Milton Friedman's theory of inflation.

1. MONETARIST THEORY OF
INFLATION
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. 2
Milton Friedman’s Restatement of
QTM
• According to Friedman, “Inflation is always and
everywhere a monetary phenomenon.”
• “Money alone Matters”
• When Money Supply increases in the economy,
there is excess supply of real cash balances with
the public over the demand for money.
• This disturbs the equilibrium.
• So the public will reduce their real cash
balances, by spending more on goods and
services.
Prabha Panth

3. 3
• If there is no increase in output, then extra
D for goods > supply of goods.
• This leads to increase in prices.
MS > kPY  AD   P 
• MS = supply of money, and M/P = real
cash balances, kPY = demand for real
cash balances.
• AD = Aggregate demand.
Prabha Panth

4. 4
• Keeping k constant,
P = MS - Y
P MS Y
• P/P = rate of inflation, MS/MS = rate of growth
of money supply, and Y/Y = rate of growth of
output.
• Thus rate of inflation is determined by rate of
growth of money supply minus rate of growth of
output, k remaining constant.
• At full employment, there is no increase in
growth of output, therefore, inflation is directly
related to increase in supply of money.
Prabha Panth

5. 5
Demand for money
• DM is for real cash balances (M/P)
• It is a function of 6 factors:
1. Rate of return on bonds, r , DM 
2. Rate of return on equities (stock) , DM 
3. Change in prices. P , DM 
4. Physical K/Human K changes, DM changes
5. Real income Y/P affects demand for real
cash balance M/P
6. Tastes and preferences, economic and non-
economic conditions
Prabha Panth

6. 6
Demand for cash balances:
• Friedman includes Keynesian features
with Permanent Y hypothesis:
DM/P = k(i. P)Y ----- (1)
• Friedman assumes that k is stable,
• Elasticity of DM to i and P is small,
• Based on US time series data,
Supply of Cash Balances:
• Is most important in determining the level
of income and prices.
Prabha Panth

7. 7
• At equilibrium MS = MD -------- (2)
• Assuming k is stable,
MD = kPY ------- (3)
• Since MS = MD, so MS = kPY
• Or PY = MS/k, since k = 1/V, or
• MV = PY or PT, (Fisher’s equation)
Prabha Panth

8. 8
Criticism
• Not much difference between Fisher and
Friedman.
• Starts with Keynes, ends with Fisher,
• Full employment is assumed, as increase
in MS increases P, not Y
• Completely ignored Fiscal Policy
• Speculative DM is neglected.
Prabha Panth