The View of Money: Keynes vs. Friedman

Chahir Zaki

FEPS, Cairo University

Second semester, 2012

Outline

1. Introduction

2. Keynes’ view of Money

3. Friedman’s view of Money

4. Conclusion

Outline

1. Introduction

2. Keynes’ view of Money

3. Friedman’s view of Money

4. Conclusion

Introduction

• In the classical approach, individuals are assumed to hold money because it is a medium of exchange that can be used to carry out everyday transactions.

Introduction

• In his famous 1936 book The General Theory of Employment, Interest, and Money, John Maynard Keynes abandoned the classical view that velocity was a constant and developed a theory of money demand that emphasized the importance of interest rates.

• His theory of the demand for money, which he called the liquidity preference theory, asked the question: Why do individuals hold money? He postulated that there are three motives behind the demand for money: the transactions motive, the precautionary motive, and the speculative motive.

Outline

1. Introduction

2. Keynes’ view of Money

3. Friedman’s view of Money

4. Conclusion

Transactions Motive

• Keynes believed that these transactions were proportional to income, like the classical economists, he took the transactions component of the demand for money to be proportional to income

Precautionary Motive

• Keynes went beyond the classical analysis by recognizing that in addition to holding money to carry out current transactions, people hold money as a cushion against an unexpected need.

• Money demand determined primarily by the level of transactions that they expect to make in the future and that these transactions are proportional to income.

Speculative Motive

• Keynes took the view that money is a store of wealth and called this reason for holding money the speculative motive. Since he believed that wealth is tied closely to income, the speculative component of money demand would be related to income.

• However, Keynes looked more carefully at the factors that influence the decisions regarding how much money to hold as a store of wealth, especially interest rates.

The Three Motives

M d

P f (i,Y) where the demand for real money balances is

negatively related to the interest rate i,

and positively related to real income Y

Rewriting

P

M d

1

f (i,Y)

Multiply both sides by Y and replacing M d with M

V PY

M

Y

f (i,Y)

Keynes was careful to distinguish between nominal

quantities and real quantities

The Three Motives (cont’d)

• By deriving the liquidity preference function for velocity

PY/M, Keynes’s theory of the demand for money implies that

velocity is not constant, but instead fluctuates with movements

in interest rates:

• The demand for money is negatively related to interest

rates; when i goes up, f (i, Y ) declines, and therefore

velocity rises.

•A rise in interest rates encourages people to hold lower real

money balances for a given level of income; therefore, the

rate of turnover of money (velocity) must be higher.

• Because interest rates have substantial fluctuations, the

liquidity preference theory of the demand for money

indicates that velocity has substantial fluctuations as well.

The Three Motives (cont’d)

The procyclical movement of interest rates should induce

procyclical movements in velocity

Velocity will change as expectations about future normal

levels of interest rates change

• There is an opportunity cost and benefit to holding money

• The transaction component of the demand for money is negatively related to the level of interest rates: – As interest rates increase, the amount of cash held for

transactions purposes will decline, which in turn means that velocity will increase as interest rates increase.

– So, the transactions component of the demand for money is negatively related to the level of interest rates.

Transaction Demand

Precautionary Demand

• Similar to transactions demand

• As interest rates rise, the opportunity cost of holding precautionary balances rises

• The precautionary demand for money is negatively related to interest rates

Speculative Demand

• Implication of no diversification: – only money as a store of wealth when the expected

return on bonds is less than the expected return on money and holds

– only bonds when the expected return on bonds is greater than the expected return on money

• For this reason, Tobin showed that people will look at: – the expected return on one asset versus another

when they decide what to hold in their portfolio – but they also care about the riskiness of the returns

from each asset.

Speculative Demand

• Only partial explanations developed further

– Risk averse people will diversify

– Did not explain why money is held as a store of wealth

• An important characteristic of money is that its return is certain; Tobin assumed it to be zero. Bonds, by contrast, can have substantial fluctuations in price, and their returns can be quite risky and sometimes negative.

• The Tobin analysis also shows that people can reduce the total amount of risk in a portfolio by diversifying; that is, by holding both bonds and money

Wrap-Up

• Although Keynes took the transactions and precautionary components of the demand for money to be proportional to income, he reasoned that the speculative motive would be negatively related to the level of interest rates.

• Velocity is not constant, but instead is positively related to interest rates, which fluctuate substantially: because changes in people’s expectations about the normal level of interest rates would cause shifts in the demand for money that would cause velocity to shift as well.

Wrap-Up

• Doubt on the classical quantity theory that nominal income is determined primarily by movements in the quantity of money.

Outline

1. Introduction

2. Keynes’ view of Money

3. Friedman’s view of Money

4. Conclusion

Friedman’s Modern Quantity Theory of Money In 1956, Milton Friedman developed a theory of the demand

for money in a famous article, “The Quantity Theory of

Money: A Restatement”

Variables in the Money Demand Function

• Permanent income (average long-run income) is stable, the demand for money will not fluctuate much with business cycle movements

• Wealth can be held in bonds, equity and goods; incentives for holding these are represented by the expected return on each of these assets relative to the expected return on money

• The expected return on money is influenced by:

– The services provided by banks on deposits

– The interest payment on money balances

Outline

1. Introduction

2. Keynes’ view of Money

3. Friedman’s view of Money

4. Conclusion

Differences between Keynes’s and Friedman’s Model

• Friedman

– Includes alternative assets to money

– Viewed money and goods as substitutes

– The expected return on money is not constant; however, rb – rm does stay constant as interest rates rise

– Interest rates have little effect on the demand for money

Differences between Keynes’s and Friedman’s Model (cont’d)

• Friedman (cont’d)

– The demand for money is stable velocity is predictable

– Money is the primary determinant of aggregate spending

References

• Mishkin, Chapter 22.