THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 598

566 PA R T V I I Monetary Theory Therefore, Friedman s money demand function is essentially one in which permanent income is the primary determinant of money demand, and his money demand equation can be approximated by Md = f (Yp) P (7) In Friedman s view, the demand for money is insensitive to interest rates not because he viewed the demand for money as insensitive to changes in the incentives for holding other assets relative to money but rather because changes in interest rates should have little effect on these incentive terms in the money demand function The incentive terms remain relatively constant because any rise in the expected returns on other assets as a result of the rise in interest rates would be matched by a rise in the expected return on money The second issue Friedman stressed is the stability of the demand for money function In contrast to Keynes, Friedman suggested that random fluctuations in the demand for money are small and that the demand for money can be predicted accurately by the money demand function When combined with his view that the demand for money is insensitive to changes in interest rates, this means that velocity is highly predictable We can see this by writing down the velocity that is implied by the money demand equation (Equation 7): V = Y f (Yp) (8) Because the relationship between Y and Yp is usually quite predictable, a stable money demand function (one that does not undergo pronounced shifts so that it predicts the demand for money accurately) implies that velocity is predictable as well If we can predict what velocity will be in the next period, a change in the quantity of money will produce a predictable change in aggregate spending Even though velocity is no longer assumed to be constant, the money supply continues to be the primary determinant of nominal income as in the quantity theory of money Therefore, Friedman s theory of money demand is indeed a restatement of the quantity theory because it leads to the same conclusion about the importance of money to aggregate spending You may recall that we said that the Keynesian liquidity preference function (in which interest rates are an important determinant of the demand for money) can explain the procyclical movement of velocity that we find in the data Can Friedman s money demand formulation explain this procyclical velocity phenomenon as well? The key clue to answering this question is the presence of permanent income rather than measured income in the money demand function What happens to permanent income in a business cycle expansion? Because much of the increase in income will be transitory, permanent income rises much less than income Friedman s money demand function then indicates that the demand for money rises only a small amount relative to the rise in measured income, and as Equation indicates, velocity rises Similarly, in a recession, the demand for money falls less than income because the decline in permanent income is small relative to income, and velocity falls In this way we have the procyclical movement in velocity To summarize, Friedman s theory of the demand for money used a similar approach to that of Keynes and the earlier Cambridge economists but did not go into detail about the motives for holding money Instead, Friedman made use of the theory of asset demand to indicate that the demand for money will