Milton Friedman Theory Introduction
Milton Friedman Theory Introduction
Milton Friedman Theory Introduction
At Chicago, Milton Friedman, Henry Simons, Lloyd Mints, Frank Knight and
Jacob Viner taught and developed ‘a more subtle and relevant version’ of
the quantity theory of money in its theoretical form “in which the quantity
theory was connected and integrated with general price theory.” The
foremost exponent of the Chicago version of the quantity theory of money
who led to the so-called “Monetarist Revolution” is Professor Friedman. He,
in his essay “The Quantity Theory of Money—A Restatement” published in
1956′, set down a particular model of quantity theory of money. This is
discussed below.
Friedman’s Theory:
In his reformulation of the quantity theory, Friedman asserts that “the
quantity theory is in the first instance a theory of the demand for money. It
is not a theory of output, or of money income, or of the price level.” The
demand for money on the part of ultimate wealth holders is formally
identical with that of the demand for a consumption service. He regards the
amount of real cash balances (M/P) as a commodity which is demanded
because it yields services to the person who holds it. Thus money is an
asset or capital good. Hence the demand for money forms part of capital or
wealth theory.
For ultimate wealth holders, the demand for money, in real terms,
may be expected to be a function primarily of the following variables:
1. Total Wealth:
The total wealth is the analogue of the budget constraint. It is the total that
must be divided among various forms of assets. In practice, estimates of
total wealth are seldom available. Instead, income may serve as an index
of wealth. Thus, according to Friedman, income is a surrogate of wealth.
Wealth can be held in five different forms: money, bonds, equities, physical
goods, and human capital. Each form of wealth has a unique characteristic
of its own and a different yield.
ADVERTISEMENTS:
2. Bonds are defined as claim to a time stream of payments that are fixed
in nominal units.
3. Equities are defined as a claim to a time stream of payments that are
fixed in real units.
ADVERTISEMENTS:
W = y/r
Where W is the current value of total wealth, Y is the total flow of expected
income from the five forms of wealth, and r is the interest rate. This
equation shows that wealth is capitalised income. Friedman in his latest
empirical study Monetary Trends in the United States and the United
Kingdom (1982) gives the following demand function for money for an
individual wealth holder with slightly different notations from his original
study of 1956 as:
The demand function for money leads to the conclusion that a rise in
expected yields on different assets (Rb, Re and gp) reduces the amount of
money demanded by a wealth holder, and that an increase in wealth raises
the demand for money. The income to which cash balances (M/P) are
adjusted is the expected long term level of income rather than current
income being received.
Empirical evidence suggests that the income elasticity of demand for
money is greater than unity which means that income velocity is falling over
the long run. This means that the long run demand for money function is
stable and is relatively interest inelastic, as shown in fig. 68.1. where M D is
the demand for money curve. If there is change in the interest rate, the
long-run demand for money is negligible.
This spending will reduce their money balances and at the same time raise
the nominal income. On the contrary, a reduction in the money supply by
selling securities on the part of the central bank will reduce the holdings of
money of the buyers of securities in relation to their permanent income.
They will, therefore, raise their money holdings partly by selling their assets
and partly by reducing their consumption expenditure on goods and
services. This will tend to reduce nominal income. Thus, on both counts,
the demand for money remains stable. According to Friedman, a change in
the supply of money causes a proportionate change in the price level or
income or in both. Given the demand for money, it is possible to predict the
effects of changes in the supply of money on total expenditure and income.
Its Criticisms:
Friedman’s reformulation of the quantity theory of money has evoked much
controversy and has led to empirical verification on the part of the
Keynesians and the Monetarists. Some of the criticisms levelled against the
theory are discussed as under.
Friedman Vs Keynes:
Friedman’s demand for money function differs from that of Keynes’s in
many ways which are discussed as under.
Fourth, there is the difference between the two approaches with regard to
the motives for holding money balances. Keynes divides money balances
into “active” and “idle” categories. The former consist of transactions and
precautionary motives, and the latter consist of the speculative motive for
holding money. On the other hand, Friedman makes no such division of
money balances.
Money
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