The Keynesian Revolution stirred a counterrevolution by monetarists, who recognize some holes in older versions of classical theory but reject any need for massive government intervention to stabilize an economy. Their counterattack, led by Milton Friedman, began with a reformulation of the demand for money.
The Demand for Money Revisited
Monetarists concede that money might be demanded for reasons other than anticipated transactions, but see no reason to compartmentalize the demand for money as Keynesians have. Instead, they have identified certain variables that influence the amounts of money demanded. Milton Friedman has arrived at the most widely accepted formulation of the new quantity theory of money. Friedman distinguishes the nominal money people hold from their “real” money holdings. Real money is the purchasing power of the money a person holds. It can be computed by dividing the face values of money assets by the price level (M/P). As the price level rises, the face amount of money needed to buy a particular bundle of goods rises proportionally.
Determinants of the Demand for Money
According to Friedman, the variables (besides the price level) that will be positively related to the quantity of money demanded are (a) people’s total real wealth (including the value of their labor), (b) the interest rate, if any, paid on money holdings, and (c) the illiquidity of nonmonetary assets. He also identifies some variables as negatively related to the real (purchasing power) amounts of money people will hold: (a) the interest rate on bonds, (b) the rate of return on physical capital, and (c) the expected rate of inflation.
• Wealth (or Permanent Income)
Classical economists (and Keynesians, to a lesser extent) relate the demand for money to current income. Friedman suggests that expected lifetime income better explains both consumption patterns and money holdings. Take two 25-year-olds, one, a recent college graduate in accounting and the other, a manager of a convenience store. Each has a current annual income of $24,000. The consumption level of the young accountant is likely to be higher than that of the convenience store manager because higher expected lifetime income increases the prospects of borrowing money; thus, the accountant will hold more money for transactions purposes.
• The Interest Rate on Money
You do not receive interest on cash you hold and only relatively low interest on your demand deposits. Banks do, however, offer free checking accounts and other incentives for depositors who keep certain minimum balances in their accounts. Most people would probably maintain higher checking account balances if the interest rates paid to depositors were increased.
• The Illiquidity of Nonmonetary Assets
Most college students are not poor, they are just broke. That is, they have highly marketable skills. Another way of saying this is that they hold wealth in the form of human capital but lack many other assets. According to Friedman, if most of your assets are very illiquid, you will hold more money than will people who have similar amounts of wealth but whose major assets are more liquid. His reasoning is that some liquidity is desired to meet emergencies, and people with substantial human capital may not be able to liquidate their major assets (themselves) very easily. Selling yourself into bondage or slavery is illegal, and finding a job takes time. Consequently, Friedman expects that you will probably hold more cash than similarly “wealthy” people who are not in college. (We remember that when we were students, we were flat broke most of the time.)
• Interest Rates on Bonds and Rates of Return on Investment
The major alternatives to holding money are spending it on consumer goods or buying stocks, bonds, or capital goods. Monetarists stress the value of consumption as the opportunity cost of holding money (1/P), but they also recognize either direct investment or purchases of stocks or bonds as possibilities. If such activities are your best alternatives to holding money, then the prices you pay for holding money are the interest (i) that could be received from a bond or the rate of return (r) you might expect from buying stocks or investing directly in physical capital.
Friedman accepts a negative relationship between the interest rate or rate of return on capital and the quantity of money demanded, but, in support of earlier classical reasoning, his studies conclude that the demand for money is relatively insensitive to the interest rate. He absolutely rejects any hint that a liquidity trap has ever existed.
• Expected Rates of Inflation
The idea that gaining wealth requires you to “buy low and sell high” implies that if you expect inflation, then you should get rid of your money while it has a high value and buy durable assets instead. During inflation, money becomes a hot potato, because expectations of inflation cause people to reduce their money holdings. The greater the expected inflation, the more rapid the velocity of money.
The Stability of the Demand for Money
Monetarists are willing to accept the idea that the demand for money is influenced by variables other than income, but they view these relationships as very stable. Moreover, they believe that most variables that influence the demand for money are relatively constant because they are the outcomes of an inherently stable market system. Table 1 summarizes variables that influence the amounts of money people will want to hold. Monetarists believe that the bulk of any instability in a market economy arises because of erratic government policy; the Federal Reserve System is the main villain in their scenario. Before investigating why the Fed is perceived as the culprit, we need to examine the monetarist monetary transmission mechanism.
The Monetarist Monetary Transmission Mechanism
Monetarists, like their classical predecessors, believe that linkages between the money supply and nominal National Income are strong and direct. Monetarists perceive the demand for money as stable, so an expansion in the money supply is viewed as generating surpluses of money in the hands of consumers and investors. These surpluses of money, when spent, quickly increase Aggregate Demand.
Classical economics stresses Aggregate Supply, viewing Aggregate Demand as adjusting quickly and automatically when supply conditions change. (Supply creates its own demand.) Recognizing the importance of Aggregate Demand in the short run because the economy may falter occasionally, most monetarists believe that growth of the money supply can boost spending and drive a slumping economy toward full employment. Much like classical theorists, monetarists perceive the market system as inherently stable and think that the economy will seldom deviate for long from full employment.
Monetarists consequently predict that, in the long run, growth in the money supply will be translated strictly into higher prices, even if monetary expansion occurs during a recession. Expansionary macroeconomic policies will, however, induce greater output more quickly in the midst of a recession. In other words, the Aggregate Supply curve described by Keynesians may accurately represent a recessionary economy, but only in the very short run. This view of the world is portrayed in Figure 11.
Suppose the money supply is initially at $800 billion and the price level is 100. The economy is temporarily producing at point a, which is 1.5 trillion units of real GDP below capacity, because full employment income is 7.5 trillion units. If the money supply and Aggregate Demand were held constant, then prices and wages would eventually fall to a long-run equilibrium at point b. Full employment would be realized when the price level fell to 80. If the money supply were expanded to $1 trillion, Aggregate Demand would grow and full employment output of 7.5 trillion units would be realized more rapidly (point c). However, the price level is higher in this long-run equilibrium, being maintained at 100.
Most monetarists oppose active monetary policy to combat recessions. They view long-run adjustments as fairly rapid, believing instead that deflation will quickly restore an economy to full employment. An even greater fear is that discretionary monetary policy might overshoot, converting recession into inflation. This is shown in Figure 11 by too rapid growth of Aggregate Demand when the money supply is increased to $1.2 trillion. In this case, the consequence of policy to combat recession is a 20% percent increase in the price level (point d). According to this monetarist line of thinking, overly aggressive monetary expansion can eliminate recession and unemployment more quickly than do-nothing policies, but only at the risk of sparking inflation.