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4.2.1 The quantity theory as a theory of the demand for money

It was against this orthodox Keynesian background that Milton Friedman

sought to maintain and re-establish across the profession what he regarded as

the oral tradition of the University of Chicago, namely the quantity theory of

money approach to macroeconomic analysis (for a criticism of this interpretation,

see Patinkin, 1969). Although the traditional quantity theory is a body

of doctrine concerned with the relationship between the money supply and

the general price level, Friedman (1956) initially presented his restatement of

the quantity theory of money as a theory of the demand for money, rather

than a theory of the general price level or money income.

Friedman postulated that the demand for money (like the demand for any

asset) yields a flow of services to the holder and depends on three main

factors: (i) the wealth constraint, which determines the maximum amount of

money that can be held; (ii) the return or yield on money in relation to the

return on other financial and real assets in which wealth can be held; and (iii)

The orthodox monetarist school 167

the asset-holder’s tastes and preferences. The way total wealth is allocated

between various forms depends on the relative rates of return on the various

assets. These assets include not just money and bonds but also equities and

physical goods. In equilibrium wealth will be allocated between assets such

that marginal rates of return are equal. Although Patinkin (1969) has suggested

that Friedman’s restatement should be regarded as an extension of

Keynesian analysis, there are three important differences worth highlighting.

First, Friedman’s analysis of the demand for money can be regarded as an

application of his permanent income theory of consumption to the demand

for a particular asset. Second, he introduced the expected rate of inflation as a

potentially important variable into the demand for money function. Third, he

asserted that the demand for money was a stable function of a limited number

of variables.

A simplified version of Friedman’s demand function for real money balances

can be written in the following form:

M

P

f Y r P u d P e ( ; ,˙ ; ) (4.1)

where YP represents permanent income, which is used as a proxy for wealth,

the budget constraint;

r represents the return on financial assets,

represents the expected rate of inflation; and

u represents individuals’ tastes and preferences.

This analysis predicts that, ceteris paribus, the demand for money will be

greater (i) the higher the level of wealth; (ii) the lower the yield on other

assets; (iii) the lower the expected rate of inflation, and vice versa. Utilitymaximizing

individuals will reallocate wealth between different assets

whenever marginal rates of return are not equal. This portfolio adjustment

process is central to the monetarist specification of the transmission mechanism

whereby changes in the stock of money affect the real sector. This can

be illustrated by examining the effects of an increase in the money supply

brought about by open market operations by the monetary authorities. An

initial equilibrium is assumed where wealth is allocated between financial

and real assets such that marginal rates of return are equal. Following open

market purchases of bonds by the monetary authorities, the public’s money

holdings will increase. Given that the marginal return on any asset diminishes

as holdings of it increase, the marginal rate of return on money holdings will

in consequence fall. As excess money balances are exchanged for financial

and real assets (such as consumer durables), their prices will be bid up until

portfolio equilibrium is re-established when once again all assets are willingly

held and marginal rates of return are equal. In contrast to orthodox

˙P

e

Keynesian analysis, monetarists argue that money is a substitute for a wide

range of real and financial assets, and that no single asset or group of assets

can be considered a close substitute for money. A much broader range of

assets and associated expenditures is emphasized and in consequence monetarists

attribute a much stronger and more direct effect on aggregate spending

to monetary impulses.