learning objective
- What is the quantity theory of money, and how was it improved
by Milton Friedman?
Building on the work of earlier scholars, including Irving
Fisher of Fisher Equation fame, Milton Friedman improved on
Keynes’s liquidity preference theory by treating money like any
other asset. He concluded that economic agents (individuals, firms,
governments) want to hold a certain quantity of real, as opposed to
nominal, money balances. If inflation erodes the purchasing power
of the unit of account, economic agents will want to hold higher
nominal balances to compensate, to keep their real money balances
constant. The level of those real balances, Friedman argued, was a
function of permanent income (the present discounted value of all
expected future income), the relative expected return on bonds and
stocks versus money, and expected inflation.
More formally,
M d / P : f ( Y p <+> , r b − r m <−> , r s − r m
<−> , π e − r m <−> )
where
Md/P = demand for real money balances (Md
= money demand; P = price level)
f means “function of” (not equal to)
Yp = permanent income
rb − rm = the expected return on bonds
minus the expected return on money
rs − rm = the expected return on stocks
(equities) minus the expected return on money
πe − rm = expected inflation minus the
expected return on money
<+> = increases in
<−> = decreases in
So the demand for real money balances, according to
Friedman, increases when permanent income increases and declines
when the expected returns on bonds, stocks, or goods increases
versus the expected returns on money, which includes both the
interest paid on deposits and the services banks provide to
depositors.
Stop and Think Box
As noted in the text, money demand is where the action is these
days because, as we learned in previous chapters, the central bank
determines what the money supply will be, so we can model it as a
vertical line. Earlier monetary theorists, however, had no such
luxury because, under a specie standard, money was supplied
exogenously. What did the supply curve look like before the rise of
modern central banking in the twentieth century?
The supply curve sloped upward, as most do. You can think of
this in two ways, first, by thinking of interest on the vertical
axis. Interest is literally the price of money. When interest is
high, more people want to supply money to the system because
seigniorage is higher. So more people want to form banks or find
other ways of issuing money, extant bankers want to issue more
money (notes and/or deposits), and so forth. You can also think of
this in terms of the price of gold. When its price is low, there is
not much incentive to go out and find more of it because you can
earn just as much making cheesecake or whatever. When the price of
gold is high, however, everybody wants to go out and prospect for
new veins or for new ways of extracting gold atoms from what looks
like plain old dirt. The point is that early monetary theorists did
not have the luxury of concentrating on the nature of money demand;
they also had to worry about the nature of money supply.
This all makes perfectly good sense when you think about
it. If people suspect they are permanently more wealthy, they
are going to want to hold more money, in real terms, so they can
buy caviar and fancy golf clubs and what not. If the return on
financial investments decreases vis-à-vis money, they will want to
hold more money because its opportunity cost is lower. If inflation
expectations increase, but the return on money doesn’t, people will
want to hold less money, ceteris paribus, because the relative
return on goods (land, gold, turnips) will increase. (In other
words, expected inflation here proxies the expected return on
nonfinancial goods.)
The modern quantity theory is generally thought superior to
Keynes’s liquidity preference theory because it is more complex,
specifying three types of assets (bonds, equities, goods) instead
of just one (bonds). It also does not assume that the return on
money is zero, or even a constant. In Friedman’s theory, velocity
is no longer a constant; instead, it is highly predictable and, as
in reality and Keynes’s formulation, pro-cyclical, rising during
expansions and falling during recessions. Finally, unlike the
liquidity preference theory, Friedman’s modern quantity theory
predicts that interest rate changes should have little effect on
money demand. The reason for this is that Friedman believed
that the return on bonds, stocks, goods, and money would be
positively correlated, leading to little change in rb −
rm, rs − rm, or πe −
rm because both sides would rise or fall about the same
amount. That insight essentially reduces the modern quantity theory
to Md/P = f(Yp <+>).
key takeaways
- According to Milton Friedman, demand for real money balances
(Md/P) is directly related to permanent income
(Yp)—the discounted present value of expected future
income—and indirectly related to the expected differential returns
from bonds, stocks (equities), and goods vis-à-vis money
(rb − rm, rs − rm,
πe − rm ), where inflation (π) proxies the
return on goods.
- Because he believed that the return on money would increase
(decrease) as returns on bonds, stocks, and goods increased
(decreased), Friedman did not think that interest rate changes
mattered much.
- Friedman’s modern quantity theory proved itself superior to
Keynes’s liquidity preference theory because it was more complex,
accounting for equities and goods as well as bonds.
- Friedman allowed the return on money to vary and to increase
above zero, making it more realistic than Keynes’s assumption of
zero return.