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Building on the work of earlier scholars, including Irving Fisher of Fisher Equation fame, Milton Friedman improved on Keynes’s liquidity preference theory by treating money like any other asset. He concluded that economic agents (individuals, firms, governments) want to hold a certain quantity of real, as opposed to nominal, money balances. If inflation erodes the purchasing power of the unit of account, economic agents will want to hold higher nominal balances to compensate, to keep their real money balances constant. The level of those real balances, Friedman argued, was a function of permanent income (the present discounted value of all expected future income), the relative expected return on bonds and stocks versus money, and expected inflation.
Md/P = demand for real money balances (Md = money demand; P = price level)
f means “function of” (not equal to)
Yp = permanent income
rb − rm = the expected return on bonds minus the expected return on money
rs − rm = the expected return on stocks (equities) minus the expected return on money
πe − rm = expected inflation minus the expected return on money
<+> = increases in
<−> = decreases in
So the demand for real money balances, according to Friedman, increases when permanent income increases and declines when the expected returns on bonds, stocks, or goods increases versus the expected returns on money, which includes both the interest paid on deposits and the services banks provide to depositors.
As noted in the text, money demand is where the action is these days because, as we learned in previous chapters, the central bank determines what the money supply will be, so we can model it as a vertical line. Earlier monetary theorists, however, had no such luxury because, under a specie standard, money was supplied exogenously. What did the supply curve look like before the rise of modern central banking in the twentieth century?
The supply curve sloped upward, as most do. You can think of this in two ways, first, by thinking of interest on the vertical axis. Interest is literally the price of money. When interest is high, more people want to supply money to the system because seigniorage is higher. So more people want to form banks or find other ways of issuing money, extant bankers want to issue more money (notes and/or deposits), and so forth. You can also think of this in terms of the price of gold. When its price is low, there is not much incentive to go out and find more of it because you can earn just as much making cheesecake or whatever. When the price of gold is high, however, everybody wants to go out and prospect for new veins or for new ways of extracting gold atoms from what looks like plain old dirt. The point is that early monetary theorists did not have the luxury of concentrating on the nature of money demand; they also had to worry about the nature of money supply.
This all makes perfectly good sense when you think about it. If people suspect they are permanently more wealthy, they are going to want to hold more money, in real terms, so they can buy caviar and fancy golf clubs and what not. If the return on financial investments decreases vis-à-vis money, they will want to hold more money because its opportunity cost is lower. If inflation expectations increase, but the return on money doesn’t, people will want to hold less money, ceteris paribus, because the relative return on goods (land, gold, turnips) will increase. (In other words, expected inflation here proxies the expected return on nonfinancial goods.)
The modern quantity theory is generally thought superior to Keynes’s liquidity preference theory because it is more complex, specifying three types of assets (bonds, equities, goods) instead of just one (bonds). It also does not assume that the return on money is zero, or even a constant. In Friedman’s theory, velocity is no longer a constant; instead, it is highly predictable and, as in reality and Keynes’s formulation, pro-cyclical, rising during expansions and falling during recessions. Finally, unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand. The reason for this is that Friedman believed that the return on bonds, stocks, goods, and money would be positively correlated, leading to little change in rb − rm, rs − rm, or πe − rm because both sides would rise or fall about the same amount. That insight essentially reduces the modern quantity theory to Md/P = f(Yp <+>).