Macro Economics

Modern Quantity theory of money

The concept of modern quantity theory of money is developed by Prof. Milton Friedman in his essay "The Quantity Theory of Money- A Restatement". He defended the concept of the fisher quantity theory of money with his revised version at the point of time where Keynesian concept of monetary was leading the thoughts. He put-forward his new demand function. Friedman viewed that the money demand function is most stable function in the economy.

People demand money because it is considered as a wealth. A part of money is held by people parting a portion for investment in capital assets. For firms demand for money is considered as capital goods which when combined with other factors of production leads to the production of goods and services.

In nutshell,

Firms demand for money- as capital goods

Individual/people demand for money- as durable consumer goods, hold money in form of BFIs savings and capital assets like, equity and bonds

Firms gain the profit/loss with capital gains/loss due to expected changes in the market rate of interest. Whereas for individual/people, in respect to the capital goods like equity or bond they earn the annualized fixed rate of interest (dividend in respect to equity share) with capital gains or loss due to expected change in the market rates of interest. Friedman mean by holding money to the savings of amount in BFIs in saving/fixed account. The rate of interest by BFIs plus opportunity cost it forgone for is gained in holding money. But, the demand for money to hold the wealth in the form of durable consumer goods doesn't provide returns in the form of cash, it provides in kind with returns in the form of expected rate of change in their prices per unit of time.

(source of image is internet) 

The demand function equation is forwarded in two aspect: one have considered inflation influence and called equation of demand for real money whereas other one is equation of demand for nominal money.

Nominal money demand function

Md = f (W, h, rm, rb, re, P, Change in P/P, U)

Real money demand function

Md/ P = f (W, h, rm, rb, re, P, Change in P/P, U)

where, 

Md = Nominal money demand

Md / P = Real money demand

W = wealth of the individual

h = Proportion of human wealth to total wealth held by the people

rm = interest income from money holdings

rb = interest rate on bonds

re = rate of return on equity/shares

P = price level

U = institutional factors

The factors that determine the demand for money according to the Friedman are given below: 

i. Wealth: Wealth, the main component determining demand for money, is composed of human and non-human wealth according to Friedman. 

Human Wealth - value of an individual's present and future earnings or non liquid component of wealth

Non-Human Wealth - Bonds, equity shares and notes or coins

The proportion of human wealth to total wealth held by the people is included in demand function as an independent variable. The total wealth including both human and non-human wealth sets the upper limit of money holdings by an individual. As human wealth is in nature of non-liquid, the demand for money is considered rise with the rise in proportion of human wealth to non-human wealth.

ii. Rates of Return: Here, the Friedman considered the three rates, rate of bond, divided on equity and interest rate of BFIs. When the rate of interest on saving and fixed account increases, the demand for money will also rise. The purchased of bonds and equity is done by forgoing the opportunity cost which may be otherwise acquired with that sum of investment. There is negative relationship between cost of holding money and rates of return on bonds and equities. With rise in cost of holding money, economy experiences the less demand for money.

iii. Price level: The salary received by individual is the nominal money of the person where inflation is not included. So, higher the price level, higher will be the demand for money. Similarly, as the price level of commodity rise showing real income (since, inflation is included) it automatically rise the demand for money by the people to meet the demand for goods.

iv. The expected rate of inflation: In other word, change in the price level. Higher the rate of inflation, lower will be the demand for money for the holdings reason inflation reduces the value of money in terms of purchasing power. If the rate of inflation is greater than the nominal interest it is negative to hold the cash or kept wealth in form of capital goods. So, the people invest in the goods which have little or no influence of the inflation.

v. Institutional Factors:  The political instability, instability of capital market, pattern of wage payment are some of the institutional factors which gives the rise of demand for money. This have no control by individual firm or person. This shows the flowing trend. In globalization, may be influenced from globe at large. Hence, it is considered one of the important independent variable that influence demand for money.

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