non-human wealth. To avoid this difficulty Friedman has used the ratio of non-human to human wealth as a variable in the demand function. Money: Since money is primarily a medium of exchange, it real yield depends upon the price index because it is the level of prices which governs the ability of money to command goods and services. Bond: Bond is a perpetual source of money. Its yield depend upon the expected variations in the market interest rate, because it consists of the sum of its coupon plus expected capital gain or minus expected capital loss. Equity: Equity is like a bond, but it yields an income stream, which maintains constant purchasing power. The yield on equity comprises three components: a) its coupon value b) expected capital gain or loss due to variations in rates of interest and c) expected changes in the general price level. Commodities: Possession of physical goods provides an income to the owners in kind which is not measurable. But, their real return varies with the changes in the price level. Friedman uses the nominal yield of commodities to consist their expected rate of price change per unit of time. Human Capital: Since there is no market price for human capital, the rate of return on this form of wealth cannot be calculated. Other Variables: Friedman uses U to indicate other factors, which influence individual’s tastes and preferences for money. By combining all the factors described above we can obtain the following demand function for money:

M = F ( Y, W, P, yb, ye, yc, u ) Where M= aggregate demand for money: Y= total flow of income: W= ratio of nonhuman to human wealth: P = price level: yb = market bond interest rate: ye = equity yields: yc = expected rate of change of prices of commodities and u = utility determined variables which tend to influence tastes and preferences. In the above equation. The demand for money function is independent of the normal units used for measuring money variables which means that the demand for money changes in proportion to the changes in the unit in which prices and money income are indicated. It thus expresses that if price level and money increase to ^ times their original level, demand for money also increased to ^ times it original quantity, this can be expressed as follows: ^M =F(^Y, W, ^P, yb,ye,yc, u) In this equation if ^ is replaced by 1/Y, it adopts the form of the quantity theory of money as follows: M/Y = f( f(W,P/Y, yb,ye,yc,u) ) = 1 --------------------v(W,Y/P,yb,ye,yc,u) Y = f ( W,Y/P,yb,ye,yc,u), M Thus according to Friedman, a change in the stock of money brings about changes in the same direction in the price level or income or both, so long as the demand for money remains stable, a change in its supply will bring about change in the price level, the money supply also affects the real value of national income and economic activity, only in the short period. Friedman firmly holds that as long as the demand for money remains stable the effects of changes in the money supply on total expenditure and income can be predicted. If the economy is operating at less than full employment, an increase in the supply of money will increase the level of output and employment through an increase in aggregate expenditure. But this will apply only to a very short period, because other factors will come into operation to bring the economy back to less than full employment level, that is why Friedman and his followers believed that the supply of money do not affect the real variables in the long run. When the economy is operating at full employment level an increase in the supply of money will raise the price level. The following diagram explains Friedman’s quantity theory of money: In figure income (y) has been shown on the vertical axis and the demand and supply of money (M) have been show on the horizontal axis, Odom (45 line) is the demand curve of money and MS is the supply curve of money, Dm curve varies with income, while MS

curve is perfectly income-inelastic. These curves intersect at E and therefore, OY is the equilibrium income. When the supply of money rises, the MS curve shits to the right to M’S’. Consequently the supply of money exceeds the demand, the total expenditure increases and the new equilibrium is established at E’ between Dm and M’S; curves. The income increases from OY to OY”. Critical Evaluation of Restatement of quantity theory: Friedman in his definition of money includes not only currency and demand deposits, but time deposits with commercial banks as well, this means that the demand for money will not be very much interest-elastic. If the interest on time deposits increases, their demand will rise, but, at the same time the demand for currency and demand deposits will fall, so the effect of the rate of interest on the demand for money would be just very little, again, Friedman does not made choice between long and short-term rates of interest because in practice, for demand deposits a short-term rates will be preferable and for the time deposits a long term rate will be preferable. Hence, such a rate of interest structure will definitely influence the demand foe money. Friedman, in his demand for money function prefers wealth variables to income. He holds that both wealth and income variables operate simultaneously, which is not correct. According to Johnson” wealth is the present value of income which is the return on wealth” By including time deposits in the arena of money Friedman has considered money as a luxury goods most probably because he found that in the United States the trend rate of the money supply was higher than the income. But is not so with every economy. According to Friedman money supply is exogenous, because the monetary authorities change it in an exogenous manner His findings are based on the data collected from the United States. The neo-Keynesians who have verified the data hold that even in the USA the money supply is not exclusively exogenous, it contains lot of endogenous element in it. Friedman has failed to recognise the importance of factors like prices, output, rate of interest etc in affecting the money supply. Professor Kaldor has found no evidence in support of a positive correlation between money supply and money GNP established by Friedman. According to kaldor, in Britain, the best correlation is to be found between the quarterly variations in the cash holdings of the public held in the form of currency notes and coins and corresponding changes in personal consumption at market prices. Friedman has not indicated the length of the period of time to which his theory would be applicable. The validity of these criticisms can hardly be questioned. But Friedman’s contribution to the theory of money can also not be pushed aside.

Johnson has rightly said “ Friedman’s application to monetary theory of the basic principle of capital theory is probably the most important development in monetary theory since Keynes General theory. Its theoretical significance lies in the conceptual integration of wealth and income as influences on behaviour.” 18.4 Summary Friedman analysis of demand for money is based on the theory of demand. According to him the demand for money depends on total wealth, relative price and tastes and preferences. He Emphasised more on the price level rather then the rate of interest. The demand function of money is stable than the Keynes consumption function.. He means that it is stable in terms of the variables which determines its value. 18.5 Check your progress State whether the following statements true or false a) according to Friedman wealth is more important determinant of demand or money b) Friedman suggested that the monetary authority should concentrate on only fiscal policy c) Friedman’s defination of money includes only currency and time deposits d) Friedman has drawn distinction between permanent income and nominal income 18.6 Key concepts Income velocity Stable function of demand for money Human wealth Non Human wealth Return on commodities 18.7 Self Assessment questions short answer type questions 1) explain main determinants of demand for money given by Friedman? 2) Write a note on demand function of Friedman? Essay type question 1)Examine the contribution of Friedman to the quantity theory of money? 2. Explain Friedman for money, and how does it differ from that of Keynes? 18.8 Answers to check your progress a) True b) False c) False d) True

18.9 Suggested Readings TN Hajela :Monetary economics SB Gupta : Monetary economics Gurley and Shaw : Money in a theory of finance N kaldor : The New Monetarism

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