Friedman’s demand for money (Md) function1
Friedmans’ Md function is the single
most important element of the new and
improved version of the Quantity
theory (also called “Monetarism,” and
the “New Classcial economics, Part I).
1Milton
Friedman. “The Quantity Theory of Money: A Restatement,”
in Studies in the Quantity Theory of Money. Chicago: University of
Chicago Press, 1956
Definitions
•Md is the demand for nominal money balances (M2
assets);
•YP is permanent income;
•  is the ratio of nonhuman to human wealth;
•rb is the rate of return on bonds;
•re is the rate of return on equities;
•p is the general price level;
•p is the expected change in the price level;and
•U is tates and preferences of the wealth-holding
agent
Basic points
Friedman argues that the demand for nominal
liquid balances by economic agents depends
on:
1.
2.
income and wealth;
the opportunity cost of holding wealth in
liquid form;
3. the purchasing power of money;
4. expected changes in the value of money
arising from future price level movements;
and
5. tastes & preferences.
Formally, it is expressed by
+ - - - + Md = f(YP, , rb, re, p, p; U)
The signs of the partial derivatives are
superimposed on the function. For example,
the “positive” sign above the YP means
that: Md/YP>0. For the uninitiated, this
can be read as follows: other things being
equal, the demand for money is positively
related to permanent income
Friedman’s Md as a methodological framework for
empirical study
•Friedman claims the demand for nominal
money balances is a “stable”function of the
variables delineated above.
•The research program of the New Quantity
theorists has accordingly been directed toward
marshaling empirical (or econometric) evidence
in support of the thesis that the demand for
money is stable.
• Having (ostensibly) “proved” the foregoing
supposition, one can draw the conclusion that
the income velocity of money (v) is also stable.
Liquidity
Trap
rb
0
M
M’
As the
money
supply
expands
in this
range, v
falls
L or Md
If v fluctuates wildly, then there
is no determinate relationship
between money and nominal
GDP—hence the importance
or “proving” that there is no
liquidity trap
The transmission mechanism
The issue is this: What is the precise nature of
the causal chain linking Federal Reserve policy
initiatives (such as open market operations) to
the time path of real sector variables--i.e.,
GDP, and employment?
Increase in the
Money supply
Change in M causes divergence between
“actual” and “desired” nominal balances
Agents draw down money balances to “desired”
level by purchasing financial assets but also new
goods and services—this is a “portfolio adjustment” process.
Increase in spending affects both prices and real ouput in the
short run. In the long run, only prices are affected.