Milton Friedman (1912 - 2006)

The Revival of the Equation of Exchange

and the Quantity Theory of Money

A Great Economist
And a Product of his Times
Roger W. Garrison

2011

CPI
CONSUMER PRICE INDEX
(1982-1984 = 100)

220

old 971.
g
t o 5, 1
k
in g. 1
l
s
u
ar on A
l
l
d o ed
e
Th ever
ss
a
w
100

221

CPI
(1982-1984 = 100)
Last five years

221
220

211

Printing
Money and
Spending it.

CFO Chapter 18, pp. 341-343:

Monetarism
The Equation
of Exchange

CFO Chapter 10:

and the The
Quantity
Theory
of
Money
Money Supply
and the Federal Reserve System

How much
money is there,
anyway?
But first.
What do we mean by money?

Tim Hudson earns a

lot of money.
Bill Gates has a lot of
money.
Its better to buy a
house when money is
cheap.
I need to cash a check
to get some money.
Money facilitates the
exchange of goods

Tim Hudson earns a

lot of money.
Bill Gates has a lot of
money.
Its better to buy a
house when money is
cheap.
I need to cash a check
to get some money.
Money facilitates the
exchange of goods

CURRENC
Y
CREDIT
MONEY
INCOME
WEALTH

How much
money is there,
(Money is the medium of
anyway?
exchange.)
$ 1,861,000,000,000

M1 = $ 1,861 billion
Currency and coin: $ 920
billion
Checking deposits: $ 941
billion
C&C/M1 = 0.494, or about
49.4%

M1 = $ 1,861 billion
Currency and coin: $ 920
billion
US Population: 311,000,000
Per capita C&C: $ 2,958
Per family of four: $ 11,833
Just whos holding all this

M is the money supply.

M1 = $ 1,861 billion
Inquiring minds want to know:
Has M1 always been $1,861
billion?
How does more MI get created?
Who makes the decisions?
Is more money always a good
thing?

Monetaris
m

Friedman was a
Marshallian,
but he was a
macroeconomist.

He had his own research

Agenda: Money and
Inflation.
MILTON FRIEDMAN

And he was out to counter

stands for the Money supply.

M1 = $ 1,861 billion
GDP = Y = $ 14,870 billion
V = Y/M = 14,870 / 1,861 =

MV = Y
M1 = $ 1,861 billion
GDP = Y = $ 14,870 billion
V = Y/M = 14,870 / 1,861 =

t
en
tm
es ss
nv e
i xc
e
h
es
it l. ri
w c o
-- in nt
to ve
in

MV = Y = E
M1 = $ 1,861 billion

GDP = Y = $ 14,870 billion

V = Y/M = 14,870 / 1,861 =

t
en
tm
es ss
nv e
i xc
e
h
es
it l. ri
w c o
-- in nt
to ve
in

MV = Y = E =
PQ
M1 = $ 1,861 billion

GDP = Y = $ 14,870 billion

V = Y/M = 14,870 / 1,861 =

t
en
tm
es ss
nv e
i xc
e
h
es
it l. ri
w c o
-- in nt
to ve
in

MV = Y = E =
2008:
V
=
PQ
10.18
2009: V =
9.09
2010: V =
Dating
8.22 from the beginning of the most

recent contraction, the velocity of money

MV = Y = E =
2008:
V
=
PQ
10.18
VELOCIT

11.0
10.0
9.0
8.0

2009: V =
9.09
2010: V =
Dating
8.22 from the beginning of the most
Y

7.0
6.0
5.0

2008 2009 2010 2011 2012

recent contraction, the velocity of money

MV = PQ
M is the money supply
(outside the banking system).

V is moneys velocity of
circulation.
P is the price level.
Q is the economys output.
PQ is total expenditures (E).

A SAMPLE QUESTION

How much money is there, anyway?

A. M1 is a little under $1.861
billion.
B. M1 is a little under $6.168
billion.
C. M1 is a little under $1.861
trillion.
Ask FRED. (FRED means Federal Reserve Economic
Data.)

