THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 596

564

PA R T V I I Monetary Theory
and the signs underneath the equation indicate whether the demand for money is
positively (*) related or negatively (,) related to the terms that are immediately
above them.12
Let us look in more detail at the variables in Friedman s money demand function and what they imply for the demand for money.
Because the demand for an asset is positively related to wealth, money demand
is positively related to Friedman s wealth concept, permanent income (indicated
by the plus sign beneath it). Unlike our usual concept of income, permanent
income (which can be thought of as expected average long-run income) has much
smaller short-run fluctuations because many movements of income are transitory
(short-lived). For example, in a business cycle expansion, income increases
rapidly, but because some of this increase is temporary, average long-run income
does not change very much. Hence in a boom, permanent income rises much less
than income. During a recession, much of the income decline is transitory, and
average long-run income (hence permanent income) falls less than income. One
implication of Friedman s use of the concept of permanent income as a determinant of the demand for money is that the demand for money will not fluctuate
much with business cycle movements.
An individual can hold wealth in several forms besides money; Friedman
categorized them into three types of assets: bonds, equity (common stocks),
and goods. The incentives for holding these assets rather than money are
represented by the expected return on each of these assets relative to the
expected return on money, the last three terms in the money demand function.
The minus sign beneath each indicates that as each term rises, the demand for
money will fall.
The expected return on money rm, which appears in all three terms, is influenced by two factors:
1. The services provided by banks on deposits included in the money supply,
such as provision of receipts in the form of cancelled cheques or the automatic
paying of bills. When these services are increased, the expected return from
holding money rises.

2. The interest payments on money balances. Deposits that are included in the
money supply currently pay interest. As these interest payments rise, the
expected return on money rises.
The terms rb , rm and re rm represent the expected return on bonds and
equity relative to money; as they rise, the relative expected return on money falls,
and the demand for money falls. The final term, +e , rm, represents the expected
return on goods relative to money. The expected return from holding goods is the
expected rate of capital gains that occurs when their prices rise and hence is equal
to the expected inflation rate +e. If the expected inflation rate is 10%, for example,
then goods prices are expected to rise at a 10% rate, and their expected return is
10%. When +e , rm rises, the expected return on goods relative to money rises,
and the demand for money falls.

12

Friedman also added to his formulation a term h that represented the ratio of human to nonhuman wealth. He reasoned that if people had more permanent income coming from labour income
and thus from their human capital, they would be less liquid than if they were receiving
income from financial assets. In this case, they might want to hold more money because it is a more
liquid asset than the alternatives. The term h plays no essential role in Friedman s theory and has
no important implications for monetary theory. That is why we ignore it in the money demand
function.