Milton Friedman (1912 - 2006)
The Revival of the Equation of Exchange
and the Quantity Theory of Money
A Great Economist
And a Product of his Times
Roger W. Garrison
2011
CPI
220
CONSUMER PRICE INDEX
(1982-1984 = 100)
100
221
CPI
(1982-1984 = 100)
Last five years
221
220
211
Printing Money
and Spending it.
CFO Chapter 18, pp. 341-343:
Monetarism
The Equation
of Exchange
CFO Chapter 10:
and the Quantity
Theory
of
Money
The Money Supply
and the Federal Reserve System
How much money
is there, anyway?
But first….
What do we mean by “money”?
Tim Hudson earns a lot of
money.
Bill Gates has a lot of
money.
It’s better to buy a house
when money is cheap.
I need to cash a check to
get some money.
Money facilitates the
exchange of goods and
services.
Tim Hudson earns a lot of
money.
Bill Gates has a lot of
money.
CURRENCY
It’s better to buy a house
when money is cheap.
CREDIT
I need to cash a check to
get some money.
INCOME
Money facilitates the
exchange of goods and
services.
MONEY
WEALTH
How much money
is there, anyway?
(Money is the medium of exchange.)
$ 1,861,000,000,000
M1 = $ 1,861 billion
Currency and coin: $ 920 billion
Checking deposits: $ 941 billion
C&C/M1 = 0.494, or about 49.4%
M1 = $ 1,861 billion
Currency and coin: $ 920 billion
US Population: 311,000,000
Per capita C&C: $ 2,958
Per family of four: $ 11,833
Just who’s holding all this C&C?
M is the money supply.
M1 = $ 1,861 billion
Inquiring minds want to know:
Has M1 always been $1,861 billion?
How does more MI get created?
Who makes the decisions?
Is more money always a good thing?
Are there some politics in play?
Did Keynes actually ignore M?
Monetarism
Friedman was a Marshallian,
but he was a macroeconomist.
He had his own research
Agenda: Money and Inflation.
And he was out to counter
Keynesian theory and policy.
MILTON FRIEDMAN
M
stands for the Money supply.
M1 = $ 1,861 billion
GDP = Y = $ 14,870 billion
V = Y/M = 14,870 / 1,861 = 7.99
MV = Y
M1 = $ 1,861 billion
GDP = Y = $ 14,870 billion
V = Y/M = 14,870 / 1,861 = 7.99
MV = Y = E
M1 = $ 1,861 billion
GDP = Y = $ 14,870 billion
V = Y/M = 14,870 / 1,861 = 7.99
MV = Y = E = PQ
M1 = $ 1,861 billion
GDP = Y = $ 14,870 billion
V = Y/M = 14,870 / 1,861 = 7.99
MV = Y = E = PQ
2008:
2009:
2010:
2011:
V
V
V
V
=
=
=
=
10.18
9.09
8.22
7.99
Dating from the beginning of the most recent
contraction, the velocity of money has declined.
MV = Y = E = PQ
V
V
V
V
=
=
=
=
10.18
9.09
8.22
7.99
VELOCITY
2008:
2009:
2010:
2011:
11.0
10.0
9.0
8.0
7.0
6.0
5.0
2008 2009 2010 2011 2012
Dating from the beginning of the most recent
contraction, the velocity of money has declined.
MV = PQ
M is the money supply
(outside the banking system).
V is money’s velocity of circulation.
P is the price level.
Q is the economy’s output.
PQ is total expenditures (E).
MV is total income (Y)
A SAMPLE QUESTION
How much money is there, anyway?
A. M1 is a little under $1.861 billion.
B. M1 is a little under $6.168 billion.
C. M1 is a little under $1.861 trillion.
D. M1 is a little under $6.168 trillion.
Ask FRED. (FRED means Federal Reserve Economic Data.)
Click on Ben to go there.
MV = PQ
This is the “Equation of Exchange.”
No economist, dead or living, has ever
denied that MV actually does equal PQ...
…because V is defined as PQ/M.
