Friedman’s Modern Quantity Theory of Money

The modern quantity theory of money, as developed by Milton Friedman, represents a significant evolution in monetary economics. Building on foundational ideas from Irving Fisher and John Maynard Keynes, Friedman introduced a nuanced view that framed money not as a passive medium of exchange but as an active asset comparable to others like bonds, stocks, and goods. His theory provides a more comprehensive understanding of money demand, connecting it to economic agents’ preferences and behaviors, and offering a dynamic view of the economy that has reshaped monetary policy and analysis.

The Quantity Theory of Money: A Historical Context
Traditionally, the quantity theory of money posited a direct relationship between the money supply and the price level. Irving Fisher’s famous equation of exchange, , captured this idea, where  is the money supply,  is velocity,  is the price level, and  is real output. Fisher assumed  and  to be constant, implying that changes in  directly influenced . However, this oversimplified view failed to account for variations in economic agents’ behavior or the complexities of financial markets.
Keynes’s liquidity preference theory added a layer of sophistication, proposing that money demand depended on interest rates, driven by three motives: transactions, precautionary, and speculative. Yet, Keynes’s framework still treated money demand simplistically, focusing solely on bonds as an alternative asset and assuming a zero return on money. This is where Friedman stepped in to refine the theory.

Friedman’s Innovations: Money as an Asset
Friedman’s modern quantity theory reimagines money demand as analogous to demand for other assets. He argued that economic agents seek to hold a certain level of real money balances (Md/P), which are influenced by several factors:
1. Permanent Income (Yp):
Friedman defined permanent income as the present discounted value of expected future income. He asserted that individuals’ demand for real money balances rises with higher permanent income, as greater wealth and stability necessitate more liquidity.
2. Relative Returns on Assets:
Unlike Keynes, who focused solely on interest rates, Friedman considered the relative returns on bonds (r_b), stocks (r_s), and goods (π_e, expected inflation) compared to money (r_m). He posited that if bonds, equities, or goods offer higher returns than money, the demand for real money balances will decline, and vice versa.
The formal representation of Friedman’s theory is:
M_d / P = f(Y_p <+>, r_b - r_m <->, r_s - r_m <->, π_e - r_m <->)
M_d/P: Demand for real money balances
Y_p: Permanent income
r_b - r_m: Expected return on bonds minus the return on money
r_s - r_m: Expected return on stocks minus the return on money
π_e - r_m: Expected inflation minus the return on money

Key Insights and Implications
1. Money Demand and Permanent Income: Friedman emphasized that real money balances increase as permanent income grows. This contrasts with Keynes’s focus on short-term income fluctuations, making Friedman’s theory more adaptable to long-term economic trends.
2. Impact of Asset Returns: By incorporating the returns on multiple asset classes, Friedman acknowledged the interconnectedness of financial markets. For example, rising interest rates on bonds may not significantly reduce money demand if returns on money, such as bank deposit interest, rise in tandem.
3. Velocity of Money: A critical advancement in Friedman’s theory is the treatment of velocity.  While earlier theories assumed velocity to be constant, Friedman argued it was predictable and pro-cyclical—rising during economic expansions and falling during recessions. This dynamic view aligns better with observed economic patterns.
4. Interest Rate Insensitivity: Friedman’s framework suggests that changes in interest rates have minimal impact on money demand. He reasoned that returns on all assets, including money, tend to move together, resulting in stable relative differentials . This insight challenges the Keynesian notion that monetary policy primarily operates through interest rate adjustments.

Money Supply and the Role of Central Banks

Friedman’s modern quantity theory also highlights the distinction between money demand and money supply. While earlier theorists had to grapple with an exogenous money supply under a specie standard, modern central banking allows for endogenous money creation. Central banks, through monetary policy tools, effectively determine the money supply, which Friedman modeled as a vertical line.
In contrast, under a gold standard or similar system, the money supply was constrained by the availability of specie (e.g., gold). The supply curve in such a system sloped upward, reflecting the higher incentive to mine or issue money as its “price” (interest or gold value) rose. This historical perspective underscores the evolution of monetary policy and its focus on managing money demand in modern economies.

Comparative Superiority of Friedman’s Theory
Friedman’s modern quantity theory is widely regarded as superior to Keynes’s liquidity preference theory for several reasons:
1. Inclusion of Multiple Assets: Friedman’s theory incorporates bonds, stocks, and goods, whereas Keynes considered only bonds. This broader scope better reflects real-world investment decisions.
2. Variable Returns on Money: Unlike Keynes, who assumed a constant zero return on money, Friedman allowed for variations in money’s return, such as interest on deposits or bank-provided services. This makes the theory more realistic.
3. Predictable Velocity: Friedman’s treatment of velocity as predictable and pro-cyclical aligns more closely with empirical evidence, enhancing the theory’s applicability.
4. Interest Rate Neutrality: By downplaying the importance of interest rates in money demand, Friedman’s theory provides a more stable framework for monetary policy analysis, particularly in environments with fluctuating interest rates.

Practical Implications
Friedman’s insights have profound implications for monetary policy and financial stability. His emphasis on the role of permanent income and predictable velocity suggests that central banks should focus on long-term economic trends rather than short-term interest rate manipulation. Additionally, the theory highlights the interconnectedness of financial markets, emphasizing the need for a holistic approach to monetary and fiscal policy.

Conclusion
Milton Friedman’s modern quantity theory of money represents a monumental advancement in monetary economics. By treating money as an asset and incorporating the interplay of multiple asset classes, Friedman provided a robust and dynamic framework that surpassed earlier theories. His insights into money demand, velocity, and the limited role of interest rates have profoundly influenced economic thought and policy. In a world of complex financial systems, Friedman’s theory remains a cornerstone of modern monetary analysis, offering valuable guidance for understanding and managing the ever-evolving dynamics of money and the economy.