D. M1 is a little under $6.168

trillion.
Click on Ben to go there.

MV = PQ
This is the Equation of
Exchange.
No economist, dead or living, has
ever denied that MV actually does
equal
PQ... V is defined as
because

PQ/M.

MV = PQ
In normal times:
V doesnt change much.
Q changes in the low single
digits.

Keynes believed that the velocity

of money was subject to dramatic
and unpredictable change.
He believed that people hoard
money, more so some times than
others. (increased hoarding means
a decrease in velocity.)
In extreme episodes, people may
be overcome by the fetish of
liquidity, the fetish often
accompanying the waning of
animal spirits.

MV = PQ
So, what happens when M is
doubledsay, from $ 1,861
billion to $ 3,722 billion?
P would also double.
But the doubling of P takes
time.

MV = PQ
In the long run and with a constant V,
the price level (P) moves in
proportion to the money supply (M)
in a no-growth (i.e., constant-Q)
economy.
This is The Quantity Theory of
Money.
A more descriptive name would be:

MV = PQ
More generally,
In the long run, money-supply growth
in excess of real economic growth
impinges wholly on the price level (P)
and not at all on the level of real
output.
Put bluntly: you cant create real

Monetaris
m
MV = PQ
This is the unadorned tautology
that we call the Equation of
Exchange

Monetaris
m
MV = PQ
18-30
months

This
is the
Theory
In the
longQuantity
run, increases
inof
Money.
M affect nothing
but P (and

Monetaris
m

Keynesianism is to Keynes as Monetarism is to

A. Ben Bernanke.

C. Claude Monet.

B. Tim Geithner.

D. Milton Friedman.

Milton Friedman (1912 - 2006)

MV = PQ
Inflation is always
and everywhere
a monetary
phenomenon!!!

The equation of exchange is so near and dear

to Milton Friedmans heart that he
A. has made
C.
B.
D.
had
written
adopted
it spelled
his
a itparody
wife
as his
out
Rose
to
vanity
inthe
pansies
promise
popular
license
inthat
the
plate
it
number
for
his
Eldorado.
Y.M.C.A
flower
will make
garden
to memorialize
a tasteful
atCadillac
Stanfords
appearance
the Hoover
equation
oninhis
song.
Institution.
head stone.

The equation of exchange is so near and dear

to Milton Friedmans heart that he
A. tasteful appearance on his head stone.
B. spelled out in pansies in flower garden.
C. parody to the popular Y.M.C.A.
D. vanity license plate number.
Gribouillis conomiques

GREG MANKIWS BLOG

Random Observations for Students of Economics

September 16, 2006:

Curious question from Mankiw:
How can you identify my car?

Gregory Mankiw
Former Chairman
Council of Economic Advisors
George W. Bush Administration

mvpy writes:
You know, I hate to spoil things, but I must say, I think Milton
Friedman has a better plate. This is from an article I came across:
"Years ago, trying to find the Friedmans apartment in San
Francisco, I knew I was in the right location when I spotted a car
with the number plate MV = PT."
A. Delaique writes:
Milton Friedman's license plate was MV = PQ, not MV = PT.
Picture here : http://gribeco.free.fr/article.php3?id_article=12
Anonymous writes:
That's pretty ridiculous..
Cane writes:
I love economists.

Monetarist
Policy
FOR A GROWING ECONOMY

MV = PQ
Policy implication:
Normally,
a healthyIncrease
economy
M at
will
a
slow,
experience
steady rate
real(2%
economic
or 3%)
growth
to
match
amounting
the long-run
to 2%
rate
orof
3%
growth.
per year.

Monetarist
Policy
FOR A GROWING ECONOMY

MV = PQ
With this Monetarist Rule in effect,
there will be no inflation and no
deflation.
Price-level stability is the hallmark
of macroeconomic stability.

