The quantity theory as a theory of money demand
In general, Friedman expressed highest esteem for the neoclassical “Cambridge cashbalance approach” (Friedman 1974: 8-10). Whereas classical analysis assumed velocity to be an institutional datum, determined by the properties of the payment system and the length of the income period, Alfred Marshall and the Cambridge tradition invoked the real demand for money as a stable behavioural relationship (Pigou 1917 is the epitome of the Cambridge tradition).
Like classical monetary economics, early neoclassical analysis was primarily concerned with the transaction motive (money is held to be spent). The real transaction demand for money was then specified as a linear function of real income:L = kY, (2)
where L denotes the aggregate demand for real balances. Linearity isolates the impact of income on money demand.
Further, neoclassical analysis would be incomplete without market- clearing conditions, supplementing the individual conditions of optimality. As a result, the quantity theory
came to rely on an equilibrium condition. The money-market equilibrium condition is given by:
where M/P measures the purchasing power of all money (real balances in the aggregate). Substituting (2) into (3) yields relationship (1) after simple rearrangements; this time, however, as a genuine equation. Given (A2)-(A3), the real demand for money in the stationary state is independent of the nominal supply of money. In the hands of Pigou, the quantity theorem became identified with the “unitary elasticity” of an aggregate cash-balance demand function (a “rectangular hyperbola”, Pigou 1917: 42), which was primarily employed in comparative-static analysis. The absence of money illusion was translated to mean that individual excess demand functions are homogeneous of degree zero.
The real-balance effect then described the convergence process at the vicinity of the stationary state (for the inconsistency of this approach; see Patinkin 1949, 1965).The focus of the Cambridge School on the behavioural foundations of money demand was a game-changing event in the history of the quantity theory. The involvement of the money market equilibrium condition changed the way the quantity theorem was presented. This impact may explain Friedman’s famous exaggeration that “the quantity theory is in the first instance a theory of the demand for money. It is not a theory of output, or of money income, or of the price level” (Friedman 1956: 4; see also Friedman 1974: 3). Taken seriously, this statement would suggest a quantity theory without its prediction, the quantity theorem. Right because Pigou’s quantity theory is centred on a market-clearing condition, it should be clear that no meaningful restatement can ignore the supply side of the money market. In fact, the money-supply theory of nominal income figures prominently in the monetarist restatement of the quantity theory. After all, monetarism owes its name to the fact that its advocates persistently stressed the predominance of money supply as a determinant of money income.
What is true, however, is that the long-run neutrality of money is of secondary importance in monetarist analysis. Otherwise, monetarism would be far less controversial. Friedman was rather interested in “a more subtle and relevant version, one in which the quantity theory” becomes “a flexible and sensitive tool for interpreting movements in aggregate economic activity and for developing relevant policy prescriptions” (Friedman 1956: 3; see also Friedman 1974: 158-9). Pigou’s real-balance effect was regarded as analytically valid, but of minor empirical relevance (Friedman 1974: 159-60, 1997: 16). Instead of this sterile convergence process, monetarist monetary analysis is concerned with how a monetary impulse is transmitted through financial markets (the portfoliobalance effect), and how it impacts “real” variables on the evidence of nominal rigidities.
In the best tradition of non-Pigovian studies on the quantity theory - from Hume to Fisher and the young Keynes (see Dimand 1988, 2013) - Friedman and the monetarists were primarily interested in the short-run non-neutrality of money. In short, monetarism resurrects the one-equation approach to business cycle analysis.In his restatement, Friedman (1956: 3-4) traced his short-run, policy-orientated version of the quantity theory back to an “oral tradition” at the University of Chicago “throughout the 1930s and 1940s”, in the teachings of Henry Simons, Lloyd Mints and, “at one remove”, Frank Knight and Jacob Viner (for a critical discussion, see Patinkin
1974: 112-18, then Friedman 1974: 162-8, and then Steindl 1990). This oral tradition, in turn, Friedman traced back to Keynes’s Tract (Friedman 1974: 168-9). There, Keynes dismissed the relevance of the long-run neutrality of money on the ground that “this long run is a misleading guide to current affairs”. In fact, “[economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean will be flat again” (Keynes 1923 [1971]: 80). Keynes’s often misunderstood dictum - “In the long run we are all dead” (ibid.: original emphasis) - is just a trenchant summary of this view.