The Optimum Quantity of Money

Milton Friedman

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351478083
• Edition: 1
• Topic: Economics
• Subtopic: Monetary Policy
• Index: Economics

This classic set of essays by Nobel Laureate and leading monetary theorist Milton Friedman presents a coherent view of the role of money, focusing on specific topics related to the empirical analysis of monetary phenomena and policy. The early chapters cover factors determining the real quantity of money held in a community and the welfare implications of policies that affect the quantity held. The following chapters formally restate why quantity analysis has become central to the science of economics. Friedman's presidential address to the American Economic Association, included here, provides a general summary of his views on the role of monetary policy, with an emphasis on its limitations and its possibilities. This theoretical framework is used in examining a number of empirical problems: the demand for money, the explanation of price changes in wartime periods, and the role of money in business cycles. These essays summarize some of the most important results of Friedman's extensive research over the course of his lifetime. The chapters on policy that follow survey the positions of earlier economists and deal with the importance of lags and the implications of destabilizing speculation in foreign markets. Taken as a whole, The Optimum Quantity of Money provides a comprehensive view of the body of monetary theory developed in leading centers of monetary analysis. This work is essential reading for economists and graduate students in the field. The volume will be no less important for practicing business and banking personnel as well. The new statement by Michael Bordo, a student of Friedman's and an expert in the field, provides a sense of where the field now stands in the economy and academy.

1

The Optimum Quantity of Money

IT IS A COMMONPLACE of monetary theory that nothing is so unimportant as the quantity of money expressed in terms of the nominal monetary unit—dollars, or pounds, or pesos. Let the unit of account be changed from dollars to cents; that will multiply the quantity of money by 100, but have no other effect. Similarly, let the number of dollars in existence be multiplied by 100; that, too, will have no other essential effect, provided that all other nominal magnitudes (prices of goods and services, and quantities of other assets and liabilities that are expressed in nominal terms) are also multiplied by 100.

The situation is very different with respect to the real quantity of money—the quantity of goods and services that the nominal quantity of money can purchase, or the number of weeks’ income to which the nominal quantity of money is equal. This real quantity of money has important effects on the efficiency of operation of the economic mechanism, on how wealthy people regard themselves as being and, indeed, on how wealthy they actually are. Yet only recently has much thought been given to what the optimum quantity of money is, and, more important, to how the community can be induced to hold that quantity of money.

When this question is examined, it turns out to be intimately related to a number of topics that have received widespread attention over a long period of time, notably (i) the optimum behavior of the price level; (2) the optimum rate of interest; (3) the optimum stock of capital; and (4) the optimum structure of capital.

The optimum behavior of the price level, in particular, has been discussed for at least a century, though no definite and demonstrable answer has been reached. Interestingly enough, it turns out that when the question is tackled indirectly, via the optimum quantity of money, a definite answer can be given. The difference is that while the conventional discussion stresses short-period adjustments, this paper stresses long-run efficiency.

In examining the optimum quantity of money, I shall start in a rather roundabout way—as befits a topic that belongs in capital theory at least as much as in monetary theory. I shall begin by examining a highly simplified hypothetical world in which the elementary but central principles of monetary theory stand out in sharp relief. Though this introduction covers familiar ground I urge the reader to be patient, since it will serve as a bridge to some unfamiliar propositions.

I Hypothetical Simple Society

Let us start with a stationary society in which there are (1) a constant population with (2) given tastes, (3) a fixed volume of physical resources, and (4) a given state of the arts. It will be simplest to regard the members of this society as being immortal and unchangeable.¹ (5) The society, though stationary, is not static. Aggregates are constant, but individuals are subject to uncertainty and change. Even the aggregates may change in a stochastic way, provided the mean values do not. (6) Competition reigns.

To this fairly common specification, let us add a number of special provisions: (7) Any capital goods which exist are infinitely durable, cannot be reproduced or used up, and require no maintenance (like Ricardo’s original, indestructible powers of the soil). More important, (8) these capital goods though owned by individuals in the sense that the rents they yield go to their owners, cannot be bought and sold. (They are like human capital in our society.)

(9) Lending or borrowing is prohibited and the prohibition is effectively enforced.

(10) The only exchange is of services for money, or money for services, or services for services. Items (7) and (8) in effect rule out all exchange of commodities.

(11) Prices in terms of money are free to change, in the sense that there are no legal obstacles to buyers’ and sellers’ trading at any price they wish. There may be institutional frictions of various kinds that keep prices from adjusting instantaneously and fully to any change. In that sense there need not be “perfect flexibility” whatever that much overused term may be taken to mean.

(12) All money consists of strict fiat money, i.e., pieces of paper, each labelled “This is one dollar.”

(13) To begin with, there are a fixed number of pieces of paper, say, 1,000. The purpose of conditions (7), (8) and (9) is, of course, to rule out the existence of a market interest rate. We shall relax these conditions later.

II Initial Equilibrium Position

Let us suppose that these conditions have been in existence long enough for the society to have reached a state of equilibrium. Relative prices are determined by the solution of a system of Walrasian equations. Absolute prices are determined by the level of cash balances desired relative to income.

Why, in this simple, hypothetical society, should people want to hold money? The basic reason is to serve as a medium of circulation, or temporary abode of purchasing power, in order to avoid the need for the famous “double coincidence” of barter. In the absence of money, an individual wanting to exchange A for B must find someone who wants to exchange precisely B for A. In a money economy, he can sell A for money, or generalized purchasing power, to anyone who wants A and has the purchasing power. The seller of A can then buy B for money from anyone who has B for sale, regardless of what the seller of B in turn wishes to purchase. This separation of the act of sale from the act of purchase is the fundamental productive function of money. It gives rise to the “transactions” motive stressed in the literature.

A second reason for holding money is as a reserve for future emergencies. In the actual world, money is but one of many assets that can serve this function. In our hypothetical world, it is the only such asset. This reason corresponds to the “asset” motive for holding money.

It is worth noting that both reasons depend critically on characteristic (5) of our economy, the existence of individual uncertainty. In a world that is purely static and individually repetitive, clearing arrangements could be made once and for all that would eliminate the first reason, and there would be no unforeseen emergencies to justify holding money for the second reason.

How much money would people want to hold for these reasons? Clearly, this question must be answered not in terms of nominal units but in terms of real quantities, i.e., the volume of goods and services over which people wish to have command in the form of money. I see no way to give any meaningful answer to this question on an abstract level. The amount will depend on the details of the institutional payment arrangements that characterize the equilibrium position reached, which in turn will depend on the state of the arts, on tastes and preferences, and on the attitudes of the public toward uncertainty.

It is easier to say something about the amount of money people would want to hold on the basis of empirical evidence. If we identify the money in our hypothetical society with currency in the real world, then the quantity of currency the public chooses to hold is equal in value to about one-tenth of a year’s income, or about 5.2 weeks’ income.² That is, desired velocity is about ten per year.

If we identify money in our hypothetical society with all non-human wealth in the real world, then the relevant order of magnitude is about three to five years’ income.³ That is, desired velocity is about .“2 to .3 per year.

Since we are only provisionally treating our money as the equivalent of all wealth, I shall use the first comparison, and assume, therefore, that the equilibr...