Milton Friedmans revival of the quantity theory of money

1 Introduction

Milton Friedman is, without a doubt, one of the most influential economists of all times. Born on 31 July 1912, in New York, he graduated at the University of Chicago and later he served there as Professor of Economics. His research in the field of economics brought him a number of awards,including the Nobel Prize in Economics in 1976,”’for his achievements in the fields of consumption analysis, monetary history and theory and for his demonstration of the complexity of stabilization policy.”’¹ Milton Friedman died on 16 November 2006. January 29th 2007, was declared as Milton Friedman day, honoring his achievements and his influence over the modern economic policy.

Milton Friedman’s scholarly contributions are numerous, but the most important are: the critique of the Phillips curve and the introduction of the natural rate of unemployment; the permanent income hypothesis; the stable link between inflation and money supply; the monetarist school of economic thought, and many more, including the revival of the quantity theory of money, the main topic of this paper.

2 Monetarism

Before explaining the quantity theory of money, the term monetarism should be explained. Monetarism² was introduced as a term, describing the macroeconomics theories, associ- ated with Milton Friedman. The main features of the monetarism could be summarized, as follows:

- monetarist transmission mechanism - agents are purchasing goods rather than bonds, when they have to dispose of excess money.
- stability of money demand - demand for money is a stable function of some variables,
more-specifically, wealth, prices, price changes and interest.
- money-to-income causality - business fluctuations are primarily caused by movements in the money supply and the changes in the aggregate demand for goods is with relatively little impact.
- natural rate of unemployment hypothesis - the existence of an unique rate of unemployment, associated with non- accelerating inflation, toward which, in long-run, the economy will converge.
- superiority of monetary policy rules - the monetary policy is much more effective than the fiscal one.³

3 ”‘Classical”’ Quantity Theory of Money

The quantity theory of money was developed by classical economists in the end of the nineteenth and the beginning of twentieth centuries. In general, it could be described as a theory of how the nominal value of the aggregate income is determined. It is also a theory of the demand for money, because it tells us how much money is held for a given amount of aggregate income. The most important feature of this theory is that it suggests that interest rates have no effect on the money demand. The clearest expression of this classical quantity theory is presented by the American economist Irving Fisher. He examined the link between the total money supply M and the total amount of spending on final goods and services, produced within an economy P X Y. The latter term is equal to the aggregate nominal income, or equivalently, to the nominal GDP. The variable that provides the necessary link is the velocity of money, which is the rate of turnover of money; the average number of times per year that a dollar is used for buying amount of goods and services. In mathematical terms, the velocity V is defined as the total spending divided by the quantity of money:

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For example, if the nominal GDP in a year is 10 billion Euro and the money supply is 2 billion Euro, this means that the velocity is 5, or that one Euro bill is spent five times in purchasing final goods and services.

Multiplying the both sides of the previous equation by M, we arrive at the equation of exchange, which relates the nominal income to the quantity of money:

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In simple words, the equation of exchange states that the quantity of money multiplied by the number of times this money is spent in a given year, must equal the total nominal amount spent on goods and services within this year. The original form of the Fisher’s equation of exchange was in terms of the nominal value of transactions within an economy P.T:

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with:

- P = average price per transaction
- T = number of transactions in a year
- Vt = P.T/M = transactions velocity of money

Since, the nominal value of transactions T is rather difficult to be measured, reformulation of the quantity theory was applied in terms of output Y, in the following manner: T is assumed to be in some proportional connection to Y, so that T = ν .Y, where ν is a constant of proportionality. Substituting ν .Y for T and V = Vt/ ν, yields the reformulated Fisher’s equation of exchange.⁴

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¹ http://www.answers.com/topic/milton-friedman

² There are two types of monetarism, recognized by James Tobin: Monetarism Mark I, which is the monetarism, originating from Milton Friedman with ”‘adaptive expectations”’, and Monetarism Mark II - with ”‘rational expectations”’

³ http://cepa.newschool.edu/het/essays/monetarism/friedmanchicago.htm

⁴ http://cepa.newschool.edu/het/essays/money/quantity.htm