THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 596

564 PA R T V I I Monetary Theory and the signs underneath the equation indicate whether the demand for money is positively (*) related or negatively (,) related to the terms that are immediately above them.12 Let us look in more detail at the variables in Friedman s money demand function and what they imply for the demand for money Because the demand for an asset is positively related to wealth, money demand is positively related to Friedman s wealth concept, permanent income (indicated by the plus sign beneath it) Unlike our usual concept of income, permanent income (which can be thought of as expected average long-run income) has much smaller short-run fluctuations because many movements of income are transitory (short-lived) For example, in a business cycle expansion, income increases rapidly, but because some of this increase is temporary, average long-run income does not change very much Hence in a boom, permanent income rises much less than income During a recession, much of the income decline is transitory, and average long-run income (hence permanent income) falls less than income One implication of Friedman s use of the concept of permanent income as a determinant of the demand for money is that the demand for money will not fluctuate much with business cycle movements An individual can hold wealth in several forms besides money; Friedman categorized them into three types of assets: bonds, equity (common stocks), and goods The incentives for holding these assets rather than money are represented by the expected return on each of these assets relative to the expected return on money, the last three terms in the money demand function The minus sign beneath each indicates that as each term rises, the demand for money will fall The expected return on money rm, which appears in all three terms, is influenced by two factors: The services provided by banks on deposits included in the money supply, such as provision of receipts in the form of cancelled cheques or the automatic paying of bills When these services are increased, the expected return from holding money rises The interest payments on money balances Deposits that are included in the money supply currently pay interest As these interest payments rise, the expected return on money rises The terms rb , rm and re rm represent the expected return on bonds and equity relative to money; as they rise, the relative expected return on money falls, and the demand for money falls The final term, +e , rm, represents the expected return on goods relative to money The expected return from holding goods is the expected rate of capital gains that occurs when their prices rise and hence is equal to the expected inflation rate +e If the expected inflation rate is 10%, for example, then goods prices are expected to rise at a 10% rate, and their expected return is 10% When +e , rm rises, the expected return on goods relative to money rises, and the demand for money falls 12 Friedman also added to his formulation a term h that represented the ratio of human to nonhuman wealth He reasoned that if people had more permanent income coming from labour income and thus from their human capital, they would be less liquid than if they were receiving income from financial assets In this case, they might want to hold more money because it is a more liquid asset than the alternatives The term h plays no essential role in Friedman s theory and has no important implications for monetary theory That is why we ignore it in the money demand function