THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 597

CHAPTER 21 The Demand for Money 565 DISTI N GU I SHI N G BE TW E E N T HE F RIE DM AN AND KE YN ESI AN TH EO RI ES There are several differences between Friedman s theory of the demand for money and the Keynesian theories One is that by including many assets as alternatives to money, Friedman recognized that more than one interest rate is important to the operation of the aggregate economy Keynes, for his part, lumped financial assets other than money into one big category bonds because he felt that their returns generally move together If this is so, the expected return on bonds will be a good indicator of the expected return on other financial assets, and there will be no need to include them separately in the money demand function Also in contrast to Keynes, Friedman viewed money and goods as substitutes; that is, people choose between them when deciding how much money to hold That is why Friedman included the expected return on goods relative to money as a term in his money demand function The assumption that money and goods are substitutes indicates that changes in the quantity of money may have a direct effect on aggregate spending In addition, Friedman stressed two issues in discussing his demand for money function that distinguish it from Keynes s liquidity preference theory First, Friedman did not take the expected return on money to be a constant, as Keynes did When interest rates rise in the economy, banks make more profits on their loans, and they want to attract more deposits to increase the volume of their now more profitable loans If there are no restrictions on interest payments on deposits, banks attract deposits by paying higher interest rates on them Because the industry is competitive, the expected return on money held as bank deposits then rises with the higher interest rates on bonds and loans The banks compete to get deposits until there are no excess profits, and in doing so they close the gap between interest earned on loans and interest paid on deposits The net result of this competition in the banking industry is that rh * rm stays relatively constant when the interest rate i rises.13 What if there are restrictions on the amount of interest that banks can pay on their deposits? Will the expected return on money be a constant? As interest rates rise, will rh * rm rise as well? Friedman thought not He argued that although banks might be restricted from making pecuniary payments on their deposits, they could still compete on the quality dimension For example, they can provide more services to depositors by hiring more tellers, paying bills automatically, or making more cash machines available at more accessible locations The result of these improvements in money services is that the expected return from holding deposits will rise So despite the restrictions on pecuniary interest payments, we might still find that a rise in market interest rates will raise the expected return on money sufficiently so that rh * rm will remain relatively constant Unlike Keynes s theory, which indicates that interest rates are an important determinant of the demand for money, Friedman s theory suggests that changes in interest rates should have little effect on the demand for money 13 Friedman does suggest that there is some increase in rb * rm when i rises because part of the money supply (especially currency) is held in forms that cannot pay interest in a pecuniary or nonpecuniary form See, for example, Milton Friedman, Why a Surge of Inflation Is Likely Next Year, Wall Street Journal, September 1, 1983 p 24