Saturday, August 22, 2009

Friedman’s Restatement of Quantity Theory of Money

Milton Friedman’s restatement of the quantity theory of money has already become a modern classic. He says that his quantity theory of money is especially a theory of demand for money. Hence his analysis is this connection is primarily concerned with exploring and explaining the nature of the demand function for money. Its objective is to discover the relatively more significant variables which determine the demand for money and to find out whether this function is stable or not. The traditional quantity theory of money was based on the assumption of a constant velocity of money. Friedman draws a distinction between the velocity and velocity function. He says that while velocity of money may and does fluctuate, the velocity function is stable. Thus the modern quantity theories like Friedman draw a distinction between demand for money and demand function for money or between velocity of money and velocity of money function. The velocity of money function is highly stable, much mor stable than the Keynesian Consumption function. Friedman therefore prefers economic analysis in terms of changes in money supply and a money multiplier derived from velocity relationship rather than use autonomous expenditures and the multiplies which emerge from consumption function as emphasised in the Keynesian theory.
The modern quantity of money theories regard the money demand function not only stable but also of vital importance in determining the variables which are very important for the economy as a whole e.g. the level of national income, employment and price level. Friedman is of the opinion that the demand function and the money supply function as the independent of each other. That is, there are some important variables which determine the supply of money but which do not affect the demand the demand for money. The nation of stable demand function is useful in order to trace out the effect of changes in supply, but it is useful only if supply is influenced by at least some factors other than those regarded as affecting demand. Thus the modern quantity theories would reject the notion that the supply f money expands or contracts according to the needs of trade. We can also say that the modern quantity theories reject the concept of Keynesian liquidity trap or infinite elasticity of demand for money. Friedman makes out a strong case for the quantity theory if the elasticity of demand for money is approximately zero.
Without going into how Friedman derives or expound the version of the Quantity Theory, it may suffice to give his restatement of Quantity Theory of Money this is set out below.
Friedman’s above equation is equivalent to the Equation of Exchange of the traditional Quantity Theory i.e. M = PY. However with the difference that Y is the real income in the traditional equation instead of the money income that Y represents in Friedman’s equation given above.
It is very necessary to berv in mind that the traditional quantity theory is only superficially equivalent to Friedman’s restatement of it. The fundamental difference between the two approaches is that Friedman has substituted the velocity function.
V(rbre1/p.dp/dt.w.y/pv) in place of the velocity constante V, or its reciprocal K in the traditional statement of the Quantity Theory. This is by no means a mere formal difference, it is unstead a very significant difference of substances.


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