FAKULTI PENGURUSAN DAN EKONOMI
JABATAN PENGURUSAN PERNIAGAAN DAN KEUSAHAWANAN
PEG3053 EKONOMI MONETARI
“FRIEDMAN THEORY (1976-1990)”
NAMA: LUCK LEE CHING (D20141067317)
NAMA PENSYARAH: PROF. MADYA DR GAN PEI THA
1.0 Milton Friedman’s Background 3
2.0 Differences Between Friedman Theory and Keynesian Theory 4
3.0 The Demand For Money 5
4.0 The Quantity Theory of Money 6-7
5.0 Conclusion 8
This paper will discuss about the theories about the money which developed by the Milton Friedman. There are two type of Friedman theories in this paper such Theory the demand for money and the quantity theory of money. Most of the theory that construct by Friedman was challenged by the Keynesians economics. In this paper also will discuss about the variable that will affected the growth of the stock of money supply in the theory for money and the quantity theory of money. The main variable that will effect the stock of money in Friedman’s theory are the price level and the income. This paper will also discuss why the interest rate are less important in the change of the demand for money and the quantity for money. Besides that, the different economists have different views about the Friedman theory.
1.0 Milton Friedman’s Background
Milton Friedman is the American Economist and also known as a monetarism’s leaders. He is one of the most popular economist in the worlds and together with J.M Keynes on the second half of the 20th century. Their research most influenced the formation of current economic theory and policy. The theory about consumption, money and stabilization policy which created by Milton Friedman was awarded the Nobel Prize for economics in 1976.
Milton Friedman also recognized as the main proponent of monetarism. His theory in monetary most focuses about the role of money in economic processes. Based on his viewpoint, the changes in money stock as the “motor” of economic processes and which particular the important of balance in the money market. His viewpoint about monetary came out from the Keynesian theories, when monetarism had no influence in academic circles and on economic policy.
Friedman’s theoretical viewpoint about the monetarism was grew successfully since his theories could be seen in parallel with an increase in the number of crises in the economy at the end of the 1960’s and the beginning of the 1970’s. The crises was happened at that time such as inflation growth, bureaucratisation of the state apparatus and in particular the emergence of stagflation. Friedman came out the “Self – regulating” mechanism in his monetarism theory.
“Self-regulating” mechanism means that the mechanism of the market enabling growth in production without “injections” from the state budget. Milton Friedman contributed more theories in economic fields. The theory of money such as a construct of the demand for money and the supply of money, monetary policy, inflations, the mutual relationship between inflation and unemployment and so on were the core of Friedman’s contributions to pure economic theory.
2.0 Differences Between Friedman Theory and Keynesian Theory
Based on the Friedman’s theory, the most significant features on his theory is the renaissance of ideas on the importance of money in economic life and explaining inflation and the belief resulting from this in the feasibility of monetary policy. In 1956, the Theory of the demand for money was created by Milton Friedman stated that the demand for money will depend on the existence of a stable dependent relationship between the money supply and other variables.
According the Theory of the demand for money (1959), the key variables in this theory are the stock of money, the real income per capita and the price. The growth of stock of money are determined by the two behaviors which is secular and cyclical behavior. Then, the secular and cyclical behavior of the stock have relations to incomes and prices.
Then, Milton Friedman also construct the new quantitative theory of money based on his theory before which is Theory of the demand for money. This theory are state that the holding of money is determined by the exchange transactions process in the market. From this theory, the money will determined by the change of price level and nominal incomes.
Otherwise, the Keynesian views the money have relationship with the interest rate and planned investment. This is because the change in money supply will affect the aggregate demand. If the money supply increases, the rate of interest rate will decreases. Thus, the planned investment will increases directly. Not only that, the Keynesian also views the quantity of money are related with the purchasing power and the price level.
Based on the Keynesian’s economic, there have three motives to holding money. For example, transaction motives, precautionary motive and speculative motive. The following table is the explanation about the three motives to holding money:
a. Transactions motive People hold money for purchasing good and services.
b. Precautionary motive People hold money for emergency.
c. Speculative motive Suppose store wealth as money or bonds.
The transaction motive and the precautionary motive have positive relationship with the income (Md). For example, if income (Md) rises, The transaction motive and precautionary motive will increases. The speculative motive have negative relationship with the income (Md). For example, if the interest rate increases, the bond become more attractive and the hold less money.
3.0 The Demand For Money
In the Theory The Demand For Money (1956), the demand for money is determined by the stock of money and the real income per capita. The movement in the money stock over business cycles will dominated by the behavior of the monetary authorities. There are two type behavior that will affect the movement in the money stock over business cycles. For example, the secular behavior and the cyclical behavior.
a. The Secular Behavior
In this theory found that the secular changes in the real stock of money per capita are highly correlated with change in real income per capita. For example, if a 1 percent increases in real income per capita, then the real cash balance per capital will increase about 0.8 percent and hence with 0.8 percent decrease in income velocity. Income velocity in this behavior found that is related rate of interest and rate of changes of price.
b. The Cyclical Behavior
According to cyclical behavior, the real stock of money like a real income have positive relationship with the business cycles. For examples, the real stock of money will rise during expansions and to fall or to rise at less rapid rate during contractions. If the secular trend in this cyclical behavior, about one-fifth of 1 percent change in real stock of money is accompanied by a 1 percent change in real income during cycles at the same directions.
