Friedman vs.

Keynes When comparing the money demand frameworks of Friedman and Keynes, several differences arise

Friedman considers multiple rates of return and considers the RELATIVE returns to be important Friedman viewed money and goods and substitutes. Friedman viewed permanent income as more important than current income in determining money demand

Friedman's money demand function is much more stable than Keynes'. Why? Consider the terms in Friedman's money demand function:

permanent income is very stable, and the spread between returns will also be stable since returns would tend to rise or fall all at once, causing the spreads to stay the same. So in Friedman's model changes in interest rates have little or no impact on money demand. This is not true in Keynes' model.

If the terms affecting money demand are stable, then money demand itself will be stable. Also, velocity will be fairly predictable. IV. Empirical Evidence on Money Demand So who is right? Well, the chief differences between Keynes and Friedman lie in the sensitivity of money demand to interest rates and the stability of the money demand function over time. Looking at the data on these two features will yield some answers about the best theory of money demand. Tobin did some of the earliest research on the relationship between interest rates and money demand and concluded that money demand IS sensitive to interest rates. Later research in the 1950s and 1960s backed up his findings. Furthermore, the sensitivity did not change over time. Many researchers looked at this question and their findings are remarkably consistent (which in economics is somewhat miraculous :)). Now for the stability of the money demand function. Up until the mid-1970s, researchers found the money demand function to be remarkably stable. In other words, money demand functions estimated in the 1930s, worked just as well predicting money demand in the 1950s or 1960s. The relationship between money demand, income and interest rates did not change over time.

However, starting in 1974, the stability of the money demand function (M1) began to breakdown. Existing money demand functions were overpredicting money demand (i.e. actual money demand was lower than what old money demand functions were predicting). This case of the "missing money" was a problem for policy makers that relied on these functions to predict the effects of monetary policy. What caused this breakdown? It is likely that financial innovations in the 1970s (money market accounts, NOW accounts, electronic funds transfers) changed the working definitions of money even though our official definitions did not change. This problem grew worse in the 1980s. With the problems in the M1 money demand functions, policy makers turned to M2 money demand. However, the stability of M2 money demand functions also broke down in the 1990s. This cause the Federal Reserve to stop setting targets for M2 in 1992 after abandoning M1 targets in 1987. FYI: Related Links Milton Friedman Read more about the 1976 Nobel Prize winner and one of the most influential living economists John M. Keynes A web page by economist Brad DeLong on John M. Keynes, definitely one of the 100 most influential thinkers of the 20th century (or so says Time Magazine) A quite different approach was put forth by Tobin (1958), in a paper that views the demand for money as arising from a portfolio allocation decision made under conditions of uncertainty. In the more influential of the paper's models, the individual wealth-holder must allocate his portfolio between a riskiess asset, identified as money, and an asset with an uncertain return whose expected value exceeds that of money. Tobin shows how the optimal portfolio mix depends, under the assumption of expected utility maximization, on the individual's degree of risk aversion, his wealth, and the mean-variance characteristics of the risky asset's return distribution. The analysis implies a negative interest sensitivity of money demand, thereby satisfying Tobin's desire to provide an additional rationalization

of Keynes's (1936) liquidity preference hypothesis. The approach has, however, two shortcomings. First, In actuality money does not have a yield that is riskiess in real terms, which Is the relevant concept for rational individuals. Second, and more seriotsly, In many actual economies there exist assets "that have precisely the same risk characteristics as money and yield higher returns" (Barro and Fischer, 1976, p. 139). Under such conditions, the model implies that no money will be held. Another influential item from this period was provided by Friedman's well-known "restatement" of the quantity theory (1956). In this paper, as in Tobin's, the principle role of money Is as a form of wealth. Friedman's analysis emphasized margins of substitution between money and assets other than bonds--e.g., durable consumption goods and equities. The main contribution of the paper was to help rekindle interest in monetary analysis from a macroeconomic perspective, however, rather than to advance the formal theory of money demand. A model that may be viewed as a formalization of Hicks's (1935) (1939) approach was outlined by Sidrauski (1967). The main purpose of Sidrauski's paper was to study the interaction of inflation and capital accumulation in a dynamic context, but his analysis gives rise to optimality conditions much like those of equations (4)-(8) of the present article and thus Implies money demand functions like (9) and (12). The main difference between Sidrauski's model and ours is merely due to our use of the "shopping time" specification, which was suggested by Saving (1971). That feature makes

real balances an argument of each individual's utility function only Indirectly, rather than directly, and Indicates the type of phenomenon that advocates of the direct approach presumably have in mind. Thus Sidrauski's implied money-demand model is the basis for the one presented above, while a stochastic version of the latter, being fundamentally similar to inventory or direct utility-yield specifications, is broadly representative of current mainstream views. Ongoing Controversies Having outlined the current mainstream approach to money demand analysis and its evolution, we now turn to matters that continue to be controversial. The first of these concerns the role of uncertainty. In that regard, one point has already been developed, i.e., that rate-of-return 18uncertainty on other assets cannot to ex:lain why individuals hod