Question

How is Friedman’s restatement of the quantity theory of money like Keynes’s monetary theory and how is it different?

Answer 1

Friedman asserted that events of 1930s had been wrongly assessed and did not in fact offer evidence against the quantity theory of money. He however realised that there was a need to restate or reformulate the quantity theory of money which should re-establish the importance of money determining the level of economic activity and the price level.

However, in his restatement of the quantity theory of money he took account of Keynes’s contribution to mon­etary theory, especially his emphasis on the demand for money as an asset.

We may describe Friedman’s monetarism into the following three propositions:

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.

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. In the short-run changes in the quan­tity of money are the dominant factors causing cyclical fluctuations in output and employ­ment.

We shall explain below the above three propositions of Friedman’s monetary theory. The above conclusions derived by Friedman depend on the restatement of the quantity theory of money. It is important to note that Friedman’s modem quantity theory of money is in fact based on his theory of demand.

Therefore, in our analysis below we start from Friedman’s theory of demand for money. We then explain how his theory of money demand explains the determination of the level of eco­nomic activity and the price level, both in the short run and long run.

Friedman’s modem quantity theory of money is very close to the Cambridge’s cash balance approach. Friedman and other modem 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 (Md) we have:

Md = kPY

Where k is assumed to be constant, PY is the nominal income obtained by multiplying the real income (F) 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 = Md =kPY…..(2)

Or M.1/k = PY …..(3)

According to Cambridge equation (3) nominal income is determined by the supply of money (AO multiplied by the reciprocal of constant k. Now, Friedman introduced changes in the above Cambridge theory of money demand incorporating important aspects of Keynes’s theory of demand for money. Keynes emphasised the role of money as an asset apart from its role in meeting transac­tions demand.

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

Md = F(P, Y, rB, rE, rD)

Where P = price level

Y = level of real income

rB = rate of interest on bonds

rE = rate of return on equity shares

rD = rate of return on durable goods

It will be seen from Friedman’s money demand function that the product of the first two variables, namely, P and Y give us the level of nominal income. It therefore follows that, in Friedman’s function, demand for money depends on nominal income. The higher the level of nominal income, the greater the demand for money.