Model Answer
0 min readIntroduction
The Quantity Theory of Money (QTM) is a foundational concept in monetary economics, attempting to explain the relationship between the money supply and the price level. The classical QTM, dating back to the works of David Hume and later formalized by Irving Fisher, posits a direct and proportional relationship between the quantity of money and the general price level. However, this theory faced challenges during the Great Depression. Milton Friedman, a Nobel laureate, restated the QTM in the mid-20th century, addressing some of these criticisms and offering a more nuanced perspective. This answer will discuss Friedman’s restatement and the conditions under which it aligns with the classical QTM.
Classical Quantity Theory of Money
The classical QTM is expressed by the equation of exchange: M * V = P * Y, where:
- M represents the money supply.
- V represents the velocity of money (the rate at which money changes hands).
- P represents the general price level.
- Y represents real output (real GDP).
Classical economists assumed that V (velocity of money) and Y (real output) are relatively stable, particularly in the long run. Therefore, changes in M (money supply) directly and proportionally affect P (price level). An increase in the money supply leads to an increase in the price level (inflation), and vice versa. This implies a neutral effect of money on real variables like output and employment.
Friedman’s Restatement of the Quantity Theory of Money
Milton Friedman challenged the classical assumption of a stable velocity of money. He argued that velocity is not constant but is influenced by various factors, including institutional arrangements, technological advancements, and people’s expectations. Friedman’s restatement emphasizes that the demand for money is stable, rather than velocity. He proposed that individuals hold money to facilitate transactions, and this demand is primarily determined by nominal income (P*Y).
Friedman’s restatement can be understood through the following points:
- Demand for Real Money Balances: Friedman focused on the demand for real money balances (M/P). He argued that this demand is a stable function of nominal income (P*Y).
- Long-Run Relationship: He maintained that the QTM holds true in the long run. While short-run fluctuations may occur due to unexpected changes in the money supply, in the long run, changes in the money supply will primarily affect the price level.
- Role of Expectations: Friedman highlighted the importance of expectations. If people anticipate inflation, they will adjust their behavior, leading to a faster increase in prices.
Conditions for Convergence to the Classical QTM
Friedman’s restatement reduces to the classical QTM under specific conditions:
- Stable Velocity: If the velocity of money (V) is indeed stable, as assumed by the classical economists, then Friedman’s restatement becomes equivalent to the classical QTM. In this scenario, changes in the money supply (M) directly translate into changes in the price level (P).
- Stable Demand for Real Money Balances: If the demand for real money balances (M/P) is stable relative to nominal income (P*Y), then changes in the money supply will primarily affect the price level.
- Long-Run Perspective: The convergence is more likely to occur in the long run. In the short run, factors like sticky prices and wages can cause deviations from the QTM. However, over time, these rigidities tend to disappear, and the long-run relationship between money supply and price level becomes more apparent.
The following table summarizes the key differences and similarities:
| Feature | Classical QTM | Friedman’s Restatement |
|---|---|---|
| Velocity (V) | Assumed stable | Variable, influenced by factors |
| Demand for Money | Not explicitly emphasized | Stable demand for real money balances |
| Time Horizon | Short-run and long-run | Primarily long-run |
| Role of Expectations | Limited consideration | Significant role in price adjustments |
| Equation of Exchange | M * V = P * Y | M * V = P * Y (but V is not constant) |
Conclusion
In conclusion, Friedman’s restatement of the QTM refined the classical theory by acknowledging the instability of velocity and emphasizing the stability of the demand for real money balances. While the classical QTM assumes a direct and proportional relationship between money supply and price level based on a constant velocity, Friedman’s version provides a more realistic and nuanced understanding of the monetary-price relationship. The convergence of Friedman’s restatement to the classical QTM hinges on the stability of velocity or the demand for real money balances, particularly in the long run. Modern monetary policy often incorporates these insights, recognizing the importance of managing expectations and considering the long-term effects of monetary interventions.
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.