Monetaris
m

Some diagnostics:

With the Monetarist Rule in

effect (2 or 3%) and a constant
V, the rate of inflation would be
zeroor very close to zero.
Has the rate of inflation been
zero?

Monetaris
m

Some diagnostics:

CPI for 1982-1984 = 100

CPI for January 2010 = 216

That is, prices on average are
more than double now what they
were in the early 1980s. (See

CPI
CONSUMER PRICE INDEX
(1982-1984 = 100)
Last five years of the CPI

Monetaris
MV = PQ
m

Some diagnostics:

Has Q been falling for the past 25

years?
Has V been rising for the past 25
years?

Monetaris
MV = PQ
m

Q rose by 88.5%, which is 2.80% per

year.
V rose by 23.7%, which is 0.90% per
year.
Suppose M had increased (in
accordance with the monetary rule)

Monetaris
m
2.50
%
0.90%

2.80%

0.60%

MV = PQ

Monetaris
m

If M had risen at the rate of 2.5%

over the period 19832008 and P
had risen at the rate of 0.60%, the
current CPI would be 115.0 instead
of 216.
That is, prices in general wouldve

5.0%

Monetaris
m

2.80%

3.1%

0.90%

MV = PQ

Monetaris
m

Q rose by 88.5%, which is 2.80% per

year.
V rose by 23.7%, which is 0.90% per
year.
M actually increased by 5.0% per
year.
M, which rose from $450 billion to

T H E N A T U R A L R A T
E
O F U N E M P L O Y M E N
T

SEPT 11 2001

SEPT 11 2001

SEPT 11 2001

Sidewalk Survey on Dexter

Avenue:
Whats the cause of
inflation?
Greed.
Oil companies.
Medical industry.
Home-building industry.

The Jane Fonda bull-by-thehorn approach to ending

inflation.
Identify major groups of
products whose prices have
risen the most:
energy, medical, housing, food.
Enact pricing policies that hold
the prices in these areas down
and thereby counter the

What about the major groups

of products whose prices have
fallen the most:
computers, cameras,
electronics.
Is the economic activity in
these areas creating
deflationary pressures?

MV =
PQ , p , p , p , p
CPI = avg.(p
1

gasoline

pn)
The P in the equation of
exchange is measured by the
CPI (or the WPI or GPI), which
is a price index. The index
tracks the average of all
prices.

?
CPI = avg.(p1, p2, p3, p4, pgasoline,
pn)
Good arithmetic; bad
economics.

MV = PQ

CPI = avg.(p1, p2, p3, p4, pgasoline,

pn)
Many other prices go down.
Some
up, too.
--the
(firewood).
--theprice
priceofofsubstitutes
complements

(RVs)
--the price of goods and services for
which
oil
in
a
substantial
input
--the price of so-called normal
(airfares).

goods generally (restaurant

Suppose that unrest in the Middle East causes a

reduction in the supply of oil flowing to the U.S., which
leads to a 20% increase in the price of oil. Economists
who accept the quantity theory of money will claim that
A. prices in general will rise because everything
depends upon (is related to) oil.
B. the Federal Reserve should increase the money
supply so that people can pay the higher gas prices.
C. whatever the Federal Reserve does, there will be
substantial inflationalthough not a 20% inflation rate.
D. there will be no inflation in the U.S. so long as the
Federal Reserve does not increase the money supply.

Bubbalonia
is experiencing inflation.
Prices INFLATION
in general are rising.
IS are
ALWAYS
AND EVERYWHERE
What
the logically
possible causes,
A MONETARY
PHENOMENON.
as implied
by the Equation
of Exchange?
What is the actual (empirically
demonstrated)
--- Milton
Friedman
cause according to the Quantity Theory?

MV = PQ

a. Increasing Q.
g. Increasing gas prices.
b. Decreasing Q
h. Credit-card mania.
c. Increasing V.
i. Labor unions.
d. Decreasing V.
j. Greed.
e. Increasing M.
f. Decreasing M.

