Monetarist theory of inflation

Milton Friedman's theory of inflation.

1. MONETARIST THEORY OF
INFLATION
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. 2
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.
Prabha Panth

3. 3
•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.
Prabha Panth

4. 4
•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.
Prabha Panth

5. 5
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 changes
5.Real income Y/P affects demand for real
cash balance M/P
6.Tastes and preferences, economic and non-
economic conditions
Prabha Panth

6. 6
Demand for cash balances:
•Friedman includes Keynesian features
with Permanent Y hypothesis:
DM/P = k(i. P)Y -----(1)
•Friedmanassumesthatkisstable,
•ElasticityofDMtoiandPissmall,
•BasedonUStimeseriesdata,
SupplyofCashBalances:
•Ismostimportantindeterminingthelevel
ofincomeandprices.
Prabha Panth

7. 7
•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)
Prabha Panth

8. 8
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.
Prabha Panth