INSTITUTE: USB

DEPARTMENT: COMMERCE
Bachelors of Commerce
International Monetary Economics 21CMT-307
By- Ravneet Kaur
Video Lecture-8

Friedman’s Restatement Theory DISCOVER . LEARN . EMPOWER

1
 International
Monetary
Economics
Course Outcome
CO Title Level
Number
Will be covered in this
CO1 The students would be able to Understand why people Understand lecture
hold money and why it is used in the trading process

CO2 The students would be able to Apply to comprehend the Apply

international developments
CO3 The students would be able to Analyze the theoretical Analyze
building blocks that are needed for an understanding of
the monetary theory
CO 4 The students would be able to Evaluate the issues in the Evaluate
present-day monetary policy implementation faced by the
central banks.
CO 5 The students would be able to Create the main channels Create
of the monetary transmission mechanism, through which
monetary policy can have real effects on the economy.
2
 Contents
• Objective: To provide conceptual understanding of Service Marketing.

• The following topics are covered in upcoming slides:

1. Introduction to Friedman’s Restatement Theory.

2. Assumptions of Theory.
3. Criticism of the theory

3
 Friedman’s Restatement Theory
• Friedman distinguishes between two types of demand for money. In the first type,
money is demanded for transaction purposes. It serves as a medium of exchange. This
view of money is the same as the old quantity theory. But in the second type, money
is demanded because it is considered as an asset. Money is more basic than the
medium of exchange. It is a temporary abode of purchasing power and hence an asset
or a part of wealth. Friedman treats the demand for money as a part of the wealth
theory.

• The demand for money depends on three factors:

• (a) The total wealth to be held in various forms.
• (b) The price or return from these various assets and
• (c) Tastes and preferences of the asset holders. 4
• Friedman considers five different forms in which wealth can be held, namely, money (M),
bonds (B), equities (E), physical non-human goods or Bank deposits (G) and human capital
(H). In a broad sense, total wealth consists of all types of “income”. By “income” Friedman
means “aggregate nominal permanent income” which is the average expected yield from
wealth during its life time.

• The wealth holders distribute their total wealth among its various forms so as to maximize
utility from them. They distribute the assets in such a way that the rate at which they can
substitute one form of wealth for another is equal to the rate at which they are willing to do.

• Accordingly the cost of holding various assets except human capital can be measured by the
rate of interest on various assets and the expected change in their prices. Thus Friedman
says there are four factors which determine the demand for money. They are: (1)price
level, (2)real income, (3)rate of interest and (4)rate of increase in the price level.

5
• The demand for money is unitarily elastic (E(dm) = 1). The relationship between the
demand for money and real income (output of goods and services) is also direct (Md ∞ Y).
But it is not proportional as in the case of price. Thus while changes in the price level cause
direct and proportional changes in the demand for money, changes in real income create
direct but more than proportional changes in the demand for money E(y) > 1.

• The rate of interest and the rate of increase in the price level constitute the cost of holding
cash balances. If money is kept in the form of cash, it does not earn any income. But if the
same money is lent out, it could earn some income in the form of interest to the owner.

• The interest is the cost of holding cash. At higher interest rate the demand for money would
be less. On the other hand, a lower rate of interest creates an increase in the demand for
money. Thus there is an inverse relationship between the rate of interest and the demand
for money (Md ∞ 1/ROI).
6
• The rate of increase in the price level also influences the demand for money. There is an
inverse relationship between the rate of increase in the price level and the demand
for money. When the price level increases at a high rate, the cost of holding money will
increase.
• The people would like to hold smaller cash balances. The demand for money will decline.
On the other hand when the price level increases at a low rate, the cost of holding money
will decline and the demand for money increases.
• Fourthly, Friedman believes that each form of wealth has its own characteristics and a
different yield or return. In a broad sense money includes currency, demand deposits and
time deposits which yield interest. Money also yields real return in the form of
convenience, security etc., to the holder which is measured in terms of price (P). When the
price level falls, the rate of return on money is positive because the value of money
increases. When the price level rises, the value of money falls and the rate of return is
negative. Thus P is an important variable in the demand function of Friedman.
7
• The rate of return on bonds, equities and physical assets consists of currently paid interest
rate and changes in their prices. As far as human wealth is concerned it is very difficult to
measure the conversion of human into non-human wealth due to institutional constraints.
But there is some possibility of substituting human wealth for non-human wealth.

