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Friedmans theory of demand

  2. 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.
  3. 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.
  4. 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
  5. 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
  6. 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 .
  7. 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
  8. 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 .
  9. 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.
  10. 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 .
  11. 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
  12. 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.
  13. 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.
  14. 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.
  15. 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.