Quantity Theory of Money (With Criticisms)

In this article we will discuss about Friedman’s reformulation of quantity theory of money with its criticisms.

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.

2. The Division of Wealth between Human and Non-Human Forms:

The major source of wealth is the productive capacity of human beings which is human wealth. But the conversion of human wealth into non- human wealth or the reverse is subject to institutional constraints. This can be done by using current earnings to purchase non-human wealth or by using non-human wealth to finance the acquisition of skills.

Thus the fraction of total wealth in the form of non-human wealth is an additional important variable. Friedman calls the ratio of non-human to human wealth or the ratio of wealth to income as w.

3. The Expected Rates of Return on Money and Other Assets:

These rates of return are the counterparts of the prices of a commodity and its substitutes and complements in the theory of consumer demand. The nominal rate of return may be zero as it generally is on currency, or negative as it sometimes is on demand deposits, subject to net service charges, or positive as it is on demand deposits on which interest is paid, and generally on time deposits.

The nominal rate of return on other assets consists of two parts: first, any currently paid yield or cost, such as interest on bonds, dividends on equities, and costs of storage on physical assets, and second, changes in the prices of these assets which become especially important under conditions of inflation or deflation.

4. Other Variables:

Variables other than income may affect the utility attached to the services of money which determine liquidity proper. Besides liquidity, variables are the tastes and preferences of wealth holders. Another variable is trading in existing capital goods by ultimate wealth holders. These variable also determine the demand function for money along with other forms of wealth. Such variables are noted as u by Friedman.

Broadly, total wealth includes all sources of income or consumable services. It is capitalized income. By income, Friedman means “permanent income” which is the average expected yield on wealth during its life time.

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.

1. Money is taken in the broadest sense to include currency, demand deposits and time deposits which yield interest on deposits. Thus money is luxury good. It also yields real return in the form of convenience, security, etc. to the holder which is measured in terms of the general price level (P).

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.

4. Physical goods or non-human goods are inventories of producer and consumer durable.

5. Human capital is the productive capacity of human beings. Thus each form of wealth has a unique characteristic of its own and a different yield either explicitly in the form of interest, dividends, labour income, etc., or implicitly in the form of services of money measured in terms of P, and inventories.

The present discounted value of these expected income flows from these five forms of wealth constitutes the current value of wealth which can be expressed as:

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 capitalized 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:

M/P=f(y, w; R_m, R_b R_e, g_p, u)

where M is the total stock of money demanded; P is the price level; y is the real income; w is the fraction of wealth in non-human form: R_m is the expected nominal rate of return on money; R_b is the expected rate of return on bonds, including expected changes in their prices; R is the expected nominal rate of return on equities, including expected changes in their prices; g_p =(1 /P) (dP/dt) is the expected rate of change of prices of goods and hence the expected nominal rate of return on physical assets; and u stands for variables other than income that may affect the utility attached to the services of money.

The demand function for business is roughly similar, although the division of total wealth and human wealth is not very useful since a firm can buy and sell in the market place and hire its human wealth at will. But the other factors are important.

The aggregate demand function for money is the summation of individual demand functions with M and y referring to per capita money holdings and per capita real income respectively, and w to the fraction of aggregate wealth in non-human form.

The demand function for money leads to the conclusion that a rise in expected yields on different assets (R_b, R_e and g ) 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. 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.

In Friedman’s restatement of the quantity theory of money, the supply of money is independent of the demand for money. The supply of money is unstable due to the actions of monetary authorities. On the other hand, the demand for money is stable.

It means that money which people want to hold in cash or bank deposits is related in a fixed way to their permanent income. If the central bank increases the supply of money by purchasing securities, people who sell securities will find their holdings of money have increased in relation to their permanent income.

They will, therefore, spend their excess holdings of money partly on assets and partly on consumer goods and services. 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.

