THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 598

566

PA R T V I I Monetary Theory
Therefore, Friedman s money demand function is essentially one in which permanent income is the primary determinant of money demand, and his money
demand equation can be approximated by
Md
= f (Yp)
P

(7)

In Friedman s view, the demand for money is insensitive to interest rates not
because he viewed the demand for money as insensitive to changes in the incentives for holding other assets relative to money but rather because changes in
interest rates should have little effect on these incentive terms in the money
demand function. The incentive terms remain relatively constant because any rise
in the expected returns on other assets as a result of the rise in interest rates would
be matched by a rise in the expected return on money.
The second issue Friedman stressed is the stability of the demand for money
function. In contrast to Keynes, Friedman suggested that random fluctuations in
the demand for money are small and that the demand for money can be predicted
accurately by the money demand function. When combined with his view that the
demand for money is insensitive to changes in interest rates, this means that velocity is highly predictable. We can see this by writing down the velocity that is
implied by the money demand equation (Equation 7):
V =

Y
f (Yp)

(8)

Because the relationship between Y and Yp is usually quite predictable, a stable

money demand function (one that does not undergo pronounced shifts so that it
predicts the demand for money accurately) implies that velocity is predictable as
well. If we can predict what velocity will be in the next period, a change in the
quantity of money will produce a predictable change in aggregate spending. Even
though velocity is no longer assumed to be constant, the money supply continues
to be the primary determinant of nominal income as in the quantity theory of
money. Therefore, Friedman s theory of money demand is indeed a restatement
of the quantity theory because it leads to the same conclusion about the importance of money to aggregate spending.
You may recall that we said that the Keynesian liquidity preference function
(in which interest rates are an important determinant of the demand for money)
can explain the procyclical movement of velocity that we find in the data. Can
Friedman s money demand formulation explain this procyclical velocity phenomenon as well?
The key clue to answering this question is the presence of permanent income
rather than measured income in the money demand function. What happens to
permanent income in a business cycle expansion? Because much of the increase
in income will be transitory, permanent income rises much less than income.
Friedman s money demand function then indicates that the demand for money rises
only a small amount relative to the rise in measured income, and as Equation 8
indicates, velocity rises. Similarly, in a recession, the demand for money falls less
than income because the decline in permanent income is small relative to income,
and velocity falls. In this way we have the procyclical movement in velocity.
To summarize, Friedman s theory of the demand for money used a similar
approach to that of Keynes and the earlier Cambridge economists but did not
go into detail about the motives for holding money. Instead, Friedman made
use of the theory of asset demand to indicate that the demand for money will