1. The View of Money:
Keynes vs. Friedman
Chahir Zaki
FEPS, Cairo University
Second semester, 2012
2. Outline
1. Introduction
2. Keynes’ view of Money
3. Friedman’s view of Money
4. Conclusion
3. Outline
1. Introduction
2. Keynes’ view of Money
3. Friedman’s view of Money
4. Conclusion
4. Introduction
• In the classical approach, individuals are
assumed to hold money because it is a
medium of exchange that can be used to carry
out everyday transactions.
5. Introduction
• In his famous 1936 book The General Theory of
Employment, Interest, and Money, John Maynard
Keynes abandoned the classical view that velocity was
a constant and developed a theory of money demand
that emphasized the importance of interest rates.
• His theory of the demand for money, which he called
the liquidity preference theory, asked the question:
Why do individuals hold money? He postulated that
there are three motives behind the demand for money:
the transactions motive, the precautionary motive, and
the speculative motive.
6. Outline
1. Introduction
2. Keynes’ view of Money
3. Friedman’s view of Money
4. Conclusion
7. Transactions Motive
• Keynes believed that these transactions were
proportional to income, like the classical
economists, he took the transactions
component of the demand for money to be
proportional to income
8. Precautionary Motive
• Keynes went beyond the classical analysis by
recognizing that in addition to holding money
to carry out current transactions, people hold
money as a cushion against an unexpected
need.
• Money demand determined primarily by the
level of transactions that they expect to make
in the future and that these transactions are
proportional to income.
9. Speculative Motive
• Keynes took the view that money is a store of
wealth and called this reason for holding money
the speculative motive. Since he believed that
wealth is tied closely to income, the speculative
component of money demand would be related
to income.
• However, Keynes looked more carefully at the
factors that influence the decisions regarding
how much money to hold as a store of wealth,
especially interest rates.
10. The Three Motives
Keynes was careful to distinguish between nominal
quantities and real quantities
Md
f ( i, Y) where the demand for real money balances is
P
negatively related to the interest rate i,
and positively related to real income Y
Rewriting
P 1
d
M f ( i, Y)
Multiply both sides by Y and replacing M d with M
PY Y
V
M f ( i, Y)
11. The Three Motives (cont’d)
• By deriving the liquidity preference function for velocity
PY/M, Keynes’s theory of the demand for money implies that
velocity is not constant, but instead fluctuates with movements
in interest rates:
• The demand for money is negatively related to interest
rates; when i goes up, f (i, Y ) declines, and therefore
velocity rises.
•A rise in interest rates encourages people to hold lower real
money balances for a given level of income; therefore, the
rate of turnover of money (velocity) must be higher.
• Because interest rates have substantial fluctuations, the
liquidity preference theory of the demand for money
indicates that velocity has substantial fluctuations as well.
12. The Three Motives (cont’d)
The procyclical movement of interest rates should induce
procyclical movements in velocity
Velocity will change as expectations about future normal
levels of interest rates change
13. Transaction Demand
• There is an opportunity cost and benefit to holding
money
• The transaction component of the demand for
money is negatively related to the level of interest
rates:
– As interest rates increase, the amount of cash held for
transactions purposes will decline, which in turn means
that velocity will increase as interest rates increase.
– So, the transactions component of the demand for
money is negatively related to the level of interest
rates.
14. Precautionary Demand
• Similar to transactions demand
• As interest rates rise, the opportunity cost of
holding precautionary balances rises
• The precautionary demand for money is
negatively related to interest rates
15. Speculative Demand
• Implication of no diversification:
– only money as a store of wealth when the expected
return on bonds is less than the expected return on
money and holds
– only bonds when the expected return on bonds is
greater than the expected return on money
• For this reason, Tobin showed that people will
look at:
– the expected return on one asset versus another
when they decide what to hold in their portfolio
– but they also care about the riskiness of the returns
from each asset.
16. Speculative Demand
• Only partial explanations developed further
– Risk averse people will diversify
– Did not explain why money is held as a store of wealth
• An important characteristic of money is that its
return is certain; Tobin assumed it to be zero.
Bonds, by contrast, can have substantial
fluctuations in price, and their returns can be
quite risky and sometimes negative.
• The Tobin analysis also shows that people can
reduce the total amount of risk in a portfolio by
diversifying; that is, by holding both bonds and
money
17. Wrap-Up
• Although Keynes took the transactions and
precautionary components of the demand for money
to be proportional to income, he reasoned that the
speculative motive would be negatively related to
the level of interest rates.
• Velocity is not constant, but instead is positively
related to interest rates, which fluctuate
substantially: because changes in people’s
expectations about the normal level of interest rates
would cause shifts in the demand for money that
would cause velocity to shift as well.
18. Wrap-Up
• Doubt on the classical quantity theory that
nominal income is determined primarily by
movements in the quantity of money.
19. Outline
1. Introduction
2. Keynes’ view of Money
3. Friedman’s view of Money
4. Conclusion
20. Friedman’s
Modern Quantity Theory of Money
In 1956, Milton Friedman developed a theory of the demand
for money in a famous article, “The Quantity Theory of
Money: A Restatement”
21. Variables in the Money Demand
Function
• Permanent income (average long-run income) is stable, the
demand for money will not fluctuate much with business
cycle movements
• Wealth can be held in bonds, equity and goods; incentives for
holding these are represented by the expected return on each
of these assets relative to the expected return on money
• The expected return on money is influenced by:
– The services provided by banks on deposits
– The interest payment on money balances
22. Outline
1. Introduction
2. Keynes’ view of Money
3. Friedman’s view of Money
4. Conclusion
23. Differences between Keynes’s and
Friedman’s Model
• Friedman
– Includes alternative assets to money
– Viewed money and goods as substitutes
– The expected return on money is not constant;
however, rb – rm does stay constant as interest
rates rise
– Interest rates have little effect on the demand for
money
24. Differences between Keynes’s and
Friedman’s Model (cont’d)
• Friedman (cont’d)
– The demand for money is stable
velocity is predictable
– Money is the primary determinant of aggregate
spending
