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Monetary Central Planning and the State, Part 25: Milton Friedman and the Demand for Money

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In 1951, economist Howard S. Ellis happily pointed out, “Money is currently in the process of being rediscovered…. During the late thirties and the war years, it became fashionable with certain theoretical economists [the Keynesians] to stamp any especial concern with the supply of money and credit with the stigma of a hopelessly naive quantity theory. This tendency in economic theory was reflected and increased by government policies. Fiscal policy preempted the field during the [great] depression of the thirties, and direct controls during the [second world] war…. Both monetary theory and monetary practice were consigned to limbo.”

Keynes and the Keynesians had argued that economywide instability in output and employment was due to the erratic “animal spirits” of private-sector investors whose unpredictable changes in optimism and pessimism generated fluctuations in investment spending. However, when investors’ demand to borrow decreased and interest rates declined, savers did not decrease their savings and increase their consumption even though the interest income earned from lending a portion of their wealth had now gone down.

Instead, they increased their holding of idle cash balances because spending out of income was determined independently of relative prices and the rate of interest by what Keynes called the “psychological law” of the propensity to consume. Therefore, as a result of a decline in private-sector investment, total money spending in the economy would decrease. And since workers were unwilling to decrease their money-wage demands for being employed because of “money illusion,” total employment would decline as well, leaving the economy in a potential state of high unemployment.

Money, in the Keynesian framework, was relegated to a place of secondary importance in the policy toolkit of activist government. Increasing the money supply to try to stimulate the economy, in the Keynesian view, was pointless. Any such increases would merely be absorbed for the most part into unspent cash hoards, leaving total spending in the economy unchanged. Instead, government needed to run a budget deficit and either borrow the private sector’s idle cash savings to put it into circulation or directly spend any increases in the money supply upon various public-works projects to stimulate employment and private-sector investment.

The quotation from Howard Ellis suggests that there had been growing criticisms of the Keynesian theory of the demand for money. The most thoroughgoing criticism of this Keynesian conception in the decade after the Second World War was made by Milton Friedman. In 1956, Friedman edited a collection of essays entitled Studies in the Quantity Theory of Money , for which he wrote the introductory essay, entitled “The Quantity Theory of Money – A Restatement.”

Friedman argued that the Keynesian view of the demand for money was too narrow. Suppose that an individual had an income of $100. And further suppose that the Keynesian “psychological propensity to consume” at that level of income was for this individual to spend $50. That would leave the individual with $50 to allocate between investment (in the form of bonds) and idle cash. And also suppose that at a rate of interest of 6%, this individual would invest $25 of his unspent income in bonds. That would leave him with $25 as a cash balance, or 25% of his income.

If the rate of interest were to decrease to, say, 5%, because of a decline in investment demand caused by those “animal spirits” becoming more pessimistic, according to the Keynesians this individual would decrease his investment in bonds by, say, $10, since the return on this form of investment would have declined. But he would not increase his consumption spending by $10 as the alternative to saving in the form of investing in bonds. Instead, the individual would shift that $10 into his cash balance holdings. As a result, the percentage of his income held as idle cash would have increased to 35% ($35 out of his $100 income). In this Keynesian view, the demand for money was considered “unstable.” That is, the desire to hold cash balances as a percentage of income could fluctuate in a wide range.

Total spending in the economy would no longer be $75 ($50 on consumption spending and $25 by those issuing bonds to others who had savings to lend). It would now be $65 (initially the same $50 on consumption spending by income earners and only $15 by those still issuing bonds to facilitate investment spending now that those “animal spirits” had made businessmen more pessimistic). And average unspent cash balances would have changed from $25 to $35.

Friedman argued that holding money has both costs and benefits, just like holding any other asset in which an individual might invest his wealth. The prospective benefit from holding a certain sum of one’s wealth in the form of a cash balance is that it provides the individual with a readily available purchasing power over goods in the marketplace. The real value of holding any given quantity of money as a cash balance is based on the general purchasing power, or exchange value, of money as expressed in the average price level of goods in the market.

But the benefit of holding a sum of money as a cash balance can also be influenced by any expected change in the general price level of goods. If prices are expected to rise by a certain percentage over a year, the benefit from holding that cash balance will be reduced, since with each passing day the real buying power of each unit of money will be falling as prices rise. Conversely, if prices are expected to fall by a certain percentage during that year, the benefit from holding that cash balance will increase, since with each passing day the real buying power of each unit of money will be rising as prices decline. In the case of expected price inflation, the demand for money will decrease while the demand for real goods and other assets expected to increase in market value as prices rise will increase; in the case of expected price deflation, the demand for money will increase and the demand for real goods and other assets expected to decrease in market value as prices go down will decrease.

Competing against money as ways in which an individual can invest and hold his wealth are, Friedman argued: (1) real consumer goods that provide the individual with valued services from their use or consumption; (2) bonds offering an interest return from lending money to an enterprise wishing to borrow; (3) equities, or ownership shares, in a enterprise offering an expected return from net revenues resulting from the selling of a product or service on the market; (4) human capital, or investment in acquiring improved skills through more education or professional training that will increase the market value of one’s future labor services on the market.

An individual divides his wealth among these competing uses until he has a preferred combination at which the expected return from any one of them is tending to equal the expected return from all the others. That is, the last dollar invested in holding bonds gives the same expected return as the last dollar invested in buying an equity share in a company, and gives the same expected return as the last dollar invested in improving one’s labor skills, and gives the same expected return as the last dollar spent on goods and services for consumer satisfaction, and gives the same expected return as the last dollar chosen to be held in a cash balance for facilitating future buying opportunities. And any change in the price or expected return from any one of these ways of holding one’s wealth will modify the combination of them that will be considered most attractive to have.

If the choices open to the individual are widened to include more than just a tradeoff between bonds and cash holdings, then the demand for money is far more “stable” than the Keynesians had argued. Think of the example given earlier of the situation in which the rate of interest decreased from 6% to 5% because of a decrease in the investors’ demand to borrow. But now assume that the individual has a variety of different directions into which he can shift that portion of his savings previously invested in bonds, as Friedman suggested. The individual now takes that $10 no longer invested in bonds and, say, puts $2.50 into buying more consumer goods, $2.50 into purchasing equity shares in some enterprises, $2.50 into investing in improving his future labor skills through additional education or professional training, and an additional $2.50 into his cash balance holdings.

The percentage of his $100 income held as an average cash balance would have increased from 25 to 27.5 percent, a change in his demand for money far smaller than that suggested in the Keynesian example. That change would represent a much smaller decrease in total money spending in the economy than the Keynesians believed and, therefore, a much smaller required decrease in the general level of prices and wages to bring aggregate supply in the economy into balance with the lower aggregate demand for goods and services. In the Keynesian case, the decrease in total spending from $75 to $65 represented a 13.3% decrease in aggregate demand in the economy. In the example using Friedman’s assumptions, the decrease in total spending from $75 to $72.50 represented only a 3.3% decrease in aggregate demand in the economy.

Friedman’s conclusion, therefore, was that if the demand for money was far more stable than the Keynesians had assumed, then significant short-run fluctuations in economywide output and employment, as well as price inflations and deflations, had to have their source in changes in the supply of money. And it is what led Friedman to argue:

“The central fact is that inflation is always and everywhere a monetary phenomenon. Historically, substantial changes in prices have always occurred together with substantial changes in the quantity of money relative to output. I know of no exception to this generalization, no occasion in the United States or elsewhere when prices have risen substantially without a substantial rise in the quantity of money relative to output or when the quantity of money has risen substantially relative to output without a substantial rise in prices.”

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).