About Friedman’s Optimum Quantity of Money

Money and Finance Semester III

University of Calcutta

Money and Finance Semester III (University of Calcutta) About Friedman’s Optimum Quantity of Money 1/9
 Model

The representative agent’s two-periods life-time utility function

1
V = u (c1 , m1 ) + u (c2 , m2 ) (1)
1+ρ
The periodic budget constraints:

P1 y + M0 + P1 T1 = P1 c1 + M1 (2)

P2 y + M1 + P2 T2 = P2 c2 + M2 (3)
M0 is given
Pt Tt represents lump-sum cash transfers received from the government
The representative agent takes these transfers as parametrically given in making his
optimal plans (though in general equilibrium thay are endogenously determined)

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 Model

The constant rate of money supply growth

∆Mt
=µ (4)
Mt−1
µ is a policy instrument of the government
The increase in nominal money supply is disbursed to the representative agent in the
form of lump-sum transfers:

Pt Tt = ∆Mt (5)

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 Household’s Optimization

The household chooses chooses ct and Mt in order to maximize equation(1) subject

to equations (2) and (3)
Assuming an iterior solution, the first order conditions are:
 
uc (c1 , m1 ) um (c1 , m1 ) 1 uc (c2 , m2 )
= + (6)
P1 P1 1+ρ P2

uc (c2 , m2 ) = um (c2 , m2 ) (7)

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 Household’s Optimization

The LHS of equation (6) implies that the marginal utility of spending one dollar on
consumption
The RHS of equation (6) implies that the marginal utility from holding one dollar as
money balances. It consists of
Marginal utility due to reduced transaction costs
Marginal utility due to store of value function of money
Equation (7) relates to the terminal period when money is no longer being used as a
store of value
So in equation (7) only transaction demand for money motive is operative

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 Market Equilibrium

The market clearing conditions for general equilibrium requires

y = c1 = c2 (8)
Multiplying (6) by M1 and using equations (4), (7) and (8), one gets the perfect
foresight equilibrium as
   
1 1
[uc (y , m1 ) − um (y , m1 )] m1 = m2 uc (y , m2 ) (9)
1+ρ 1+µ

uc (y , m2 ) = um (y , m2 ) (10)
These two equations (9) and (10) recursively determine the equilibrium values for
real money supply

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 Market Equilibrium

We assume an additively separable utility function

u (ct , mt ) = u (ct ) + v (mt ) , u ′ (ct ) > 0, v ′ (mt ) > 0 (11)

Then equations (9) and (10) reduce to
   
 ′ 1 1
u (y ) − v ′ (m1 ) m1 = m2 u ′ (y )

(12)
1+ρ 1+µ

u ′ (y ) = v ′ (m2 ) (13)
Substituting mt into equation (1), we get the indirect utility function
 
1
V = u (y ) + v (m1∗ (ρ, y , µ)) + [u (y ) + v (m2∗ (ρ, y ))] (14)
1+ρ

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 Satiation Result

A benevolent policy-maker can pursue an optimal monetary policy

He chooses money growth rate for which the welfare of the representative agent is
maximum
So maximize (14) with respect to µ

∂v ∂m1∗
= v ′ (m1∗ (ρ, y , µ∗ )) =0 (15)
∂µ ∂µ
This implies

v ′ (m1∗ (ρ, y , µ∗ )) = 0 (16)

∗
µ is the optimal money growth rate
This is a variant of Friedman’s satiation result

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 Implication

With the choice of some approprite functional form it can be shown that
 
ρ
µ∗ = − (17)
1+ρ
And
 
ρ
r= (18)
1+ρ
The money growth rate, which is a constant, also represents the inflation rate
µ∗ = π
ρ ρ ρ
R =r +π = + µ∗ = − =0 (19)
1+ρ 1+ρ 1+ρ

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