If the economy is operating at less than full employment level, an increase in the supply of money will raise output and employment with a rise in total expenditure. But this is only possible in the short run. Friedman’s quantity theory of money is explained in terms of Figure 2, where income (Y) is measured on the vertical axis and the demand for the supply of money are measured on the horizontal axis. M_D is the demand for money curve which varies with income. MS is the money supply curve which is perfectly inelastic to changes in income.

The two curves intersect at E and determine the equilibrium income OY. If the money supply rise, the MS curve shifts to the right to M₁S₁. As a result, the money supply is greater than the demand for money which raises total expenditure until new equilibrium is established at E₁ between M_D and M₁S₁ curves. The income rises to OY₁.

Thus Friedman presents the quantity theory as the theory of the demand for money and the demand for money is assumed to depend on asset prices or relative returns and wealth or income. He shows how a theory of the stable demand for money becomes a theory of prices and output.

A discrepancy between the nominal quantity of money demanded and the nominal quantity of money supplied will be evident primarily in attempted spending. As the demand for money changes in response to changes in its determinants, it follows that substantial changes in prices or nominal income are almost invariably the result of changes in the nominal supply of money.

Criticisms of Friedman’s Theory of Money:

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:

1. Very Broad Definition of Money:

Friedman has been criticised for using the broad definition of money which not only includes currency and demand deposits (M₁) but also time deposits with commercial banks (M₂). This broad definition leads to the obvious conclusion that the interest elasticity of the demand for money is negligible.

If the rate of interest increases on time deposits, the demand for them (M₂) rises. But the demand for currency and demand deposits (M₁) falls. So the overall effect of the rate of interest will be negligible on the demand for money. But Friedman’s analysis is weak in that he does not make a choice between long-term and short-term interest rates.

In fact, if demand deposits (M₁) are used a short-term rate is preferable, while a long- term rate is better with time deposits (M₂). Such an interest rate structure is bound to influence the demand for money.

2. Money not a Luxury Good:

Friedman regards money as a luxury good because of the inclusion of time deposits in money. This is based on his finding that there is higher trend rate of the money supply than income in the United States. But no such ‘luxury effect’ has been found in the case of England.

3. More Importance to Wealth Variables:

In Friedman’s demand for money function, wealth variables are preferable to income and the operation of wealth and income variables simultaneously does not seem to be justified. As pointed out by Johnson, income is the return on wealth, and wealth is the present value of income. The presence of the rate of interest and one of these variables in the demand for money function would appear to make the other superfluous.

4. Money Supply not Exogenous:

Friedman takes the supply of money to be unstable. The supply of money is varied by the monetary authorities in an exogenous manner in Friedman’s system. But the fact is that in the United States the money supply consists of bank deposits created by changes in bank lending.

Bank lending, in turn, is based upon bank reserves which expand and contract with:

(a) Deposits and withdrawals of currency by non-bank financial intermediaries;

(b) Borrowings by commercial banks from the Federal Reserve System;

(c) Inflows and outflows of money from and to abroad; and

(d) Purchase and sale of securities by the Federal Reserve System.

The first three items definitely impart an endogenous element to the money supply. Thus the money supply is not exclusively exogenous, as assumed by Friedman. It is mostly endogenous.

5. Ignores the Effect of Other Variables on Money Supply:

Friedman also ignores the effect of prices, output or interest rates on the money supply. But there is considerable empirical evidence that the money supply can be expressed as a function of the above variables.

6. Does not Consider Time Factor:

Friedman does not tell about the timing and speed of adjustment or the length of time to which his theory applies.

7. No Positive Correlation between Money Supply and Money GNP:

Money supply and money GNP have been found to be positively correlated in Friedman’s findings. But, according to Kaldor, in Britain the best correlation is to be found between the quarterly variations in the amount of cash held in the form of notes and coins by the public and corresponding variations in personal consumption at market prices, and not between money supply and the GNP.

Conclusion:

Despite these criticisms, “Friedman’s application to monetary theory of the basic principle of capital theory—that is the yield on capital, and capital the present value of income—is probably the most important development in monetary theory since Keynes’s General Theory. Its theoretical significance lies in the conceptual integration of wealth and income as influences on behaviour.”