Question

Explain carefully the Keynesian theory of money demand. Then discuss the critiques made by Friedman to the Keynesian theory of money demand.

Answer 1

According to the Keynesian theory of Money demand:
The Keynesian revolution overwhelmed the traditional quantity theory and for a long time its acceptance was so complete that it was above challenge.
This lofty throne disintegrated with the advent of the 1970's and the combination of rapid monetary growth and accelerated inflation.
Friedman adopted an empirical approach to the quantity theory and he expresses his conclusions as follows:
'"The Quantity Theory has increasingly become the generalization that changes in desired real balances (in the demand for money) tend to proceed slowly and gradually or to be the result of events set in train by prior changes in supply, whereas, in contrast.
Substantial changes in the supply of nominal balances can and frequently do occur independently of any changes in demand.
The conclusion is that substantial changes in prices or nominal income are almost always the result of changes in the nominal supply of money.
This approach has tended to be labelled as the modern quantity theory and indeed it is evident from the quote above that its conclusions are Similar even if the reasoning differs.
The modern quantity theory is in fact very much a development of the Cambridge cash balance formulation of the quantity theory.
Just as in that formulation the modern quantity theory is concerned with the determination of the money national income incorporating prices and output.
Furthermore, in doing so, both view money in its role as an asset, looking at the demand for money in terms of an exercise in portfolio selection.
Milton Friedman, at the forefront of the modern quantity theory, outlines a stable demand for money and its determinants.
In doing so he distinguishes between different uses for money; as an asset and as a factor of production, by considering separately the demand for money of ultimate wealth holders and of business enterprises.
Starting with the former, Friedman said that the demand for money was a function of several variables. First was total wealth in its capacity as a budget constraint in determining resources available for distribution among different assets.
The critiques made by Friedman to the Keynesian theory of money demand.
Given difficulties in measuring total wealth, income tended to be used as a proxy for it, but Friedman preferred a concept of permanent income, as nominal income is too prone to year-to-year fluctuations and because he believed that permanent income provided a more realistic base for consumption.
Second he considered the division of wealth between non-human and human forms. This is relevant because non-human wealth is more liquid and human wealth tends not to be readily realizable into non-human wealth - borrowing on the collateral of earning power is limited.
Hence the higher the ratio of non-human to human wealth the higher the demand for money is likely to be. Third is the expected rates of return on money and other assets.
The modern quantity theory sees money as being a substitute for a wide range of other assets and so it must consider the net yield attaching to money and these other assets.
Money will have a convenience yield and a negative yield equal to the rate of inflation and perhaps net charges or interest if it is held on deposit.
The yield of other assets will consist of currently paid yields and the possibility of a capital gain.
Arbitrage between these assets will tend to equalize the yields at the margin so that the interaction of these factors will affect the demand for money.
Finally Friedman mentions various other factors determining the utility attaching to services rendered by money to those rendered by other assets.
In this is included items such as expectations as to the future degree of economic stability and variability of the rate of inflation.