When, how, and why did Friedman’s modern quantity theory of
money prove an inadequate guide to policy?
Until the 1970s, Friedman was more or less correct.
Interest rates did not strongly affect the demand for money, so
velocity was predictable and the quantity of money was closely
linked to aggregate output. Except when nominal interest rates hit
zero (as in Japan), the demand for money was somewhat sensitive to
interest rates, so there was no so-called liquidity trap (where
money demand is perfectly horizontal, leaving central bankers
impotent). During the 1970s, however, money demand became more
sensitive to interest rate changes, and velocity, output, and
inflation became harder to predict. That’s one reason why
central banks in the 1970s found that targeting monetary aggregates
did not help them to meet their inflation or output goals.
Stop and Think Box
Stare at Figure 20.1 for a spell. How
is it related to the discussion in this chapter? Then take a gander
at Figure 20.2 . In addition to giving us a new perspective on
Figure 20.1 , it shows that the velocity of money (velocity =
GDP/M1 because MV = PY can be solved for V: V = PY/M) has increased
considerably since the late 1950s. Why might that be?
The chapter makes the point that
velocity became much less stable and much less predictable in the
1970s and thereafter. Figure 20.1 shows that by measuring the
quarterly change in velocity. Before 1970, velocity went up and
down between −1 and 3 percent in pretty regular cycles. Thereafter,
the variance increased to between almost −4 and 4 percent, and the
pattern has become much less regular. This is important because it
shows why Friedman’s modern quantity theory of money lost much of
its explanatory power in the 1970s, leading to changes in central
bank targeting and monetary theory.
Figure 20.2 suggests that velocity
likely increased in the latter half of the twentieth century due to
technological improvements that allowed each unit of currency to be
used in more transactions over the course of a year. More efficient
payment systems (electronic funds transfer), increased use of
credit, lower transaction costs, and financial innovations like
cash management accounts have all helped to increase V, to help
each dollar move through more hands or the same number of hands in
less time.
The breakdown of the quantity theory had severe repercussions
for central banking, central bankers, and monetary theorists. That
was bad news for them (and for people like myself who grew up in
that awful decade), and it is bad news for us because our
exploration of monetary theory must continue. Monetary economists
have learned a lot over the last few decades by constantly testing,
critiquing, and improving models like those of Keynes and Friedman,
and we’re all going to follow along so you’ll know precisely where
monetary theory and policy stand at present.
Stop and Think Box
Examine Figure 20.3 , Figure 20.4 , and
Figure 20.5 carefully. Why might velocity have trended upward to
approximately 1815 and then fallen? Hint: Alexander
Hamilton argued in the early 1790s that “in countries in which the
national debt is properly funded, and an object of established
confidence, it answers most of the purposes of money. Transfers of
stock or public debt are there equivalent to payments in specie; or
in other words, stock, in the principal transactions of business,
passes current as specie. The same thing would, in all probability
happen here, under the like circumstances”—if his funding plan was
adopted. It was, and interest rates fell dramatically as a result
and thereafter remained at around 6 percent in peacetime.
Velocity rises when there are money
substitutes, highly liquid assets that allow economic agents to
earn interest. Apparently Hamilton was right—the national debt
answered most of the purposes of money. Ergo, not as much M1 was
needed to support the gross domestic product (GDP) and price level,
so velocity rose during the period that the debt was large. It then
dropped as the government paid off the debt, requiring the use of
more M1.
key takeaways
Money demand was indeed somewhat sensitive to interest rates
but velocity, while not constant, was predictable, making the link
between money and prices that Friedman predicted a close one.
Friedman’s reformulation of the quantity theory held up well
only until the 1970s, when it cracked asunder because money demand
became more sensitive to interest rate changes, thus causing
velocity to vacillate unpredictably and breaking the close link
between the quantity of money and output and inflation.