Suppose that new taxes on tobacco products cause

the tax-included price of cigarettes to double.
Microeconomists would predict that the quantity of
tobacco products bought will fall only slightly and
that total spending on cigarettes will nearly double.
Monetarists would claim that the tax will
A. result in a slightly higher rate of inflation.
B. cause the Federal Reserve to undertake
compensatory policy actions.
C. have no effect on the general price level.
D. result in a slightly higher velocity of money.

Can you apply similar reasoning

to show that none of the other
oft-mentioned culprits are
responsible for inflation?
Greed.
Oil companies.
Medical industry.
Home-building industry.

Labor unions.

Do labor unions cause inflation?

Labor unions can call a strike
or just threaten to call a
strikein order to get higher
wages.
And higher wages get
translated into higher prices.
Thats inflation, isnt it?

S
D

Union labor

S
D

Union labor

S
S

Non-union labor

D
N

S
D

Union labor

Product market

S
S

Non-union labor

D
N

S
D

Union labor

Product market

Non-union labor

D
N

S
D
Product market

Do labor unions cause inflation?

No. But they can cause the
prices of goods made by
unionized labor to rise and the
prices of goods made by nonunionized labor to fall.
However, if the central bank
increases the money supply in
an attempt to neutralize the
effects of labor unions, the

A Ceiling on Your Home (1945)

By the Office of Price Administration
(OPA)
CLICK ON POSTER GIRL TO SEE VIDEO

Synopsis: [This 12 minute film] shows

the economic factors affecting
postwar inflation and an appeal for
public cooperation, an appeal to the
public to assist in retail price control,
and the difficulties veterans faced in
locating jobs and housing.

Reviewer: ERD -- March 7, 2006

Subject: "Ceiling on Your Home" does a good job
This 1945 film does a good job explaining about the
purpose of rent control after World War II. Excellent
narrative script and filming.

Reviewer: Christine Hennig -- December 9, 2003

Subject: No Rentals Today, But Keep in Touch!
This post-WWII film advocates rent control as a way to
control inflation as a result of the post-war housing
shortage. It portrays young couples struggling to find a
decent place to live and start their families, and finding
NO RENTALS signs everywhere. This is an interesting
slice of life from the post-WWII era, before the problem
would be eventually solved by huge housing
developments in the suburbs.

Reviewer: Spuzz -- February 26, 2003

Subject: Rent Rant.
As the boys were coming home from war, much concern
(I guess) was made about the lack of affordable housing
for the soldiers and their new families. Luckily, the Office
of Price Administration (whatever that is) was there to see
that there was rent fixing, and that everyone would pay
the same price. A persuasive film with plenty of great
images.

Is it possible to increase the

money supply without causing
inflation?
Suppose that the velocity of
money can (somehow) be made
to fall as the money supply was
being increased?
Couldnt an increased M and a
decreased V combine to allow
for a constant price level?

The Anti-inflation
campaign of the Ford
Administration

Whip
W
I
Inflation
N
Now

The Anti-inflation
campaign of the Ford
Administration
People should wear
their WIN buttons.
They should look
for bargains
holding on to
their money while
they look.
Dont spend it.
Just hold it.

MV=P
Q

The Anti-inflation
campaign of the Ford
Administration
The Federal
Reserve is
increasing the
money supply.

That means that

prices will be
rising.
Its called
inflation.
What can you do

MV=P
Q

The Anti-inflation
campaign of the Ford
Administration
You can earn
money
and
then
In other
words,
just
hold on to it.
the government
can create
money
Holding
on to
and spend
it, and
money
means
a
that wont
decrease
incause
inflation if you are
velocity.
willing to earn
The
decreased
money
and notV
will
offset
spend
it. our
increasing M,

MV=P
Q

The Anti-inflation
campaign of the Ford
Administration MV=PQ: Its

always right, but

there are no
votes in it.

Milton Friedman (1912- 2006)

MV = PQ
Inflation is
always and
everywhere
a monetary
phenomenon!!!