200 MONETARIST POLICY
income and consume only a small
share of their total income; those
with the lowest incomes will have
negative transitory income and
will consume more than their
income. But if you add all their
incomes together, the positive
and negative transitory incomes
largely cancel each other out.
Friedman’s theory seemed to fit the
evidence well. In a cross-section of
the population, consumption did
not rise much with income. But,
measured over time and looking
at the total population (so that
transitory income effects cancelled
out), consumption did rise with
income. Friedman concluded that
Keynes’s model of consumption
was wrong. State spending would
be treated as transitory income
and would simply “crowd out”
private spending. Continuing
slumps caused by inadequate
consumption would not happen.
Quantity theory of money
Friedman aimed to show that
monetary policy works: a change
to the amount of money in the
economy has a predictable effect
on total incomes. Keynes had
suggested that this relationship
was unstable because people held
money for different reasons; some
of these reasons were what he
called “speculative” and hard to pin
down. To help prove the quantity
theory right, Friedman needed to
show that the demand for money
is stable. He had to come up with
a testable theory about the
demand for money.
In 1956, Friedman published
The Quantity Theory of Money:
A Restatement. He treated money
as a good, a “temporary abode of
purchasing power.” The market
demand for a good depends on
people’s overall budget and its
relative price against other
competing goods, as well as
buyers’ tastes. Friedman thought
that the demand for money would
be influenced by various factors.
First, it would increase with the
general level of prices, since money
is wanted for its purchasing power
over real goods. It would also be
influenced by people’s “real” wealth
or their permanent income, and the
returns on money, bonds, equities,
and durable goods. Finally, demand
for money would be influenced by
“tastes,” which in this context
means factors such as economic
uncertainty, which leads people
to want to hold money.
Given a well-defined level of
demand for money, an extra supply
of money would not be required by
consumers: they would already be
holding the money that they
needed. They would therefore
spend any extra cash. Prices do not
adjust instantly in the short run, so
this would lead to higher output.
But in the long run, prices would
adjust, and the only effect of the
extra money would be higher
prices. Friedman’s approach can
therefore be seen as a revival of
the quantity theory of money, a
formula that states MV = PT, where
“M” is the money supply and “V”
represents how quickly money
circulates. “P” is the price level,and by multiplying this by “T,”
the number of transactions,
we arrive at the total value of
transactions. Roughly, this
equation says that if V and T
are constant then a higher money
supply means a higher price level.
In the long run money has no
“real” effects on the economy.Natural unemployment
The word “monetarism” was
first used in 1968, the year that
Friedman presented a new account
of the Phillips Curve (p.203). This
showed the supposedly stable
relationship between inflation and
unemployment, which allowed
governments to choose between
less inflation with more
unemployment, or more inflation
with less unemployment. Friedman
denied that such a trade-off exists,
except in the very short run. He
said there is a single “natural rate”
of unemployment, which consists of
unemployed workers temporarily in
the process of looking for jobs.
In practice the economy is at fullInflation is taxation
without legislation.
Milton FriedmanBetween 1975 and 1999, the US
government set yearly targets for
growth in the money supply. However,
it regularly grew by more than the
upper limit of the government target.012ANNUAL PERCENTAGE GROWTHYEAR1975Upper
target1980 1985639Lower
targetActual
growth