MV = PQ
In normal times:
V doesn’t change much.
Q changes in the low single digits.
Keynes believed that the velocity of
money was subject to dramatic and
unpredictable change.
He believed that people “hoard” money,
more so some times than others.
(increased hoarding means a decrease
in velocity.)
In extreme episodes, people may be
overcome by the “fetish of liquidity,”
the fetish often accompanying the
waning of animal spirits.
MV = PQ
So, what happens when M is
doubled—say, from $ 1,861
billion to $ 3,722 billion?
P would also double.
But the doubling of P takes time.
MV = PQ
In the long run and with a constant V, the
price level (P) moves in proportion to the
money supply (M) in a no-growth (i.e.,
constant-Q) economy.
This is “The Quantity Theory of Money.”
A more descriptive name would be:
“The Quantity of Money Theory of the Price Level.”
MV = PQ
More generally,
In the long run, money-supply growth in
excess of real economic growth impinges
wholly on the price level (P) and not at all
on the level of real output.
Put bluntly: you can’t create real wealth
by slapping green ink on paper.
Monetarism
MV = PQ
This is the unadorned tautology
that we call the Equation of Exchange
Monetarism
MV = PQ
18-30 months
ThisInisthe
thelong
“Quantity
Theory ofinMoney.”
run, increases
M
affect nothing
P (and
W).
(The Quantity
of Moneybut
Theory
of the
Price Level)
Monetarism
Keynesianism is to Keynes as Monetarism is to
A. Ben Bernanke.
C. Claude Monet.
B. Tim Geithner.
D. Milton Friedman.
Milton Friedman (1912 - 2006)
• MV = PQ
• Inflation is always
and everywhere
a monetary
phenomenon!!!
The equation of exchange is so near and dear
to Milton Friedman’s heart that he
A. has made
C.
B.
D.
had
written
adopted
it spelled
his
a itparody
wife
as his
out
Rose
to
vanity
inthe
pansies
promise
popular
license
inthat
the
plate
it
Y.M.C.A
flower
number
will make
garden
for
to memorialize
his
a tasteful
atCadillac
Stanford’s
appearance
Eldorado.
the Hoover
equation
oninhis
head stone.
song.
Institution.
The equation of exchange is so near and dear
to Milton Friedman’s heart that he
A. tasteful appearance on his head stone.
B. spelled out in pansies in flower garden.
C. parody to the popular Y.M.C.A.
D. vanity license plate number.
Gribouillis économiques
GREG MANKIW’S BLOG
Random Observations for Students of Economics
September 16, 2006:
Curious question from Mankiw:
“How can you identify my car?”
Gregory Mankiw
Former Chairman
Council of Economic Advisors
George W. Bush Administration
mvpy writes:
You know, I hate to spoil things, but I must say, I think Milton
Friedman has a better plate. This is from an article I came across:
"Years ago, trying to find the Friedman’s apartment in San
Francisco, I knew I was in the right location when I spotted a car
with the number plate MV = PT."
A. Delaique writes:
Milton Friedman's license plate was MV = PQ, not MV = PT.
Picture here : http://gribeco.free.fr/article.php3?id_article=12
Anonymous writes:
That's pretty ridiculous..
Canée writes:
I love economists.
Monetarist Policy
FOR A GROWING ECONOMY
MV = PQ
Policy implication:
Normally,
a healthyIncrease
economyMwill
at a
experience
slow,
steadyreal
rate
economic
(2% or 3%)
growth
to
match
the long-run
growth.
amounting
to 2% orrate
3%of
per
year.
Monetarist Policy
FOR A GROWING ECONOMY
MV = PQ
With this “Monetarist Rule” in effect,
there will be no inflation and no deflation.
Price-level stability is the hallmark of
macroeconomic stability.
Monetarism
Some diagnostics:
With the “Monetarist Rule” in effect
(2 or 3%) and a constant V, the rate
of inflation would be zero—or very
close to zero.
Has the rate of inflation been zero?
Monetarism
Some diagnostics:
CPI for 1982-1984 = 100
CPI for January 2010 = 216
That is, prices on average are more
than double now what they were in
the early 1980s. (See FRED.)
