THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 597

CHAPTER 21

The Demand for Money

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DISTI N GU I SHI N G BE TW E E N T HE F RIE DM AN
AND KE YN ESI AN TH EO RI ES
There are several differences between Friedman s theory of the demand for
money and the Keynesian theories. One is that by including many assets as alternatives to money, Friedman recognized that more than one interest rate is important to the operation of the aggregate economy. Keynes, for his part, lumped
financial assets other than money into one big category bonds because he felt
that their returns generally move together. If this is so, the expected return
on bonds will be a good indicator of the expected return on other financial
assets, and there will be no need to include them separately in the money
demand function.
Also in contrast to Keynes, Friedman viewed money and goods as substitutes;
that is, people choose between them when deciding how much money to hold.
That is why Friedman included the expected return on goods relative to money as
a term in his money demand function. The assumption that money and goods are
substitutes indicates that changes in the quantity of money may have a direct effect
on aggregate spending.
In addition, Friedman stressed two issues in discussing his demand for money
function that distinguish it from Keynes s liquidity preference theory. First, Friedman
did not take the expected return on money to be a constant, as Keynes did. When
interest rates rise in the economy, banks make more profits on their loans, and they
want to attract more deposits to increase the volume of their now more profitable
loans. If there are no restrictions on interest payments on deposits, banks attract
deposits by paying higher interest rates on them. Because the industry is competitive, the expected return on money held as bank deposits then rises with the higher
interest rates on bonds and loans. The banks compete to get deposits until there are
no excess profits, and in doing so they close the gap between interest earned on
loans and interest paid on deposits. The net result of this competition in the banking industry is that rh * rm stays relatively constant when the interest rate i rises.13

What if there are restrictions on the amount of interest that banks can pay on
their deposits? Will the expected return on money be a constant? As interest rates
rise, will rh * rm rise as well? Friedman thought not. He argued that although banks
might be restricted from making pecuniary payments on their deposits, they could
still compete on the quality dimension. For example, they can provide more services to depositors by hiring more tellers, paying bills automatically, or making
more cash machines available at more accessible locations. The result of these
improvements in money services is that the expected return from holding deposits
will rise. So despite the restrictions on pecuniary interest payments, we might still
find that a rise in market interest rates will raise the expected return on money sufficiently so that rh * rm will remain relatively constant. Unlike Keynes s theory,
which indicates that interest rates are an important determinant of the
demand for money, Friedman s theory suggests that changes in interest
rates should have little effect on the demand for money.

13

Friedman does suggest that there is some increase in rb * rm when i rises because part of the money
supply (especially currency) is held in forms that cannot pay interest in a pecuniary or nonpecuniary
form. See, for example, Milton Friedman, Why a Surge of Inflation Is Likely Next Year, Wall Street
Journal, September 1, 1983. p. 24.