In this article we will discuss about the quantity theory of money by Friedman.

Also known as the Hicks-Hansen model, the IS-LM curve is a macroeconomic tool used to show how interest rates and real economic output relate. IS refers to Investment-Saving while LM refers to Liquidity preference-Money supply. These curves are used to model the general equilibrium and have been given two equivalent interpretations. About the interest rate, it is the return on real capital, and not a variable that might be affected by monetary policy. There is no monetary policy, there is no money, in the model. Likewise when we open up the economy: the exchange rate is a real exchange rate, adjusted for relative price levels, and in long-run equilibrium it is not affected.

Friedman in his essay, “The Quantity Theory of Money—A Restatement” published in 1956 beautifully restated the old quantity theory of money. In his restatement he says that “money does matter”. For a better understanding and appreciation of Friedman’s modern quantity theory, it is necessary to state the major assumptions and beliefs of Friedman.

First of all Friedman says that his quantity theory is a theory of demand for money and not a theory of output, income or prices.

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Secondly, Friedman distinguishes between two types of demand for money. In the first type, money is demanded for transaction purposes. It serves as a medium of exchange. This view of money is the same as the old quantity theory. But in the second type, money is demanded because it is considered as an asset. Money is more basic than the medium of exchange. It is a temporary abode of purchasing power and hence an asset or a part of wealth. Friedman treats the demand for money as a part of the wealth theory.

Thirdly, Friedman treats the demand for money just like the demand for any durable consumer good.

The demand for money depends on three factors:

(a) The total wealth to be held in various forms

(b) The price or return from these various assets and

Friedman considers five different forms in which wealth can be held, namely, money (M), bonds (B), equities (E), physical non-human goods (G) and human capital (H). In a broad sense, total wealth consists of all types of “income”. By “income” Friedman means “aggregate nominal permanent income” which is the average expected yield from wealth during its life time.

The wealth holders distribute their total wealth among its various forms so as to maximise utility from them. They distribute the assets in such a way that the rate at which they can substitute one form of wealth for another is equal to the rate at which they are willing to do.

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Accordingly the cost of holding various assets except human capital can be measured by the rate of interest on various assets and the expected change in their prices. Thus Friedman says there are four factors which determine the demand for money. They are: price level, real income, rate of interest and rate of increase in the price level.

The demand for money is unitarily elastic. The relationship between the demand for money and real income (output of goods and services) is also direct. But it is not proportional as in the case of price. Thus while changes in the price level cause direct and proportional changes in the demand for money, changes in real income create direct but more than proportional changes in the demand for money.

The rate of interest and the rate of increase in the price level constitute the cost of holding cash balances. If money is kept in the form of cash, it does not earn any income. But if the same money is lent out, it could earn some income in the form of interest to the owner.

The interest is the cost of holding cash. At higher interest rate the demand for money would be less. On the other hand, a lower rate of interest creates an increase in the demand for money. Thus there is an inverse relationship between the rate of interest and the demand for money.

The rate of increase in the price level also influences the demand for money. There is an inverse relationship between the rate of increase in the price level and the demand for money. When the price level increases at a high rate, the cost of holding money will increase.

The people would like to hold smaller cash balances. The demand for money will decline. On the other hand when the price level increases at a low rate, the cost of holding money will decline and the demand for money increases.

Fourthly, Friedman believes that each form of wealth has its own characteristics and a different yield or return. In a broad sense money includes currency, demand deposits and time deposits which yield interest. Money also yields real return in the form of convenience, security etc., to the holder which is measured in terms of price (P). When the price level falls, the rate of return on money is positive because the value of money increases. When the price level rises, the value of money falls and the rate of return is negative. Thus P is an important variable in the demand function of Friedman.

The rate of return on bonds, equities and physical assets consists of currently paid interest rate and changes in their prices. As far as human wealth is concerned it is very difficult to measure the conversion of human into non-human wealth due to institutional constraints. But there is some possibility of substituting human wealth for non-human wealth.

Freidman calls the ratio of non-human wealth to human wealth or ratio of wealth to income as W. According to Friedman, income elasticity of demand for money is greater than unity. Besides, there are certain variables like the tastes and preferences of the wealth holders which also affect the demand functions. These variables are represented by m.

Friedman’s Demand Function:

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On the basis of the above assumptions and formulations, Friedman has derived a demand function for an individual wealth holder.

It may be symbolically expressed as

Where M is the total demand for money, P is the general price level,

r_b is the market interest rate on bonds,

r_e is the market interest rate on equities,

1/p. dp/dt is the nominal return from physical goods,

W is the ratio of non-human to human wealth,

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Y is the money income available to the wealth holder,

m is the variables affecting tastes and preferences on the wealth holders.

By assuming rb and re to be stable, Friedman replaces the variables representing the return on bonds and equities

in equation I by simply r_b and r_e. As a result of this replacement, the demand function can be written as

Further Friedman says that when there are changes in price and money income, there will be a proportionate change in the demand for money. This means that equation 2 must be regarded as homogenous of the first degree in P and Y, so that equation 2 becomes as

In this form, the equation 4 expresses the demand for real cash balances as a function of “real” variable.

In Friedman’s modern quantity theory of money, the supply of money is independent of demand for money. Due to the actions of the monetary authorities, the supply of money changes, whereas the demand for money remains more or less stable. It means that the amount of money which people want to have as cash or bank deposits is more or less fixed to their permanent income.

If the central bank purchases securities, people who sell securities to the central bank receive money and this leads to an increase in their cash holdings. The people will spend this excess money partly on consumer goods and partly by purchasing assets. This spending will reduce their cash balances and at the same time there is a rise in the national income.

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On the other hand, when the central bank sells securities, the money holding of the people reduces, in relation to their permanent income. Therefore, they will try to increase their cash partly by reducing their consumption and pa

Long Run Market For Real Money Balances