CPI
CONSUMER PRICE INDEX
(1982-1984 = 100)
Last five years of the CPI
Monetarism
MV = PQ
Some diagnostics:
Has Q been falling for the past 25 years?
Has V been rising for the past 25 years?
Has M been rising for the past 25 years?
Monetarism
MV = PQ
Q rose by 88.5%, which is 2.80% per year.
V rose by 23.7%, which is 0.90% per year.
Suppose M had increased (in accordance
with the monetary rule) at the rate of
2.5% per year.
Monetarism
2.80%
2.50%
0.90%
0.60%
MV = PQ
Monetarism
If M had risen at the rate of 2.5% over
the period 1983—2008 and P had risen at
the rate of 0.60%, the current CPI would
be 115.0 instead of 216.
That is, prices in general would’ve been
only 15% higher than they were in 1983.
5.0%
Monetarism
2.80%
3.1%
0.90%
MV = PQ
Monetarism
Q rose by 88.5%, which is 2.80% per year.
V rose by 23.7%, which is 0.90% per year.
M actually increased by 5.0% per year.
M, which rose from $450 billion to $1,383
billion (in 2008), more than tripled.
P more than doubles (from 100 to 216
THE NATURAL RATE
OF UNEMPLOYMENT
SEPT 11 2001
SEPT 11 2001
SEPT 11 2001
Sidewalk Survey on Dexter Avenue:
“What’s the cause of inflation?”
Greed.
Oil companies.
Medical industry.
Home-building industry.
Labor unions.
The Jane Fonda bull-by-the-horn
approach to ending inflation.
Identify major groups of products
whose prices have risen the most:
energy, medical, housing, food.
Enact pricing policies that hold the
prices in these areas down and
thereby counter the inflationary
pressures.
What about the major groups of
products whose prices have fallen
the most:
computers, cameras, electronics.
Is the economic activity in these
areas creating deflationary
pressures?
MV = PQ
CPI = avg.(p1, p2, p3, p4, pgasoline, … pn)
The P in the equation of exchange
is measured by the CPI (or the
WPI or GPI), which is a price
index. The index tracks the
average of all prices.
?
CPI = avg.(p1, p2, p3, p4, pgasoline, … pn)
Good arithmetic; bad economics.
MV = PQ
CPI = avg.(p1, p2, p3, p4, pgasoline, … pn)
Many other prices go down.
Some
up, too.
--the
(firewood).
--theprice
priceofofsubstitutes
complements
(RV’s)
--the
and services
for which
--theprice
priceofofgoods
so-called
“normal”
oil
in
a
substantial
input
(airfares).
goods generally (restaurant meals).
Suppose that unrest in the Middle East causes a
reduction in the supply of oil flowing to the U.S., which
leads to a 20% increase in the price of oil. Economists
who accept the quantity theory of money will claim that
A. prices in general will rise because everything
depends upon (is related to) oil.
B. the Federal Reserve should increase the money
supply so that people can pay the higher gas prices.
C. whatever the Federal Reserve does, there will be
substantial inflation–although not a 20% inflation rate.
D. there will be no inflation in the U.S. so long as the
Federal Reserve does not increase the money supply.
Bubbalonia
is experiencing inflation.
Prices INFLATION
in general are rising.
IS ALWAYS
AND EVERYWHERE
What
are the logically
possible causes,
A MONETARY
PHENOMENON.
as implied
by the Equation
of Exchange?
What is the actual (empirically
demonstrated)
--- Milton
Friedman
cause according to the Quantity Theory?
MV = PQ
a. Increasing Q.
g. Increasing gas prices.
b. Decreasing Q
h. Credit-card mania.
c. Increasing V.
i. Labor unions.
d. Decreasing V.
j. Greed.
e. Increasing M.
f. Decreasing M.
Suppose that new taxes on tobacco products cause
the tax-included price of cigarettes to double.
Microeconomists would predict that the quantity of
tobacco products bought will fall only slightly and
that total spending on cigarettes will nearly double.
