CHAPTER 21 The Demand for Money 563 Although Tobin s analysis did not explain why money is held as a store of wealth, it was an important development in our understanding of how people should choose among assets Indeed, his analysis was an important step in the development of the academic field of finance, which examines asset pricing and portfolio choice (the decision to buy one asset over another) To sum up, further developments of the Keynesian approach have attempted to give a more precise explanation for the transactions, precautionary, and speculative demands for money The attempt to improve Keynes s rationale for the speculative demand for money has been only partly successful; it is still not clear that this demand even exists However, the models of the transactions and precautionary demands for money indicate that these components of money demand are negatively related to interest rates Hence Keynes s proposition that the demand for money is sensitive to interest rates suggesting that velocity is not constant and that nominal income might be affected by factors other than the quantity of money is still supported FRI ED MAN S M O DE RN Q UAN TI TY TH EO RY O F MO N EY In 1956, Milton Friedman developed a theory of the demand for money in a famous article, The Quantity Theory of Money: A Restatement 11 Although Friedman frequently refers to Irving Fisher and the quantity theory, his analysis of the demand for money is actually closer to that of Keynes Like his predecessors, Friedman pursued the question of why people choose to hold money Instead of analyzing the specific motives for holding money, as Keynes did, Friedman simply stated that the demand for money must be influenced by the same factors that influence the demand for any asset Friedman then applied the theory of asset demand to money The theory of asset demand (Chapter 5) indicates that the demand for money should be a function of the resources available to individuals (their wealth) and the expected returns on other assets relative to the expected return on money Like Keynes, Friedman recognized that people want to hold a certain amount of real money balances (the quantity of money in real terms) From this reasoning, Friedman expressed his formulation of the demand for money as follows: Md = f (Yp, rb - rm, re - rm, pe - rm ) P + - (6) where Md/P * demand for real money balances Yp * Friedman s measure of wealth, known as permanent income (technically, the present discounted value of all expected future income, but more easily described as expected average long-run income) rm * expected return on money rb * expected return on bonds re * expected return on equity (common stocks) +e * expected inflation rate 11 Milton Friedman, The Quantity Theory of Money: A Restatement, in Studies in the Quantity Theory of Money, ed Milton Friedman (Chicago: University of Chicago Press, 1956), pp 21