Friedman Theory: Friedman's Theory Of Demand For Money

Friedman’s Theory

In his reformulation of the quantity theory,’ Friedman explains that “the quantity theory is the first theory of demand for money. It is not a theory of output, or of money income, or of the price level rather it is a wealth theory of demand. He explains the amount of real cash balances(M/P) as a commodity which is demanded because it yields services to the person who hold it. Thus money is an asset or capital good. Hence the demand for money forms part of capital of wealth theory.

For ultimate wealth holders, the demand for money, in real terms, is a function primarily of the following variables:

M/P = f(Y, w, Rm, Rb, Re, gp, u)

Where M is aggregate demand for money

P is the price level

Y is the total flow of income w is

Other variables. Variables other than income may affect the utility attached to the services of money which determine liquidity proper. Tastes and preferences of wealth holders, trading in existing capital goods by ultimate wealth holders are other variables determine the demand for money along with other forms of wealth. Such variables are noted as ‘u’ by Friedman.

Broadly speaking, total wealth includes all sources of income or consumable services. It average expected yield on wealth during its life time. Thus Wealth can be held in five different forms: money, bonds, equities, physical goods, and human capital. Each form of wealth has a unique characteristic of its own and a different yield.

1. Money is taken in the broadest sense to include currency, demand deposits and time deposits which yield interest on deposits. Thus money is a luxury good. It also yields real return in the form of convenience, security, etc. to the holder which is measured in terms of the general price level (P).

2. Bonds are defined as claim to a time stream of payments that are fixed in nominal units.

3. Equities refers to the claim to a time stream of payments that are fixed in real units.

4. Physical goods or non-human goods are inventories of producer and consumer

or implicitly in the form of services of money measured in terms of P, and inventories. The demand function for money leads to the conclusion that a increase in the expected yields on different assets decreases the amount of money demanded by a wealth holder, and that a rise in wealth increases the demand for money. The income to which cash balances (M/P) are adjusted is the expected long term level of income rather than the current income being received. Empirical evidence suggests that the income elasticity of demand for money is greater than unity which means that income velocity is decreasing over the long run. This means that the long run demand for money function is constant. In other words, the interest elasticity of the long run demand function for money is negligible.

Thus Friedman presents the quantity theory as the theory of the demand for money and the demand for money is assumed to depend on asset prices or relative returns and wealth or income. He shows how a stable demand for money becomes a theory of prices and