Friedman’s Theory of Demand for Money –
Friedman put forward demand for money function which shows how the changes in the money supply affect the price level in the economy. He treats money as one type of asset in which people holds their wealth. For business firms money is a capital good or factor of production which they use with other factors to produce goods.
According to Friedman, individuals hold money for the transaction purposes. It (money) serves as a purchasing power and it is also very convenient for buying goods and services. His approach to demand for money does not consider any other motives for holding money and it also does not differentiate between speculative and transactions demand for money.
Friedman analyzed the various factors which determine the demand for money.
The amount of goods and services which money can buy represents the real yield on money or real value of money. This real yield of money depends on the price level of goods and services.
Bonds are also a type of asset in which people can hold their wealth. Bonds are securities which gives interest income, fixed in nominal terms. Yield on bonds is the rate of interest and also anticipated capital gain or loss due to expected changes in the market rate of interest.
Equities or Shares are another form of asset in which people can hold their wealth. The return from equity is determined by the dividend rate, expected capital gain or loss and expected changes in the price level.
Friedman’s nominal demand function (Md) –
Md = f(W, h, rm, rb, re, P, ∆P/P, U)
Demand for real money is the nominal demand for money divided by the price level, so, demand for real money balances –
Md/P = f(W, h, rm, rb, re, P, ∆P/P, U)
Md = nominal demand for money
Md/P = demand for real money balances
W = wealth of the individuals
h = proportion of human wealth to the total wealth held by the individuals
rm = rate of return or interest on money
rb = rate of interest on bonds
re = rate of interest on equities
P = price level
∆P/P = change in price level or rate of inflation
U = institutional factors