Monetarists would claim that the tax will
A. result in a slightly higher rate of inflation.
B. cause the Federal Reserve to undertake
compensatory policy actions.
C. have no effect on the general price level.
D. result in a slightly higher velocity of money.
Can you apply similar reasoning to
show that none of the other oftmentioned culprits are responsible
for inflation?
Greed.
Oil companies.
Medical industry.
Home-building industry.
● Labor unions.
Do labor unions cause inflation?
Labor unions can call a strike—or
just threaten to call a strike—in
order to get higher wages.
And higher wages get translated
into higher prices.
That’s inflation, isn’t it?
W
S
D
Union labor
N
W
S
D
Union labor
N
W
S
S’
Non-union labor
D
N
W
P
S
S’
S
D
Union labor
D
N
W
Product market
S
S’
Non-union labor
D
N
Q
W
P
S
S’
S
D
Union labor
D
N
W
Q
Product market
P
S
S
S’
Non-union labor
D
N
S’
D
Product market
Q
Do labor unions cause inflation?
No. But they can cause the prices of
goods made by unionized labor to
rise and the prices of goods made
by non-unionized labor to fall.
However, if the central bank
increases the money supply in an
attempt to neutralize the effects of
labor unions, the general price level
will rise.
A Ceiling on Your Home (1945)
By the Office of Price Administration
(OPA)
Synopsis: [This 12 minute film] shows
the economic factors affecting
postwar inflation and an appeal for
public cooperation, an appeal to the
public to assist in retail price control,
and the difficulties veterans faced in
locating jobs and housing.
CLICK ON POSTER GIRL TO SEE VIDEO
Reviewer: ERD -- March 7, 2006
Subject: "Ceiling on Your Home" does a good job
This 1945 film does a good job explaining about the
purpose of rent control after World War II. Excellent
narrative script and filming.
Reviewer: Christine Hennig -- December 9, 2003
Subject: No Rentals Today, But Keep in Touch!
This post-WWII film advocates rent control as a way to
control inflation as a result of the post-war housing
shortage. It portrays young couples struggling to find a
decent place to live and start their families, and finding
“NO RENTALS” signs everywhere. This is an interesting
slice of life from the post-WWII era, before the problem
would be eventually solved by huge housing
developments in the suburbs.
Reviewer: Spuzz -- February 26, 2003
Subject: Rent Rant.
As the boys were coming home from war, much concern
(I guess) was made about the lack of affordable housing
for the soldiers and their new families. Luckily, the Office
of Price Administration (whatever that is) was there to
see that there was rent fixing, and that everyone would
pay the same price. A persuasive film with plenty of great
images.
Is it possible to increase the money
supply without causing inflation?
Suppose that the velocity of
money can (somehow) be made to
fall as the money supply was being
increased?
Couldn’t an increased M and a
decreased V combine to allow for a
constant price level?
The Anti-inflation campaign
of the Ford Administration
Whip
W
I
Inflation
N
Now
The Anti-inflation campaign
of the Ford Administration
People should wear
their WIN buttons.
They should look for
bargains…
…holding on to their
money while they
look.
Don’t spend it.
Just hold it.
MV=PQ
The Anti-inflation campaign
of the Ford Administration
The Federal Reserve
is increasing the
money supply.
That means that
prices will be rising.
It’s called inflation.
What can you do to
keep inflation from
occurring?
MV=PQ
The Anti-inflation campaign
of the Ford Administration
You can earn money
and
then words,
just hold
In other
the
on
to it.
government
can
create money
and
Holding
on to money
spend it,
and that in
means
a decrease
won’t cause inflation
velocity.
if you are willing to
The
V will
earndecreased
money and
not
offset
spendour
it. increasing
M, keeping P from
rising.
MV=PQ
The Anti-inflation campaign
of the Ford Administration
MV=PQ: It’s always
right, but there are
no votes in it.
Milton Friedman (1912- 2006)
•MV = PQ
• Inflation is
always and
everywhere
a monetary
phenomenon!!!