• Freidman calls the ratio of non-human wealth to human wealth or ratio of wealth to
income as W. According to Friedman, income elasticity of demand for money is greater
than unity. Besides, there are certain variables like the tastes and preferences of the wealth
holders which also affect the demand functions. These variables are represented by m.

8
• Friedman’s Demand Function:
• On the basis of the above assumptions and formulations, Friedman has derived a demand function for an
individual wealth holder.
• It may be symbolically expressed as

• Where M is the total demand for money, P is the general price level,
• rb is the market interest rate on bonds,

• re is the market interest rate on equities,

• 1/p. dp/dt is the nominal return from physical goods,
• W is the ratio of non-human to human wealth,
• Y is the money income available to the wealth holder,
• m is the variables affecting tastes and preferences on the wealth holders.
9
• In Friedman’s modern quantity theory of money, the supply of money is independent of
demand for money. Due to the actions of the monetary authorities, the supply of money
changes, whereas the demand for money remains more or less stable. It means that the
amount of money which people want to have as cash or bank deposits is more or less fixed
to their permanent income.
• If the central bank purchases securities, people who sell securities to the central bank
receive money and this leads to an increase in their cash holdings. The people will spend
this excess money partly on consumer goods and partly by purchasing assets. This spending
will reduce their cash balances and at the same time there is a rise in the national income.
• On the other hand, when the central bank sells securities, the money holding of the people
reduces, in relation to their permanent income. Therefore, they will try to increase their
cash partly by reducing their consumption and partly by selling their assets. This will
reduce national income. Thus in both cases the demand for money remains stable.

10
• If the demand for money is given, it is possible to predict the
effects of changes in the supply of money on expenditure and
income. If the economy is at less than full employment level, an
increase in the supply of money raises the expenditure, output and
employment levels. But this is possible only in the short run.

• Friedman’s quantity theory of money can be explained

diagrammatically in the following figure

• In the figure while the X-axis shows the demand and supply of
money, Y-axis measures the income level. MD is the demand
curve for money which changes along with income. MS is the
supply curve for money. These two curves intersect at point E and
the equilibrium income level OY is determined. If there is an
increase in money supply, the supply curve shifts to M1S1. At this
level the supply is greater than demand and a new equilibrium is
established at E1. At the new equilibrium level the income
https://images.app.goo.gl/kcTQrm3qnACkfTVC7
increases to OY1.
11
 Criticism Of Friedman’s Theory
1. Very Broad Definition of Money: Friedman has been criticized for using the broad definition of money which
not only includes currency and demand deposits (М1) but also time deposits with commercial banks (M2). This
broad definition leads to the obvious conclusion that the interest elasticity of the demand for money is
negligible. If the rate of interest increases on time deposits, the demand for them (M 2) rises. But the demand for
currency and demand deposits (M1) falls. So the overall effect of the rate of interest will be negligible on the
demand for money. But Friedman’s analysis is weak in that he does not make a choice between long-term and
short-term interest rates. In fact, if demand deposits (M1) are used a short-term rate is preferable, while a long-
term rate is better with time deposits (M2). Such an interest rate structure is bound to influence the demand for
money.
2. Ignores the Effect of Other Variables on Money Supply: Friedman also ignores the effect of prices, output or
interest rates on the money supply. But there is considerable empirical evidence that the money supply can be
expressed as a function of the above variables.
3. Does not consider Time Factor: Friedman does not tell about the timing and speed of adjustment or the length
of time to which his theory applies.
12
4. More Importance to Wealth Variables: In Friedman’s demand for money function, wealth
variables are preferable to income and the operation of wealth and income variables
simultaneously does not seem to be justified. As pointed out by Johnson, income is the return on
wealth, and wealth is the present value of income. The presence of the rate of interest on these
assets show the future income of the investors about which Friedman did not discuss.

5. Money Supply not Exogenous: Friedman takes the supply of money to be unstable. The supply
of money is varied by the monetary authorities in an exogenous manner in Friedman’s system.
But the fact is that the money supply consists of bank deposits created by changes in bank
lending. Bank lending, in turn, is based upon bank reserves which expand and contract with (a)
deposits and withdrawals of currency by non-bank financial intermediaries; (b) borrowings by
commercial banks from the Federal Reserve System; (c) inflows and outflows of money from
and to abroad: and (d) purchase and sale of securities by the Federal Reserve System. The first
three items definitely impart an endogenous element to the money supply. Thus the money
supply is not exclusively exogenous, as assumed by Friedman. It is mostly endogenous.

