Modern QTM refers to Friedman’s reformulation or restatement of the earlier simple or crude QTM (or Friedman’s QTM), first pre­sented by him in his well-known article, “Quantity Theory of Money— A Restatement” (Friedman, 1956), repeated in Friedman (1968 b). The reformulation is a sophisticated attempt to rid the earlier crude version of the QTM of its shortcomings and overstatements or its main vulnerable aspects by underplaying the over-simple and crude ‘quan­tity equation’ and bringing instead a well-articulated theory of the demand function for money as the centre piece of the QTM. Not all monetarists, however, agree to this shift in focus. But that is another matter.

As we have seen above, the QTM was usually stated in the form of an equation that looked like a tautology. Even the Cam­bridge cash-balance equation was based on the crudest form of the demand function for money that did not point the possibil­ity of any substitution between money and non-money assets and whose K, though a choice variable of the public, was nevertheless a constant.

Thus, this equation also (despite its potential) failed to make the QTM a behavioural rather than a mechanical relation between M and Y and failed to provide systematically (on the basis of a well- articulated theory) for those factors that intervene the process whereby ∆M gets translated into ∆Y. Besides, the QTM needed rehabilitation against the devastating onslaughts to Keynes (1936) and his followers which had brought monetary policy into much disrepute.

Keynes’ criticism was directed towards the stability of V (or K or the demand for money). He argued that under conditions of unemploy­ment equilibrium V was highly unstable and would, for the most part, passively adapt to whatever changes independently occurred in money income or the stock of money.


Hence, under such conditions, the QTM equation was largely useless for policy or prediction. In the limit­ing case of the ‘liquidity trap’, in fact, Y can change without a change in M and M can change without a change in Y (because of shifts bet­ween M1 and M2 corresponding to L1 and L2—see equation Md = L1(Y) + L(r). (11.3) and after).

Md = L1(Y) + L(r). (11.3)

Keynes’ followers have argued further that, outside of the liquid­ity trap, changes in the quantity of money would affect only the interest rate on bonds and that changes in this rate in turn would have little further effect, because they argued that both consumption expendi­tures and investment expenditures were nearly completely insensitive to changes in interest rates. That being so, a change in M would merely be offset by an opposite and compensatory change in V, leaving P and Y almost completely unaffected. Tobin (1961) also asserted that only paper securities were substitutes for money, not real assets.

From all this, Friedman (1968 b) concluded that the issues raised for the QTM by the Keynesian analysis were empirical rather than theoretical. For example, is it a fact that the quantity of money demanded in a function primarily of current income and of the bond rate of interest? Is it a fact that the amount demanded is highly elastic with respect to this rate, especially when this rate is quite low?


Is it a fact that expenditures are highly inelastic with respect to such a rate of interest? Or, is it a fact that velocity is a highly unstable and unpredictable magnitude that generally varies in a direction opposite to that of the quantity of money? Friedman’s restatement of the QTM provides a firm analytical basis for such questions and his extensive empirical work and that of his camp-followers much empirical evi­dence in answer to these and related empirical questions.

With the above introduction in mind, we now proceed with sub­stantive discussion of the key points of Friedman’s modern QTM, dis­cussed below:

1. The QTM is a Theory of the Demand for Money:

In his restate­ment (1956), Friedman has clearly stressed that “the quantity theory is in the first instance a theory of the demand for money.” He has gone on to add that “it is not a theory of output, or of money income, or of the price level,” because “any statement about these var­iables requires combining the quantity theory with some specifications about the conditions of supply of money and perhaps about other var­iables as well.”


2. The Stability and Importance of the Demand Function for Money:

In the context of Keynes’ criticism, Friedman has laid much stress on the stability of the demand for money function. As an empirical hypothesis he has claimed that this function is more stable than functions such as the consumption function that are offered as alternative key relations.

By stability he means functional stability that the functional relation between the quantity of money demanded and the variables that determine it is highly stable. This means that even the sharp rise in the velocity of circulation of money during hyperinflations is entirely consistent with a stable functional relation, as Cagan (1956) clearly demonstrated in his classic study, ‘The Monet­ary Dynamics of Hyperinflation’, where he could explain successfully this dynamic in terms of a highly stable demand for money as a function of only the expected rate of change of prices.

This further means that the real quantity of money demanded per unit of output, or V, is not to be regarded as numerically constant over time. Further, functional stability also requires that the variables that it is empirically important to include in the function should be sharply limited and explicitly specified. For, to treat too many variables as empirically significant is to empty the hypothesis of its empirical content.


Modern QTM not only regards the demand function for money as stable, it also regards this function as playing a vital role in determining values (or time paths) of variables of great importance for the analysis of the economy as a whole, such as the level of Y and of prices. It is this consideration that leads the modern quantity theorist to put great emphasis on the demand for money than on, say, the demand for pins, even though the latter might be as stable as the former.

We need not repeat the dis­cussion except to note that Friedman’s reformulation of the demand for money and so of the QTM has been strongly influenced by the Keynesian analysis of liquidity preference. So, it emphasizes the role of money as an asset and treats the demand for money as part of capital or wealth theory, concerned with the composition of the balance sheet or portfolio of assets, (More on this under the next point.) This marked a significant departure of Friedman’s modern QTM from the earlier

QTM which has been based on money viewed as only a medium of exchange.

(3) Monetary Transmission Mechanism:


The earlier statements of the QTM had practically neglected any discussion of the monetary transmission mechanism, that is, of the channels whereby monetary influences are transmitted to other sectors of the economy, particularly the commodity market.

