MILTON FRIEDMAN

Milton Friedman, father of monetary economics was the most prominent advocate of
free markets. Born in 1912 to Jewish family in New York City, USA. He earned hi
s BA from Rutgers University, MA from the University of Chicago and his PhD was
from the Columbia University in 1946.In 1976, he was awarded Nobel Prize in econ
omics for his achievements in the field of consumption analysis, monetary histor
y and theory and for his demonstration of his complexity of stabilization policy
. He was a self-proclaimed quantity theorist and classical liberal. He is famou
s for his quotation that “inflation is everywhere and at all time a monetary phe
nomenon”.
THE QUANTITY THEORY OF MONEY DEMAND-CLASSICAL
The quantity theory of money explains the unique relationship between the supply
of money and the general price level. The classical quantity theory was propoun
ded by Irvin Fisher, an American economist in 1911.He examined the link between
the quantity of money and(M) and the total amount of spending on final goods and
services produced in the economy (PxY).
P xY=Aggregate nominal income/Total spending
If velocity of money (average number of times per year that a dollar is spend)
V=PxY/M
Multiply both sides of the equation by M
VxM/1=PxY/1 x M/1
MV=PY
Where, M=quantity of money
V=velocity
P=price level
Y=aggregate output or income
MV=PY, states that quantity of money multiplied by the number of times that this
money is spend in a given year must be equal to nominal income. When M changes
nominal income changes in the same direction.

HOW NOMINAL INCOME IS DETERMINED?

