FRIEDMAN’S THEORY OF DEMAND
FOR MONEY

INTRODUCTION
 At Chicago, Milton Friedman, taught and developed a more subtle and relevant
version of the quantity theory of money in its theoretical form “ in which the quantity
theory was connected and integrated with general price theory “
 The quantity theory of money – A Restatement was published in 1956, set down a
particular model of quantity theory of money.

FRIEDMAN’S THEORY
In his reformulation of the quantity theory, Friedman asserts that “the quantity theory
is in the first instance a theory of demand for money. It is not a theory of output, or of
money income, or of the price level’’.
The demand for money on the part of ultimate wealth holders is formally identical with
that of the demand for a consumption service.

VARIABLES
 TOTAL WEALTH : The total wealth is the analogue of the budget constraint. It is the
total that must be divided among various forms of assets. Thus, according to
Friedman, income is a surrogate of wealth.
 DIVISION OF WEALTH BETWEEN HUMAN & NO HUMAN : The major source of
wealth is the productive capacity of humans.
The total wealth in the form of non-human
wealth is an additional variable.
 RATES OF RETURN : These rates of return are the counterparts of the prices of a
commodity and its substitute and complements in the theory of consumer demand

CONTINUED…
 BOND : Bond is considered to be a perpetual security ,or consol, which yields an
income stream whose value is fixed in nominal terms . Thus, the the yield on bond
(rb) consists of the sum of its coupon plus any anticipated capital gain due to an
expected fall in the market interest rate or less any anticipated capital loss due to an
expected rise in the market rate.
 EQUITY : The equity is identical to the bond except that it contains a cost of living
escalator so that its income stream always maintains constant purchasing power.
The yield on equity (re) is composed of three elements
(a) its coupon yield
(b) any expected capital gain or losses due to changes in interest rate
(c) any expected changes in the general price level

CONTINUED…
 COMMODITIES : Physical goods held by wealth owners yield income in kind which
cannot be measured by an explicit interest rate. However, their real return is affected
by the changes in the price level.
 HUMAN CAPITAL : In the absence of slavery , no market price for human capital
exists and thus a rate of return on this form of wealth cannot be computed directly.
 OTHER VARIABLES :Friedman introduces a variable designated by u to stand for
any influence other than income that can be expected to effect tastes and
preferences for money .

FRIEDMAN’S DEMAND-FOR-MONEY
FUNCTION
The demand function for money given by Friedman is given below
M = f(Y, w, P, rb ,re , rc, u)
M = aggregate demand for money
Y = total flow of income
w = ratio of non human to human wealth
P = general price level
rb = the market bond interest rate
re = the market interest rate of equity
rc = the expected rate of change of prices of commodities
u = variables which tend to influence taste and preferences

FRIEDMAN vs KEYNES
 Friedman uses a broader definition of money than that of Keynes in order to explain
his demand for money function. Friedman treats money as an asset or capital good
capable of serving as a temporary abode of purchasing power. On the other hand
Keynes definition of money consists of demand deposits and non interest bearing
debt of the govt.
 Friedman prostulates a demand for money function quite different from that of
Keynes. The demand for money on the part of wealth holders is a function of many
variables . These are Rm , Rb , gp and u referring to other variables. Keyne’s theory
, the demand for money as an asset is confined to best bonds where interest rates
are the relevant cost of holding money .

CONTINUED…
 The difference between the monetary mechanisms of Keynes and Friedman as to
how changes in the quantity of money affect economic activity. According to Keynes,
monetary changes effect economic activity indirectly through bond prices and interest
rates . On the other hand in Friedman’s theory monetary disturbances will directly
effect prices and production of all types of goods since people will buy or sell any
asset held by them.
 Keynes divides money balances into “ active’’ and “ idle” categories. On the other
hand, Friedman makes no such divisions of money balances.
 Friedman introduces permanent income and nominal income to explain his theory.
Permanent income is the amount a wealth holder can consume . Nominal income is
measured in the prevailing units of currency . Keynes on the other hand does not
make such a distinction.

RESULT OF EMPIRICAL STUDIES
The following are the broad conclusions of these studies :-
 The demand for money has been found to be a highly stabled function of a few
specified variables.
 The interest elasticity of the demand for money was found to be significant but low
and stable.
 There is no evidence of a liquidity trap or even of a tendency for a rise in interest
elasticity of demand for money during the grant depression .
 There is no evidence to suggest that the risk of capital losses on long term bonds
affect the demand for money .

CONTINUED…
 The demand for money appears to be more a function of wealth , permanent income
than of current income.
 The response of demand for money to the price level has been found to be
proportional .
TO CONCLUDE: Although there exists a difference between demand for money function
on the theoretical level, such difference shrinks considerably when we view the results
of the empirical studies. The studies have found permanent income and the actual rate
of interest , and not the rate of change in the price level , as explaining most of the
variation in the demand for money

DEMAND FOR MONEY IN
UNDERDEVELOPED COUNTRIES
 DUALISTIC ECONOMY : The economies in the underdeveloped countries are
fundamentally dualistic in nature. One would expect a rise in the transaction demand
for money as a result of economic growth .
 FINANCIAL DUALISM : The underdeveloped countries are also marked by financial
dualism, which implies the co-existence of heterogeneous interest rates in the
organized money market and the unorganized money market.
 INFLUENCE OF NON-ECONOMIC FORCES : It is argued that in the most of the
underdeveloped countries, the interest rate is administered rather than determined
by the market forces of demand and supply of money in the organized sector.

CONTINUED…
 UNSTABLE INCOME VELOCITY : Some researchers observed short-run
fluctuations in their estimates of income velocity of money for underdeveloped
countries. In view of the unstable income velocity, the use of the quantity theory of
money to explain the demand for money will not be stable.
 INTEREST-INELASTIC DEMAND : In the underdeveloped countries rate of interest,
is not regarded as an appropriate variable in the determination of demand for money
due to a number of reasons .
1. Limited size of the organized financial market.
2. The institutional interest rates .
3. Limited financial assets.
4. Limited degree of substitution between money and financial assets.

EMPIRICAL EVIDENCE
1) Stable demand for money functions for the underdeveloped countries can be
estimated on the same lines as for the developed countries .
2) Expected price changes rather than interest rates tend to be important determinant of
money demand.
3) Some measure of income remains the major determinant of real money holdings.
4) The effects of different levels of monetary developments are also reflected in the
studies which have investigated the variability of income velocity.

CONTINUED…
5) The almost universal use of annual rather than quarterly data has been a
constraining factor, particularly in the investigation of lag in adjustment of money market
towards equilibrium.
6) Changes in the distribution of income between the agriculture sector and the rest of
the economy as represented by variations of the ratio of agriculture income to net
national income have been found to affect negatively the demand for money.