In simple words, they lacked any explanation of how changes in the quantity of money came to affect the commodity market. And it is this lack of the explanation of transmission mechanism which had rendered the earlier statements of the QTM mechanical.

We had sketched above one plausible explanation of the transmission mechanism implicit in the Cambridge QTM. But its extreme assumptions and total neglect of portfolio choice should have struck the readers as near-caricature of reality and may be left them breathless.

The Keynesian interest-rate mechanism also suffers from being excessively narrow. Modern QTM has widened greatly the range of substitution between money and non-money assets, not restricting the latter to only financial assets, but including real physical goods as well.


In Friedman’s words, “emphasis on the role of money as a component of wealth is important because of the variables to which it directs attention. It is important also for its implications about the process of adjustment to a difference between actual and desired stocks of money [that is, about the transmission mechanism]”.

Since any such discrepancy is a disturbance in a balance sheet, “it can be cor­rected in either of two ways by a rearrangement of assets and liabilities, through purchase, sale, borrowing and lending or by the use of current flows of income and expenditure to add to or subtract from some assets and liabilities. The Keynesian liquidity-preference analysis stressed the first and, in its most rigid form, one specific re­arrangement: that between money and bonds.

The earlier quantity theory stressed the second to the almost complete exclusion of the first. The reformulation [that is, modem QTM] enforces consideration of both”. In our view, the relative importance of the two ways will differ from one economy to the other, depending on the level of financial development in an economy.

About the process of portfolio adjustment, Friedman has stressed. Its two features:

(i) That it is time consuming & that whereas pure portfolio substitution may be relatively fast, the adjustment through flows is generally long drawn;

(ii) That portfolio adjustment does not stay restricted to merely one asset of immediate impact (e.g. bonds of the Keynesian liquidity-preference theory), but tends to spread to other assets and liabilities in a balance sheet, as a change in one asset price spreads to changes in other asset prices in ever-widening ripples. In the process, relative prices of capital items and their services are also affected.

On another occasion Friedman has argued that the portfolio suo-situation process stimulates directly spending upon items not normally considered to be assets at all ( Friedman, 1972). He writes:

“The major difference between us and the Keynesians is less in the nature of the process [of portfolio substitution] than in the range of assets considered [emphasis added]. The Keynesians tend to concentrate on a narrow range of marketable assets and recorded interest rates.

We insist that a far wider range of assets and interest rates must be taken into account—such assets as durable and semi-durable consumer goods, structures and other real property. As a result, we regard the market rates stressed by the Keynesians as only a small part of the total spectrum of rates that are relevant…” He continues:

“After all, it is most unusual to quote houses, automobiles, let alone furniture, household appliances, clothes and so on, in terms of the ‘interest rate’ implicit in their sales and rental prices. Hence the prices of these items continued to be regarded as an institutional datum, which forced the transmission process to go through an extremely narrow channel.”

(4) Independence of the Factors affecting Demand and Supply of Money:

Modern QTM holds that there are important factors affecting the supply of money that do not affect the demand for money. A stable demand function is useful precisely in order to trace out the effects of changes in supply, which means that it is useful only if supply is affected by at least some factors other than those regarded as affecting demand.

(5) The Relation between M and Y:

The centre piece of Cam­bridge QTM is the relation between M and Y. To a degree, this is also implied in Fisher’s equation of exchange. But as said under point (1) above, with Friedman QTM is not a theory of Y. The reason is that with the demand function for money (and so also V) of Friedman’s specification, even if we assume the supply of money to be autonomously given, the equilibrium equa­tion of modern QTM will read as Y = V(Y, w, rm, rb, re, pe, u).M. (12.16).

(M/p)d =f(y, w, rm, rb, repe, u) (11.5)

Obviously, this equation alone is not sufficient to determine Y. To convert the above equation into a complete model of Y determina­tion, it will be “necessary to suppose either that the demand for money is highly inelastic with respect to the variables in V or that all these var­iables are to be taken as rigid and fixed”.

Making either of these assumptions reduces modern QTM virtu­ally (or for all practical purposes) to simple Cambridge QTM, though under modern QTM, any of the variables in V can always be resur­rected as needed—an option not open to Cambridge equation.

Thus, the work of Friedman and Meiselman (1964) in which ∆Y was explained by V∆ M appears puzzling if viewed in the light of Fried­man’s modern QTM. The only plausible answer to the puzzle seems to be provided by the title of their study (1964) The Relative Stability of Monetary Velocity and Investment Multiplier in the United States”.

In this study, Friedman and Meiselman had only pitted V against the Keynesian multiplier as statistically more stable of the two, despite the observed variability of V due to the variance in its determinants, studied elsewhere (e.g., in Selden, 1956). In other words, Friedman holds that, as a matter of experience (not theory), though the relation between M and Y is not very close, that between ∆ M and ∆ Y is observed to be quite close under a wide variety of conditions.

(6) Relation between M and P:

Most economists think that the QTM is essentially a theory of prices (P), but modern QTM rejects this view. As we have seen under point (5) above, equation as Y = V(Y, w, rm, rb, re, pe, u).M. (12.16) gives at most a theory of Y. But it tells us nothing about how much of any change in Y is reflected in real output and how much in prices. To infer this requires bringing in outside information, as, for example, that real output is at its feasible maximum . Only then, we can translate the change in Y into change in P.

In practical applications it means that movements in P should be related with movements in the stock of money per unit of output rather than movements in M per se. In Friedman’s words “inflation can be prevented if and only if the stock of money per unit of output can be kept from increasing appreciably.”