THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 595

CHAPTER 21

The Demand for Money

563

Although Tobin s analysis did not explain why money is held as a store of
wealth, it was an important development in our understanding of how people
should choose among assets. Indeed, his analysis was an important step in the
development of the academic field of finance, which examines asset pricing and
portfolio choice (the decision to buy one asset over another).
To sum up, further developments of the Keynesian approach have attempted
to give a more precise explanation for the transactions, precautionary, and speculative demands for money. The attempt to improve Keynes s rationale for the
speculative demand for money has been only partly successful; it is still not clear
that this demand even exists. However, the models of the transactions and precautionary demands for money indicate that these components of money demand
are negatively related to interest rates. Hence Keynes s proposition that the
demand for money is sensitive to interest rates suggesting that velocity is not
constant and that nominal income might be affected by factors other than the
quantity of money is still supported.

FRI ED MAN S M O DE RN Q UAN TI TY TH EO RY O F MO N EY
In 1956, Milton Friedman developed a theory of the demand for money in a
famous article, The Quantity Theory of Money: A Restatement. 11 Although
Friedman frequently refers to Irving Fisher and the quantity theory, his analysis of
the demand for money is actually closer to that of Keynes.
Like his predecessors, Friedman pursued the question of why people choose
to hold money. Instead of analyzing the specific motives for holding money, as
Keynes did, Friedman simply stated that the demand for money must be influenced by the same factors that influence the demand for any asset. Friedman then
applied the theory of asset demand to money.
The theory of asset demand (Chapter 5) indicates that the demand for
money should be a function of the resources available to individuals (their

wealth) and the expected returns on other assets relative to the expected return
on money. Like Keynes, Friedman recognized that people want to hold a certain amount of real money balances (the quantity of money in real terms). From
this reasoning, Friedman expressed his formulation of the demand for money
as follows:
Md
= f (Yp, rb - rm, re - rm, pe - rm )
P
+
-

(6)

where Md/P * demand for real money balances
Yp * Friedman s measure of wealth, known as permanent income (technically, the present discounted value of all expected future income,
but more easily described as expected average long-run income)
rm * expected return on money
rb * expected return on bonds
re * expected return on equity (common stocks)
+e * expected inflation rate

11

Milton Friedman, The Quantity Theory of Money: A Restatement, in Studies in the Quantity Theory
of Money, ed. Milton Friedman (Chicago: University of Chicago Press, 1956), pp. 3 21.