20.3 Friedman versus Keynes #Notebook

20.3 Friedman versus Keynes #Notebook

The modern quantity theory is superior to Keynes’s liquidity preference theory because it is more complex, specifying three types of assets (bonds, equities, goods) instead of just one (bonds). 

In Friedman’s theory, velocity is no longer a constant and does not assume that the return on money is zero. Instead, it is highly predictable.

Unlike the liquidity preference theory, Friedman’s modern quantity theory predicts that interest rate changes should have little effect on money demand. 

Md / Plv: f (Pi varies directly with, ERoB – ERoM varies indirectly with, ERoS – ERoM varies indirectly with, EIf – ERoM varies indirectly with)

The reason for this is that Friedman believed that the return on bonds, stocks, goods, and money would be positively correlated, leading to little change in ERoB – ERoM, ERoS – ERoM, or EIf – ERoM because both sides would rise or fall about the same amount. 

Interest rates did not strongly affect the demand for money, so velocity was predictable and the quantity of money was closely linked to aggregate output. Except when nominal interest rates hit zero (as in Japan), the demand for money was somewhat sensitive to interest rates, it's a liquidity trap, where money demand is perfectly horizontal. Since the money demand became more sensitive to interest rate changes, velocity, output, and inflation became harder to predict.  

Transfers of stock or public debt are there equivalent to payments in species. So, velocity rises when there are money substitutes, highly liquid assets that allow economic agents to earn interest. 

Not as much money supply was needed to support the GDP and price level. Velocity can rise during the period that government debts are large. It then dropped as the government paid off the debt, requiring the use of more M1.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.