Chapter 6 complete

wealth, rather than the measure of work to be done by money has been claimed by 
Friedman as the basic conceptual difference between his formulation of the demand for 
money and the earlier formulations, both neoclassical and Keynesian, concerned with the 
transaction approach to the demand for money; (ii) the price of and return on this form of 
wealth and alternative forms; and (iii) the tastes and preferences of the wealth-holders,for 
example, it seems reasonable that, other things being the same, individual wants to hold a 
large fraction of their wealth in the form of money when they are moving around 
geographically or are subject to unusual uncertainty than otherwise. 
Total wealth includes all sources of income or consumable services. One such source 
is the productive capacity of human beings, and accordingly, this is one form in which wealth 
can be held. From this point of view, the rate of interest expresses the relationship between 
the stock, which is wealth and the flow, which is income. 
There are other variables, which must be included in the demand function for money. 
One such variable suggested by Friedman is “the degree of economic stability expected to 
prevail in the future.” According to Friedman, wealth-holders will demand more money in 
cash or in liquid form when they expect economic instability/ uncertainty in the future and 
vice versa. However, it is difficult to express this variable quantitatively. 
Friedman analysed that wealth can be held in numerous forms. He considered the five 
different form of wealth i.e., (i) money (M), interpreted as claims or commodity units that are 
generally accepted in payment of debts at a fixed nominal value; (ii) bonds (B), interpreted as 
claims to time streams of payments that are fixed in nominal units; (iii) equities (E), 
interpreted as claims to stated pro-rata shares of the returns of the enterprises; (iv) physical 
non-human goods (G); and (v) human capital (H). 
Money may yield a return in the form of money, for example, interest rate on demand 
deposits. The magnitude of this return in ‘real’ terms per nominal unit of money clearly 
depends on the volume of goods that corresponds to, or on the general price level, which we 
may designate by P. 

---

A bond is a long-term debt obligation of a corporation that can generally be traded on 
the market. When a company needs fund, it sells a bond. When it sells a bond, it is actually 
borrowing money. Company commits itself to repay the money to bondholders with interest 
payment on debt after a specific numbers of years. The face value of the bond and the interest 
thereupon are usually stated on the face of the bond. Bond prices and interest rate are 
inversely related to each other. In other words, bond prices and interest rate move in opposite 
directions, i.e., when interest rate falls, bond prices increases and when bond prices falls, 
interest rate increases. Let us take the case of a government bond. A government bond always 
yields a fixed annual income. Suppose that a bond of the face value (price of the bond) of Rs. 
200 that pays interest of Rs. 4 per annum (called its coupon rate). The effective rate of 
interest on bond will be: 
Effective rate of interest on bond = 
100
6.24 
Effective rate of interest on bond = 
.
.
100 = 2 "#$ %#&'
If interest rate increases, bond prices decreases, for example, if interest rate increases to 4 per 
cent, bond prices will be reciprocal of interest rate times coupon rate (i.e., Rs.4). So the bond 
price will be: 
Bond price = reciprocal of interest rate X coupon rate 
6.25 
Bond price = 
(
4
= Rs. 100. 
The bond price decreases to Rs. 100 from Rs. 200 when interest rate increases to 4 per cent 
per annum in order to compensate Rs. 4 per annum to bondholders. Similarly, if interest rate 
decreases to 1.5 per cent, bond price will increase to compensate Rs. 4 per annum on the 
bond. The bond price will be: 
Bond price = 
(
(.*
4
= Rs. 266.66. With decrease in interest rate, the bond prices increases 
so that bondholders will get Rs. 4 per annum (i.e., 1.5 per cent of Rs. 266.67 = Rs.4).
Analogously to our treatment of bonds, we take the ‘standard’ unit of equity to be 
claim to a perpetual income stream of constant ‘real’ amount; that is; to be a standard bond 
with a purchasing-power escalator clause, so that it promises a perpetual income stream equal 
in nominal units to constant number times a price index. 
Physical non-human goods or physical goods held by ultimate wealth-holders are 
similar to equities except that the annual stream they yield as in kind rather than in money. 
The return on physical units in terms of nominal units is based on the behaviour of price. In 
addition, like equities, physical goods must be regarded as yielding a nominal return in the 
form of appreciation or depreciation in money value. If we suppose the price level, P, 
introduced earlier, to apply to the value of these physical goods, then, at time zero, 
(
6.26 

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Together with P, it defines the “real” return from holding of Rs.1 in the form of 
physical goods. 
Human capital cannot be expressed in terms of market prices or rate of return. At any 
one point in time there is some division between human and non-human wealth in his 
portfolio of assets; he may be able to change this over time, but we shall treat it at a point in 
time. Let W be the ratio of non-human to human wealth, which means that it is closely allied 
to what is usually defines as the ratio of wealth to income. This is then, the variable that 
needs to be taken into account so far as human wealth is concerned.
Friedman’s theory of the demand function for money for an individual wealth-holder 
is summed up symbolically below: 
Md = f [P; Bi; Ei; 
(
; W; Y; U] 
6.27 
Where, Md stands for total demand for money; P for general price level; Bi for market 
bond interest rate; Ei for the market rate of interest on equities;
(
;
for the size of nominal 
return per unit of money i.e., Rs.1 of physical goods. Together with P, it defines the “real” 
return from holding of Rs.1 in the form of physical goods; W for the ratio of non-human to 
human wealth; Y for the total remaining wealth or real income and; and U for the utility 
determining index.
The aggregate demand function for money is the summation of the individual demand 
functions. The demand function for money leads to the conclusion that a rise in expected 
yields on different assets reduces the amount of money demanded by wealth holders, and that 
an increase in wealth raises the demand for money. The income to which cash balances are 
adjusted is the expected long-term level of income rather than current income being received. 
Empirical evidence suggests that the income elasticity of demand for money is greater than 
unity, which means that income velocity is falling over the long run. This means that long run 
demand function for money is stable. 
Modern QTM not only regards the demand function for money as stable, it also 
regards this function as playing vital role in determining value (or time paths) of variables of 
great importance for the analysis for the economy as a whole, such as the level of income and 
of the prices. 
In modern quantity theory of money, supply of money is independent of the factors 
affecting the demand for money. The supply of money is influenced by the actions of 
monetary authorities. It means that money which people want to hold is related in a fixed way 
to their permanent income i.e., yield on different assets. 
Modern monetarism is distinguished from other versions of QTM by the assumption 
that velocity is relatively stable in the short run
7
. The short-run effects of changes in the stock 
of money therefore fall entirely on PY. The question then becomes one of the division of 
7.
Kamerschen, David, R, op.cit,: 367

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effects between P and Y. Although a host of factors can affect that division, most monetarists 
place great emphasis on expectations. That part of the monetary expansion (or contraction) 
that is unanticipated will cause output to change; that part that is anticipated will cause the 
price level to change. Because all changes will eventually be known and therefore, 
anticipated, in the long run we are left with the quantity theory result that changes in the 
money stock affect prices alone.
It has been found that it is the permanent income and the actual rate of interest and not 
the changes in the price level that explains most of the variations in the demand for money. 
Friedman’s version of the quantity theory of money is criticised on two grounds viz; (i) 
Friedman argued that rate of interest did not play a crucial role in determining the demand for 
cash balances in the community, and (ii) Friedman argued that supply of money is not 
influenced by the changes in the prices and income.
Having understood the earlier or traditional QTM and modern QTM, let us distinguish 
between the traditional QTM and modern QTM