He believed that the velocity of money is determined by the institution in an ec
onomy, which control and conduct individual transactions. Institutional and tech
nological features of the economy would affect the velocity slowly over time. So
he assumed that velocity of money would normally constant in the short run.
CAMBRIDGE RESTATEMENT
Divide both sides of the exchange equation by V
MxV/V=PxY/v
M=PY/V
It can be written as,
M=1/VxPY
Here we can replace M in the equation by Md. By using k we can represent 1/V,
Then the equation will be,
Md=kxPY
Where, k is constant
Demand for money is purely a function of income and interest has no affect on th
e demand for money. Fisher assumes that people hold money to conduct transaction
only.
So the demand for money determined
1 By the level of transactions generated by the level of nominal income.
2. By the institution in the economy which affect the way people conduct transac
tions that determines velocity and, hence k.
FINDINGS OF FISHER
* Velocity is constant and Y would always tend to full employment.
* Aggregate output at full employment level, so Y is also fairly constant in sho
rt run.
* Prices are perfectly flexible.
CRITICISM
Critics of the theory argued that money velocity is not stable in the short run,
prices are sticky, and so the direct relationship between money equation and pr
ice level doesn’t hold. Pre world war second economist hadn’t accurate data to v
erify the constant velocity of money and Keynes abandoned the idea of constant v
elocity.
LIQUDITY PREFERENCE THEORY
J M Keynes in his masterpiece ‘the general theory of employment, interest and mo
ney’ attacked the classical quantity theory and abandoned the view of constant v
elocity and emphasized the role of interest rate.
He emphasized three reasons for why people hold money. They are
Transaction Motive (Mdt)
Money is medium of exchange to conduct day to day transactions. Tdm is proportio
nal to income.
Mdt=f(y)
Precautionary Motive (Mdp)
Money as cushion against unexpected contingencies and any economic misfortune.
Mdp=f(y)
Speculative Motive (Mds)
Money as a store of wealth.Mds depends not only income but also the rate of inte
rest rate.
Keynes divided the asset in to two, viz money and bond. He assumes that the expe
cted return on money is zero. Whereas the expected return on bond consists of in
terest rate and the expected rate of capital gain.
When interest rate increases prices of bond falls, so people will be more likely
to hold their wealth as money rather bonds and the demand for money will be low
, so money demand is negatively related to the level of interest rate. Keynes de
veloped liquidity preference function, which says that the demand for money bala
nce (Md/p) is a function of interest rate and income.
Md/p=f(y, i)
I=nominal interest rate
Y=real income Md/p=real money balances
Transaction demand for money and precautionary demand for money is positively re
lated to Y and speculative demand for money is negatively related to the interes
t rate. So
Md/p=L1(Y)+L2(i)
So the liquidity preference equation can be write as ,
P/Md=1/f (I,y)
Md=Ms
Multiply both sides of the equation by Y
V=PY/M=Y/f
(i,y)
FREDMAN’S RESTATEMENT
Friedman developed a theory of the demand in his famous article ‘’the quantity t
heory of money a restatement’’ in 1956.In the words of Friedman ‘’in monitory th
eory that analysis was taken to meet that in the quantity equation MV=PY, the te
rm for velocity could be taken as determined independently of the other terms in
the equation, and that a result changes in the quantity money of money would be
reflected either in prices or output.
According to Friedman the demand for money is affected by some factors which inf
luence the demand for any asset. The demand for money is a function of the recou
rses available to the individual and the expected return on other assets relativ
e to the expected return on money.
Md/p=f(Yp,rb,rm,re, пe,w,u
)
Md/p=f(Yp, ,rb-rm, re- rm, пe- rm)
Md/p=demand for real money
Yp=permanent income (+ve)
rb=expected return on bond (-ve)
rm=expected return on money(-ve)
re=expected return on equity (-ve)
SПe=expected inflation rate (-ve)
w=proportion of human and non human wealth(-ve)
u=other factors influencing demand for money
The demand for any asset is positively related to wealth, money demand is positi
vely related to permanent income. The permanent income is stable and demand for
money will not fluctuate much with business cycle movement.
There are three types of asset
1. Bond 2.equity 3.goods
The incentives for holding these asset rather than money are represented by the
expected return on each of these assets relative to the expected return on money
is influenced by two factors.
1. The service provided by the bank.
2. The interest payment on money balances.
Friedman’s major insight is that interest rates should have little effect on mon
ey demand. In Friedman’s money demand function ,the rb-rm mean the expected retu
rn on bond and equity relative to money, when they rise, the relative expected r
eturn on money falls, and the demand for money falls. Пe-rm means the expected r
eturn on goods relative to money, when it raises, the expected return on goods r
elative to money rises, and the demand for money falls.
The conclusion of Friedman’s theory is that velocity is predictable and the equa
tion can simplified in to
Md/p=f (Yp)
EMPHIRICAL EVIDENCE
Prior to 1970, evidence strongly supported stability of the money demand functio
n. Since 1973 instability of money demand function caused velocity to be herder
to predict.
• Is money demand for money sensitive to the changes in interest rate?
If not velocity is more likely to be a constant, then money supply has a tight
link to aggregate spending.
The more sensitive, the more increasingly volatile v will be
Extreme situation: liquidity trap-infinitely elastic money demand
• Is money demand is stable?
If yes, velocity would be unpredictable.
Helps central bank decide whether to target money growth or inflation.
MESSEGES OF FRIEDMAN
• The correlation between interest rate and money demand is week
• The random fluctuation in the demand for money should be small and thus
his money demand equation predicts well money demand and hence velocity.
• If so, a change in the quantity of money demand should produce a predict
able change in aggregate spending.
• Finally, can also account for pro cyclical behavior of velocity.
DIFFERENTS BETWEEN KEYNES AND FRIEDMAN
Friedman
• Include alternative asset like bond, equities, durable goods to money, b
ut Keynes focused on the choice of money versus bond.
• Viewed money and goods are substitute.
• The expected return on money is not constant; however rb-rm does stag c
onstant as interest rate rise and interest rate have little effect on the demand
for money.
• money demand can be approximated by Md/p=f(Yp)
• Permanent income is stable and therefore demand for money is stable and
velocity is predictable.
• The interest elasticity of money demand is low, for Keynes it is extrem
ely high.
CONCLUSION
M=PxY/V
• classical quantity theory
V and Y are unaffected by changes in M
• Keynes money demand theory
V is sensitive to interest rate
• Friedman quantity theory
Y/V is roughly constant