However, the secular behavior and the cyclical behavior are the key facts on the income velocity. Basically, velocity measured has tended to rise during business expansions and decline during business contractions. For example, the permanent income is use to measured income in computing velocity rather than a longer term concept. The permanent income can be known as a wealth. The holding the cash are not linked to total wealth but primarily to non-human wealth such as luxuries.
Unfortunately, the available evidence on the secular and cyclical behavior not enough to explain the linked between the holding the cash and the non-human wealth. The terms of money in this theory includes an assets, on a par with bonds, equities, houses, consumers good and the like. Not only that, the interest rates also will affect the velocity income and the stock of money. It is agreed that the velocity is related to interest rates.
In Friedman theory, the changes in interest rates have been a minor factor in the velocity. But at another research found that the changes in interest rates are either the primary or a major source of all cyclical and secular changes in velocity (Latane 1954; 1960; Brunner and Meltzer 1967). According to Friedman (1959), the changes in interest rate less much important than real income per capita for secular change in velocity and also differences between measured and permanent income for cyclical changes.
4.0 Quantity Theory of Money
In this theory, Friedman found that the quantity of money will determined by the two variables which is income and the price. He developed this theory based on his interpretation of economic history. His interpretation of economic history led him to make two generalisations as the following:
a. All major changes in the supply money are accompanied by the major changes in prices and income or vice versa; and
b. Changes in money supply are generally independent of change in price and income.
That two generalisations led him founded that there are strong relationship between the supply of money with the movement in income and the price level. He conclude that money not only matters in explaining major economic fluctuations, but that it is only thing that really matters. Not only that, in this theory also mentioned that the money also like any other assets yields a flow of services to the person who hold it.
In this theory, Friedman argues that the quantity of money increase are directly will increase the demand for resources. This is because the money as a store of value. According to this theory, there are four effects of an increasing rate the growth in the money stock as a following:
a. The initial impact of a falling rate to interest rate.
b. An Income Effect
If the stock of money increases, means that the income also increases, then the demand for money will increases. This situations will leads the liquidity preference shift upward. Then, this will tend to send the interest rate back to its initial position.
c. A Price Effect
If the price level increases, the real quantity of money will also decreases. This situation will effect of raising interest rates back to the initial level.
d. A Price Expectations Effects
If the lenders expected the price level rising in the future, the lender will insists on a higher price for the use of his money. At the same time, that will cause the interest rate to rise above their original level.
Based on this four effect, Friedman conclude that the interest rate in the quantity of money such as misleading factor. So, Friedman make the conclusions based on his own analysis that the change in interest rate have only a negligible effect on the quantity for money. Friedman state that the change in quantity of money and the change in price as perhaps the most-evidenced economic phenomenon on record.
Not only that, the expenditure factor also have relationship with the quantity of money. The relationship between the quantity of money and expenditure will seen in long-run period only. In the short run period, finding that the quantity of money have strong relationship with the price. The equation below is about the quantity of money (M) and the price (P) in this theory:
P = g(M)
In the long run period, the quantity of money have strong relationship with the nominal value of expenditure (PQ) and no systematic association of Q and M. The equation below is about the relationship between them in the long run periods:
PQ = f(M)
P = g (M)
According to the theory Irving Fisher, the quantity demand for money will have strong relationship with the price level and the inflation. If compared to theory Friedman, Friedman no mention too much about the relationship between the inflation and the quantity of money. This is because the source of inflation is fundamentally derived from the growth rate of the money supply.
Friedman and Fishes have different views about the quantity theory of money. Fishes views the quantity of money have related to the transaction. While the Friedman viewed the demand for the stock of money are related to the number of important asset such as financial and non-financial. The following is about the equation of the quantity theory of money which formed by fishes:
MV = PT or MV + M’V’
Where M is the stock of currency, V is the velocity of circulation of currency, P is the price, T is the volume of transaction, M’ is the stock of demand deposits payable by checks and V’ is the velocity of circulation of currency. There are four methods to disposing of cash such as hold in cash, purchasing the consumer and producer’s goods, lend on short term, purchasing long-term bond and corporation shares (Mints, 1945).
Robert (1980) analyses the relationship between the quantity for money with two component in his research which is the rate of price inflation and the nominal rate of interest. From his research, finding that both the inflation and the higher interest rate of the 1970’s are well accounted by the quantity theory of money, but can’t explained clearly about the relationship between that.
Humphrey (1974) stated that the change in quantity of money will affect by the price only. He found that stability of price are more impact to the change in quantity of money if compared to the non-monetary disturbance. In his research, the non-monetary disturbance included technological progress and productivity change, crop failure, monopoly power, taxes and so on.
Most of the theories constructed by the Milton Friedman has lead the anti-Keynesian. This is because the Friedman’s view about the money are quite different with Keynesian’s economics. In the demand for money, the movement of the stock of money will affected by two behavior which is the secular behavior and the cyclical behavior. This two behavior are also key fact in the income velocity. But, this two behavior in the theory the demand for money is not enough to explain the linked between the holding cash and non-human wealth.
For the quantity theory of money, the money supply have relationship with the price level. In this theory, the changes in price and income will affect the movement of money supply. The expenditure factor will also affect the movement of money supply in the long run period only. The interest rate factor such as a misleading factor in this theory because the Friedman analysis that the change in interest rate have only a negligible effect on the quantity for money. Besides that, the inflation factor also not mention too much in this theory because Friedman views the source of inflation is fundamentally derived from the growth rate of the money supply.
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