The modern quantity theory of money is associated with the name of Milton Friedman and a group of scholars associated with the University of Chicago. Milton Friedman in his article “The Quantity Theory of Money – A Restatement” published in 1956 has put forth the view that the quantity theory is just a theory of demand for money and not the theory of income investment and employment.
The theory of demand for money put forward by Milton Friedman is partly Keynesian and partly non Keynesian It is partly Keynesian as he treats demand for money as a part of he theory of capital It is partly non Keynes as because he completely ignores classification of the motives for holding money.
As part of capital theory Friedman has found that standard theory of demand for consumer goods is very much relevant to explain the demand for money. In the Consumption theory the price is the main determinant who determine the demand for a good. Similarly in asset theory the demand for an asset is determined by its yield and other properties considered in relation to other assets. The asset holder set of choices is subject to a wealth constraint. The problems encounters in specifying demand function for any other financial asset or a consumer good.
Basic Features of Friedman’s theory
The basic features of Friedman s quantity theory are as under –
1. Wealth theory of demand for money
Friedman’s theory of demand for money is a wealth theory of demand According to him money is a type of durable consumer good held for the services it renders In other words money is demanded as an asset or capital and the theory of demand for money is a part of the capital or wealth theory In Friedman s view the assets or wealth can be held in different forms (i) money (ii) bonds (iii) equities (iv) physical goods (v) human capital. The demand for money will depend upon the volume of total wealth and the relative returns on the different forms of assets in which wealth can be held.
2. Determinants of Demand for Money
In Keynesian analysis the demand for money is a function of level of income and the rate of interest. According to Friedman, the demand for money or an asset is a function of the following factors.
(i) The rate of return on bonds. If the rate of return on bonds is higher in the market, the smaller is the demand for money and vice versa.
(ii) Rate of return on shares. Higher the rate of return on equities or shares, lower is the demand for money and vice versa.
(iii) Rate of change of prices. If prices are rising rapidly in a country, the smaller is demand for money. People hold smaller amount to avoid a fall in the real purchasing power of their money holdings.
(iv) Degree of risk. The degree of risk or uncertainty of an asset’s return also affects the demand for an asset. Holding other things constant, if an asset risk rises relatively to that of an alternative asset its quantity of demand for money will fall.
(v) Liquidity. Another factor which affects the demand for an asset is how quickly it can be converted into cash without incurring large costs. If an asset is highly liquid relatively to an alternative assets, other things remaining unchanged, the greater will be its quantity demanded and vice versa.
The theory of asset demand indicates that the demand for money is a function of resources available to individuals and the expected return on other assets relative to the expected return on money. Friedman developed simplified version of the demand for money. His money demand equation is expressed as Md = f (Yp).
In Friedman’s view, the demand for money is a function of permanent income (Yp). The permanent income is affected by the yield on securities and human and non human wealth holdings.
According to Milton Friedman, demand for money is insensitive to the changes in the rate of interest.
Milton Friedman maintains that a change in the stock of money leads to a change in the price level or income or in both the variables in the same direction. Here Friedman leads the monetarist school which maintains that if there is less than full employment in the economy, an increase in money supply will lead to a rise in output arid employment because of a rise n expenditure. But this will happen only in the short run. The monetariasts believe that changes in money supply cannot affect real in the long run. At full employment level, an increase in money supply will raise prices.
CRITICISM OF FRIEDMAN’S THEORY
The Milton Friedman’s quantity theory of money is criticized on the following grounds:
(1) No importance given to rate of interest
Milton Friedman given importance to time deposits, demand deposits and currency in circulation but he has failed to attach importance to the powerful factor of the rate of interest which very much influences the demand for money.
(2) N. Kolders critics
Friedman has observed that money supply and money GNP are positively correlated with each other. Mr. N. Kolder disagrees with his views and asserts that there is no correlation between the money supply and money GNP due to number of variables which cannot be kept under control.
(3) Proportional relationship
Friedman tested the proposition that demand for money varies directly and proportionately to changes in the price Level. The fact is it is more than proportionately to changes in the level of income. Burstein is of the view that if we exclude time deposits from money, the income elasticity of demand will be closer to unity.