Milton Friendmans Quantity Theory Of Money

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Milton Friendman’s Quantity Theory of Money

Milton Friedman’s The Quantity Theory of Money- A Restatement marked the resurgence of modern economists’ interest in the Quantity Theory of Money. In that essay Friedman has asserted that quantity theory of money is primarily a theory of the demand for money.

Friedman’s approach can be easily followed by three propositions that chantries the monetarist position:
1.    The supply of money has the dominant influence on nominal income.
2.    In the long run, the influence of money supply is primarily on the price level.
3.    In the short run, the supply of money does influence real variables, but it is a dominant factor causing cyclical movements in real income and employment.

In discussion the relationship between quantity of money and the price level Friedman makes a distinction between the long run and the short run. He argues that any increase in the supply of money will in the long run be translated into higher nominal income. However. the mechanism is not the same all the time. An increase in the money supply must result in higher price implying that an increased supply of money can generate only inflation.

Friedman’s theory is often stated as follows:

 Md / P = f(r, Y, u)

where, Md / P is demand for real balances, r is rate of interest, Y is income and us represents variables that affect tastes and preference of the wealth holders.

Friedman states the following reasons for money supply increases:

1.    The inflation tax. The government earns a profit called by issuing money. The money is issued by the central bank which surrenders the profit earned in the process tot eh government. The profit is equal to the difference between the cost of issuing the money (which is almost zero) and the amount of money issued.

In this case, the holders of cash balances lose. Money supply expansion is relate to a rising price level which simples that the value of money is continually shrinking. Thus issuing of currency notes can be viewed as analogous tot eh levying of a tax on a specific commodity.

2.    The budgetary deficit. The budgetary deficit, if it persists for some time, will lead to price rise. When the government runs deficit, that deficit is financed by selling o bonds. The increased supply of bonds will push the price of bonds downward and the interest rate upwards. Since the government has to sell more bonds, it has no choice but to offer a higher interest rate. With large government borrowing requirements, the Central Bank faces a difficult situation. If the remains passive, the interest rate may rise, However, if faces pressure to prevent interest rate from rising which it can do by buying government bonds. When the Central Bank buys bonds, it creates money, and thereby causes price rise. Thus, in the monetarist model, a continual budgetary deficit creates presenter for increasing money supply.

3.    Short run benefits. In the short run wages and prices are sticky. Therefore an increase in money supply in the short run may not result in price rise. The government may be aware of long-run inflationary consequences of an increase in the supply of money, yet it will not mid expanding the supply of money if it hopes achieve some objective in the short-run.

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