The quantity of money people hold depends on: 1) The price level 2) The interest rate 3) Real GDP 4) Financial innovation 5 1. Demand for money The Price Level Nominal money is the quantity of money measured in dollars. YThe quantity of nominal money demanded is proportional to the price level. YIf price increases by 10%, people will hold 10%.

Modern QTM refers to Friedman’s reformulation or restatement of the earlier simple or crude QTM (or Friedman’s QTM), first presented by him in his well-known article, “Quantity Theory of Money— A Restatement” (Friedman, 1956), repeated in Friedman (1968 b). The reformulation is a sophisticated attempt to rid the earlier crude version of the QTM of its shortcomings and overstatements or its main vulnerable aspects by underplaying the over-simple and crude ‘quantity equation’ and bringing instead a well-articulated theory of the demand function for money as the centre piece of the QTM. Not all monetarists, however, agree to this shift in focus. But that is another matter.

Definition: Quantity theory of money states that money supply and price level in an economy are in direct proportion to one another. When there is a change in the supply of money, there is a proportional change in the price level and vice-versa. It is supported and calculated by using the Fisher Equation on Quantity Theory of Money. According to the equation of exchange MV = PY, where M is the stock of money, V is its velocity (how many times a unit of money turns over during a period of time), P is the price level and Y is real income. Consequently, PY is nominal income or in other words the number of transactions carried out in an economy during a period of time. Definition: Quantity theory of money states that money supply and price level in an economy are in direct proportion to one another.When there is a change in the supply of money, there is a proportional change in the price level and vice-versa. It is supported and calculated by using the Fisher Equation on Quantity Theory of Money. Real Money Balances Definition and Meaning: Real money balances is the quantity of money in real terms.

As we have seen above, the QTM was usually stated in the form of an equation that looked like a tautology. Even the Cambridge cash-balance equation was based on the crudest form of the demand function for money that did not point the possibility of any substitution between money and non-money assets and whose K, though a choice variable of the public, was nevertheless a constant.

Thus, this equation also (despite its potential) failed to make the QTM a behavioural rather than a mechanical relation between M and Y and failed to provide systematically (on the basis of a well- articulated theory) for those factors that intervene the process whereby ∆M gets translated into ∆Y. Besides, the QTM needed rehabilitation against the devastating onslaughts to Keynes (1936) and his followers which had brought monetary policy into much disrepute.

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Keynes’ criticism was directed towards the stability of V (or K or the demand for money). He argued that under conditions of unemployment equilibrium V was highly unstable and would, for the most part, passively adapt to whatever changes independently occurred in money income or the stock of money.

Hence, under such conditions, the QTM equation was largely useless for policy or prediction. In the limiting case of the ‘liquidity trap’, in fact, Y can change without a change in M and M can change without a change in Y (because of shifts between M₁ and M₂ corresponding to L₁ and L₂—see equation M^d = L₁(Y) + L(r). (11.3) and after).

M^d = L₁(Y) + L(r). (11.3)

Keynes’ followers have argued further that, outside of the liquidity trap, changes in the quantity of money would affect only the interest rate on bonds and that changes in this rate in turn would have little further effect, because they argued that both consumption expenditures and investment expenditures were nearly completely insensitive to changes in interest rates. That being so, a change in M would merely be offset by an opposite and compensatory change in V, leaving P and Y almost completely unaffected. Tobin (1961) also asserted that only paper securities were substitutes for money, not real assets.

From all this, Friedman (1968 b) concluded that the issues raised for the QTM by the Keynesian analysis were empirical rather than theoretical. For example, is it a fact that the quantity of money demanded in a function primarily of current income and of the bond rate of interest? Is it a fact that the amount demanded is highly elastic with respect to this rate, especially when this rate is quite low?

Is it a fact that expenditures are highly inelastic with respect to such a rate of interest? Or, is it a fact that velocity is a highly unstable and unpredictable magnitude that generally varies in a direction opposite to that of the quantity of money? Friedman’s restatement of the QTM provides a firm analytical basis for such questions and his extensive empirical work and that of his camp-followers much empirical evidence in answer to these and related empirical questions.

With the above introduction in mind, we now proceed with substantive discussion of the key points of Friedman’s modern QTM, discussed below:

1. The QTM is a Theory of the Demand for Money:

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In his restatement (1956), Friedman has clearly stressed that “the quantity theory is in the first instance a theory of the demand for money.” He has gone on to add that “it is not a theory of output, or of money income, or of the price level,” because “any statement about these variables requires combining the quantity theory with some specifications about the conditions of supply of money and perhaps about other variables as well.”

2. The Stability and Importance of the Demand Function for Money:

In the context of Keynes’ criticism, Friedman has laid much stress on the stability of the demand for money function. As an empirical hypothesis he has claimed that this function is more stable than functions such as the consumption function that are offered as alternative key relations.

By stability he means functional stability that the functional relation between the quantity of money demanded and the variables that determine it is highly stable. This means that even the sharp rise in the velocity of circulation of money during hyperinflations is entirely consistent with a stable functional relation, as Cagan (1956) clearly demonstrated in his classic study, ‘The Monetary Dynamics of Hyperinflation’, where he could explain successfully this dynamic in terms of a highly stable demand for money as a function of only the expected rate of change of prices.

This further means that the real quantity of money demanded per unit of output, or V, is not to be regarded as numerically constant over time. Further, functional stability also requires that the variables that it is empirically important to include in the function should be sharply limited and explicitly specified. For, to treat too many variables as empirically significant is to empty the hypothesis of its empirical content.

Modern QTM not only regards the demand function for money as stable, it also regards this function as playing a vital role in determining values (or time paths) of variables of great importance for the analysis of the economy as a whole, such as the level of Y and of prices. It is this consideration that leads the modern quantity theorist to put great emphasis on the demand for money than on, say, the demand for pins, even though the latter might be as stable as the former.

We need not repeat the discussion except to note that Friedman’s reformulation of the demand for money and so of the QTM has been strongly influenced by the Keynesian analysis of liquidity preference. So, it emphasizes the role of money as an asset and treats the demand for money as part of capital or wealth theory, concerned with the composition of the balance sheet or portfolio of assets, (More on this under the next point.) This marked a significant departure of Friedman’s modern QTM from the earlier

QTM which has been based on money viewed as only a medium of exchange.

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(3) Monetary Transmission Mechanism:

The earlier statements of the QTM had practically neglected any discussion of the monetary transmiss

Real Quantity Of Money Definition