MONETARIST THEORY OF INFLATION

Prof. Prabha Panth,Osmania University,

Hyderabad

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Milton Friedman’s Restatement of QTM

• According to Friedman, “Inflation is always and everywhere a monetary phenomenon.”

• “Money alone Matters”• When Money Supply increases in the economy,

there is excess supply of real cash balances with the public over the demand for money.

• This disturbs the equilibrium.• So the public will reduce their real cash

balances, by spending more on goods and services.

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• If there is no increase in output, then extra D for goods > supply of goods.

• This leads to increase in prices.MS > kPY AD P

• MS = supply of money, and M/P = real cash balances, kPY = demand for real cash balances.

• AD = Aggregate demand.

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• Keeping k constant, P = MS - Y

P MS Y• P/P = rate of inflation, MS/MS = rate of growth

of money supply, and Y/Y = rate of growth of output.

• Thus rate of inflation is determined by rate of growth of money supply minus rate of growth of output, k remaining constant.

• At full employment, there is no increase in growth of output, therefore, inflation is directly related to increase in supply of money.

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Demand for money• DM is for real cash balances (M/P)• It is a function of 6 factors:

1. Rate of return on bonds, r , DM 2. Rate of return on equities (stock) , DM 3. Change in prices. P , DM 4. Physical K/Human K changes, DM changes5. Real income Y/P affects demand for real

cash balance M/P6. Tastes and preferences, economic and non-

economic conditions

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Demand for cash balances:• Friedman includes Keynesian features

with Permanent Y hypothesis:DM/P = k(i. P)Y ----- (1)

• Friedman assumes that k is stable,• Elasticity of DM to i and P is small,• Based on US time series data,Supply of Cash Balances:• Is most important in determining the level

of income and prices.

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• At equilibrium MS = MD -------- (2)• Assuming k is stable, MD = kPY ------- (3)• Since MS = MD, so MS = kPY• Or PY = MS/k, since k = 1/V, or• MV = PY or PT, (Fisher’s equation)

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Criticism

• Not much difference between Fisher and Friedman.

• Starts with Keynes, ends with Fisher,• Full employment is assumed, as increase

in MS increases P, not Y• Completely ignored Fiscal Policy• Speculative DM is neglected.