13
6. Money not a Luxury Good: Friedman regards money as a luxury good because of the
inclusion of time deposits in money. This is based on his finding that there is higher trend
rate of the money supply than income in the United States. But no such ‘luxury effect’ has
been found in the case of England or any other developing country.

7. Confusion of Stock and Flow Concept: Friedman propounded that permanent and real
income is used for consumption, But he ignored the existence of Lagged Income. Lagged
Income is the carry forwarded income of past years, in short Friedman did not explain what
amount of money is to be stored and for how long, and also when this stored money of
income is to be floated in the economy.

8. Weightage of Assets: Friedman stated that money is used in form of different assets. But he
failed to explain the time lag between investing in different assets and the weightage different
assets carry in relation to time. For eg: Bonds have longer duration as compared to equities.

14
 Difference Between Friedman and Keynes
Friedman Keynes
1. Economic Equilibrium: At less than full 1. At full employment level.
employment 2. Weak impact on price, income and economic output
2. Monetary Changes: Strong impact on
income, output and prices. 3. Stable relationship
3. Relationship between supply and national 4. Money does not matter
income: Unstable
4. Money Supply: Money matters the most 5. By current rate of inflation

5. Price affected: By expected rate of 6. Affect both price and output in below full
inflation employment level and only prices in full
6. Change in money supply: affect only on employment level.
price level.
15
7. Demand For money: Friedman described demand for money as a creation of asset whereas Keynes
defined demand for money into 3 motives i.e. for (1). Transaction, (2) Precautionary and (3)
Speculative.

8. Government policy: Friedman advocated the importance of monetary policy of government in

economy, whereas Keynes advocated the importance of government expenditure by giving
importance to Fiscal policy of the government in general.

9. Time period for theory: Friedman failed to specify the time period or applicability of his theory in
particular time period, whereas Keynesian approach always concentrated on short period.

10. Nature of Income: Friedman advocated the concept of aggregate nominal income out of all the
assets available for investment, Whereas Keynes advocated the concept of real income or income
through rate of interest on bond investments only.
16
 Summary Of The Topic
• Students will get a clear picture of the concept of Theories of demand for Money.
• This conceptual understanding will help them in gaining an insight into the monetary economics.

17
 Assessment Pattern
Sr. No. Type of Assessment Task Weightage of actual Frequency of Task Final Weightage in Internal Remarks
conduct Assessment
1. Assignment* 10 marks of each One Per Unit 10 marks As applicable to course
assignment types depicted above.

2. Time Bound Surprise 12 marks for each test One per Unit 4 marks As applicable to course
Test types depicted above.

3. Quiz 4 marks of each quiz 2 per Unit 4 marks As applicable to course

types depicted above.

4. Mid-Semester Test** 20 marks for one MST. 2 per semester 20 marks As applicable to course
types depicted above.

5. Presentation*** Non Graded: Engagement Task Only for Self Study MNG
Courses.
6. Homework NA One per lecture topic [ of 2 Non-Graded: Engagement Task As applicable to course
questions] types depicted above.

7. Discussion Forum NA One per Chapter Non Graded: Engagement Task As applicable to course
types depicted above.

8. Attendance and Engagement NA NA 2 marks

Score on BB

18
 APPLICATION
• Application of International Monetary Economics can be as follows:
1. Better understanding of concept of theory of demand for money.
2. Better Strategic Planning is possible.
3. Helps in analyzing various features, classification and importance of money and demand for
money.

19
 REFERENCES
• Reference Books:
"Monetary Economics" by Jagdish Handa, Volume- 2009/2nd Edition PDF link for the book
ishttp://data%20backup%2006012022/Desktop/Chandigarh%20University/IME%20(Jan-DEc
%202020)/IME%20PPT/international%20Monetary%20Economics.pdf , book can also be
purchased from Amazon and link for same is https://www.amazon.in/Monetary-Economics-
Jagdish-Handa/dp/0415199255.

"A Guide to International Monetary Economics", Third Edition: Exchange Rate Theories,
Systems and Policies by Hans Visser, Edward Elgar Publishing, 2006, PDF link for the book is
https://www.yumpu.com/en/document/read/41781471/a-guide-to-international-monetary-
economicspdf, book can also be purchased from Amazon and link for same is
https://www.amazon.in/Guide-International-Monetary-Economics-Third/dp/1845426932.

20
 THANK YOU

For queries:
Email: ravneet.usb@cumail.in

21