Essya on the Friedman Version of Quantity Theory of Money

Since 1936, along with Keynes, modern economists discarded the traditional quantity theory which held the view that changes in the price level are determined by changes in the supply of money.

Post-Keynesians, in particular, did not consider that there was any simple link between the supply of money, the level of output and the price level.

In the later fifties, however, interest in the quantity theory was revived by Milton Friedman of Chicago School, in reformulating the theory. He professed that some more direct link might exist between prices and economic activity.

Friedman presented the most sophisticated account of the quantity theory in his paper: “The Quantity Theory of Money A Restatement,” published in 1956.

However, the gist of the content of his view can be easily found in his relatively simple paper: “The Supply of Money and Changes in Prices and Output” submitted to Joint Economic Committee in 1959.

Integrating, the main strands of his thoughts, we may comprehend his theory in terms of the following propositions:

1. Friedman avows that the quantity theory is fundamentally a theory of the demand for money. It is not a theory of output, or of money income, or of the price level.

2. Friedman also concurs with the traditional view that the quantity of money is demanded by the public for using money as a medium of exchange in order to meet their transactions and it thus varies directly and proportionately with the price level. In other words, the demand for money is unitary elastic in relation to the price level.

3. Friedman further concerns with the classical dogma that real income is a major determinant of the demand for money. According to him, the demand for money desired by the community is influenced by the real income.

A change in real income affects the total volume of transactions to be effectuated. Thus, the demand for money changes in the same proportion as the volume of transactions of goods.

4. Friedman goes beyond the traditional quantity theory approach by stressing that money demand is determined not only by price and income levels, but also by an important factor, the cost of holding money or cash balances.

According to him, the cost of holding cash balances can be measured in terms of (i) the rate of interest that can be earned on alternative assets, say, bonds or equities, etc.; (ii) the expected rate of change in price level. Any increase in the rate of interest or an increase in price level leads to decrease in the cash balances the people wish to hold.

5. Friedman seeks to interpret QTM in terms of formalistic demand function as appreciation or depreciation in money value, per rupee of real assets physical goods, which together with P implies the rate of real return on these assets.

rb= the market bond interest rate.

re =the market interest rate of equities.

w = ratio of non-human to human wealth. It is closely linked to the ratio of wealth to income.

u = utility determining variables which tend to influence tastes and preferences.

This demand equation is independent of the normal units used for measuring money variables. It suggests that the amount of money demand changes proportionately to the changes in the unit in which prices and money income are expressed.

The equation, thus, expresses the first degree homogeneous function of P and Y. Therefore the equation is rendered most appropriate to represent the celebrated quantity theory of money, thus:

Friedman, thus, holds that a change in the stock of money causes a change in the price level or income, or in both the variables, in the same direction. If the demand for money is constant, then a change in money supply obviously leads to a proportionate change in the price level, after some adjustments have been made in the given monetary change.

Friedman firmly believes that the country’s real income is more closely related to the total of currency, demand deposits and time deposits of banks, and control of these components of money supply is the best means of achieving and maintaining economic stability.

According to him, the demand function, however, has strategic importance in determining the variables which are significant for the analysis of the economy as a whole, such as the price level or money income.

Friedman here points out that probably resentment against the quantity theory in the 1930s was largely due to the assertion that the demand for money shifts erratically and unpredictably with changes in expectations, hence it cannot be ascertained by specifying a few variables as its determinants. But he has successfully tried to specify a money demand function incorporated in the quantity theory.

Friedman with Anna Schwartz wrote an article “Money and Business Cycles”, wherein he furnished an explanation of the mechanism through which a change in the money supply is likely to be transmitted to a change in economic activity.

He starts with the assumption of a state of monetary equilibrium in the economy, implying a balance between the demand for and supply of money.

Suppose now, the central bank buys government securities in the open market from the commercial banks. Consequently, commercial banks’ lendable reserves increase. With the expansion of bank credit, the demand deposits will also increase.

Consequently, the monetary equilibrium of the economy will be disturbed. As the people are induced to sell securities in their possession on account of attractive prices, the money so realised in exchange by these people are most likely to be invested in buying some earning assets, which are close substitutes.

Say, for example, the sellers of the government securities may purchase high interest yielding co-operate bonds. Similarly, in the second round of transactions, the sellers of high-graded corporate bonds may purchase some other form of assets.

This sort of process goes on viciously. This means no one is likely to keep his proceeds in money only. In the process of selling and buying, the prices of various assets, however, bid high. The rise in prices gradually spreads over the whole range of assets and inventories of consumer goods too.

The rising price level induces the producers to produce more. Consequently, investment, employment and income rise. In this way, an increase in the money supply leads to an increase in the prices and real income.

The process will continue till the monetary equilibrium in the economy is restored with the rise in price and income levels such that cause the demand for money to go up to the supply of money.