Model Answer
0 min readIntroduction
The Quantity Theory of Money (QTM) is a foundational concept in macroeconomics, attempting to explain the relationship between the money supply and the price level. The classical formulation, dating back to the monetarists like David Ricardo and John Stuart Mill, posited a direct and proportional relationship. However, this theory faced challenges in explaining real-world economic fluctuations. In the mid-20th century, Milton Friedman refined the QTM, addressing some of its shortcomings. His restatement, while building upon the classical foundation, introduced crucial modifications regarding the velocity of money, making it a more robust and empirically relevant framework.
The Classical Quantity Theory of Money
The classical QTM is expressed by the equation of exchange: M x V = P x Y, where:
- M represents the money supply
- V represents the velocity of money (the rate at which money changes hands)
- P represents the price level
- Y represents real output (real GDP)
The classical theory assumes that V is stable and determined by institutional factors (payment habits, banking technology, etc.) and that Y is determined by real factors like technology and resource availability, and is independent of the money supply in the long run. Therefore, changes in M directly and proportionally affect P. An increase in the money supply leads to an equivalent increase in the price level, resulting in inflation. This theory was particularly influential before the Keynesian revolution.
Friedman’s Restatement of the Quantity Theory of Money
Milton Friedman, in his work *A Monetary History of the United States* (1963, with Anna Schwartz), challenged the classical assumption of a stable velocity of money. He argued that V is not constant but is itself influenced by several factors, including changes in income, interest rates, and institutional developments. Friedman’s restatement emphasized the importance of the demand for money. He posited that individuals hold money for various motives (transactions, precautionary, and speculative), and the demand for money is stable in the long run.
Friedman’s modified equation of exchange implicitly incorporates the demand for money. He argued that changes in the money supply primarily affect the price level in the long run, but in the short run, they can influence real output, especially if the economy is operating below its potential. He also highlighted the role of expectations. If people anticipate inflation, they will adjust their behavior, potentially leading to a more rapid increase in prices.
Similarities between Classical and Friedman’s Theories
- Long-Run Neutrality of Money: Both theories agree that money is neutral in the long run. Changes in the money supply ultimately affect only the price level and have no lasting impact on real variables like output and employment.
- Equation of Exchange: Both theories utilize the equation of exchange (M x V = P x Y) as a fundamental framework for analyzing the relationship between money, prices, and output.
- Monetary Policy’s Role: Both acknowledge the importance of monetary policy in controlling inflation.
Differences between Classical and Friedman’s Theories
| Feature | Classical QTM | Friedman’s Restatement |
|---|---|---|
| Velocity of Money (V) | Assumed to be stable and constant | Variable and influenced by factors like income, interest rates, and expectations |
| Real Output (Y) | Determined by real factors and independent of money supply | Can be affected by changes in money supply in the short run, especially when the economy is below potential |
| Demand for Money | Not explicitly considered | Central to the theory; demand for money is stable in the long run |
| Short-Run Effects | Money only affects prices | Money can affect both prices and output in the short run |
Friedman’s restatement is considered more realistic because it acknowledges the complexities of the real world and the dynamic nature of the velocity of money. The classical theory, with its rigid assumptions, often failed to explain observed economic phenomena.
Conclusion
In conclusion, Friedman’s restatement of the QTM represents a significant refinement of the classical theory. While both theories share the core principle of the long-run neutrality of money, Friedman’s emphasis on the variable velocity of money and the demand for money makes his version more empirically grounded and capable of explaining short-run economic fluctuations. His work profoundly influenced monetary policy, advocating for stable money supply growth as a means of controlling inflation, a principle still debated and applied today.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.