Monetarism and Friedman’s Restatement of Quantity Theory of Money

INTRODUCTION

Monetarism

• The classical quantity theory of money stated that an increase in money supply leads to an equal and proportionate rise in the price level.

• This theory lost credibility after the Great Depression of the 1930s, when rising unemployment and falling output could not be explained by classical ideas.

• J.M. Keynes criticised the quantity theory, arguing that expansion of money supply does not necessarily raise prices and that money is not always a dominant factor in determining economic activity.

• Early Keynesians believed that depression was not mainly caused by contraction of money supply and that monetary expansion might be ineffective.

• They argued that at low interest rates the demand for money becomes highly elastic, creating a liquidity trap, so increases in money supply fail to reduce interest rates.

• Since investment was considered highly interest-inelastic, even if interest rates fell, investment would not rise significantly, making expansionary monetary policy ineffective.

• Therefore, early Keynesians concluded that “money does not matter” much in influencing output and employment.

• In the 1950s and 1960s, Milton Friedman revived and reformulated the quantity theory, arguing that money plays a crucial role in determining both price level and economic activity.

• Friedman claimed that the events of the 1930s were misinterpreted and did not invalidate the quantity theory, but instead showed the harmful effects of monetary contraction.

• In restating the theory, Friedman incorporated Keynes’s insights on demand for money as an asset and developed a new macroeconomic approach known as monetarism, re-emphasising the central importance of money in the economy.

Five Propositions of Friedman’s Monetarism are:

1. The level of economic activity in current rupee terms, that is, the level of nominal income is determined primarily by the stock of money.
2. In the long run, the effect of expansion in money supply is primarily on the price level and other nominal variables. In the long run, the level of economic activity in real terms, that is level of real output and employment are determined by the real factors such as stock of capital goods, the state of technology, the size and quality of labour force. Therefore, longrun aggregate supply curve of output (LAS) is a vertical straight line.
3. In the short run price level as well as the level of real national income (i.e., real output) and employment are determined by the supply of money and demand for money. In the shortrun changes in the quantity of money are the dominant factor causing cyclical fluctuations in output and employment.
4. In the short run, the effect of expansion in money supply is divided between the rise in price level and increase in real natural income (GDP) depending on the elasticity of short-run aggregate supply curve. However, according to Friedman, in the long run wages and prices are perfectly flexible and lead to the establishment of equilibrium at full employment (i.e., potential GDP) level.
5. Unlike Keynes’s monetary theory increase in money supply affects prices directly and not indirectly through its effect on rate of interest.

• Friedman’s conclusions are based on a restatement of the classical quantity theory of money.

• His modern version of the theory is fundamentally grounded in his theory of demand for money.

• Friedman treats money as an asset and analyses its demand within a broader theory of wealth and portfolio choice.

• The explanation of economic activity and the price level in his framework begins with the analysis of money demand.

• From his theory of money demand, Friedman derives conclusions about the determination of economic activity and the price level in both the short run and the long run.

Demand for Money and Friedman’s Restatement of Quantity Theory of Money

• Friedman’s modern quantity theory of money is very close to the Cambridge’s cash balance approach. Friedman and other modern monetarists have emphasised that k in Cambridge approach should be interpreted as proportion of nominal income that people desire or demand to hold in the form of money balances.
• Interpreting k in this desired or ex-ante sense helps to convert the Cambridge equation of exchange into a theory of nominal income. Thus, rewriting Cambridge equation as demand for money (\(M_d\) ) we have:

$$M^d\;=\;kPY……..(1)$$

where k is assumed to be constant. PY is the nominal income obtained by multiplying the real income (Y) with the price level (P).

• Like Cambridge economists, Friedman regards the quantity of money being fixed exogenously by the central bank of the country. If M represents the quantity of money set exogenously by the central bank we have the equation which describes the Cambridge theory of determination of nominal income.

$$M\;=\;M^d\;=\;\overline kPY\;……..\;(2)\\\\M.\frac1{\overline k}\;=\;PY\;\;……..\;(3)$$

According to Cambridge equation (3), nominal income is determined by the supply of money (M) multiplied by the reciprocal of constant k.

• Friedman modified the Cambridge theory of money demand by incorporating key elements of Keynes’s theory.

• Keynes emphasised that money is not only a medium of exchange but also an asset, held as part of wealth.

• To simplify analysis, Keynes grouped all non-monetary assets into a single category called bonds and analysed how people allocate wealth between money and bonds.

• According to Keynes, the allocation of wealth depends mainly on the level of income and the rate of interest.

• In the Cambridge approach, k represents the proportion of income held as money, but Keynes interpreted k as the proportion of income people desire to hold as money for asset purposes.

• Friedman accepted Keynes’s view of money as an asset but broadened the analysis beyond bonds.

• In Friedman’s theory of demand for money, determinants include income, interest on bonds, and rates of return on other assets such as equity shares and durable goods including real property.

Thus, Friedman’s theory of demand for money can be written as follows:

$$M^d\;=\;F\;(P,\;Y,\;r_B,\;r_E,\;r_D)$$

P = price level

Y = level of real income

\(r_B\) = rate of interest on bonds

\(r_E\) = rate of return on equity shares

\(r_D\) = rate of return on durable goods

• In Friedman’s money demand function, the product of price level (P) and real income (Y) gives nominal income (PY), showing that demand for money depends directly on nominal income.

• A higher level of nominal income leads to a greater demand for money balances.

• For a given nominal income, demand for money also depends on the rates of return on non-monetary assets, similar to Keynes’s view.

• However, unlike Keynes, Friedman assumes the money demand function is stable, meaning it does not shift unpredictably over time.

• Stability implies that the key variables in the function systematically determine the quantity of money demanded.

• By incorporating this stable demand for money, Friedman restates the Cambridge equation and highlights the crucial role of money demand in determining the level of economic activity.

Thus, Friedman money demand function can be restated as follows:

$$M^d\;=\;k\;(r_B,\;rE,\;r_D)\;PY\;…………\;(4)$$

• In the Cambridge cash-balance equation, k represents the proportion of income held as money and is mainly influenced by the transactions demand for money.

• In Friedman’s theory, k is not constant but depends on the rates of return on alternative non-monetary assets such as bonds, equity shares, and durable goods.

• When returns on these alternative assets rise, people prefer holding them instead of money, causing k to fall.

• Thus, the desire to hold money is explained through portfolio choice and comparison of returns across assets.

• By redefining k in this way, Friedman systematically restated the quantity theory of money, incorporating Keynes’s insight about money as an asset while preserving the central role of money in economic analysis.