Sumner Sticks with Friedman

Scott Sumner won’t let go. Scott had another post today trying to show that the Cambridge Theory of the demand for money was already in place before Keynes arrived on the scene. He quotes from Hicks’s classic article “Mr. Keynes and the Classics” to dispute the quotation from another classic article by Hicks, “A Suggestions for Simplifying the Theory of Money,” which I presented in a post last week, demonstrating that Hicks credited Keynes with an important contribution to the demand for money that went beyond what Pigou, and even Lavington, had provided in their discussions of the demand for money.

In this battle of dueling quotations, I will now call upon Mark Blaug, perhaps the greatest historian of economics since Schumpeter, who in his book Economic Theory in Retrospect devotes an entire chapter (15) to the neoclassical theory of money, interest and prices. I quote from pp. 636-37 (4th edition).

Marshall and his followers went some way to move the theory of the demand for money in the direction of ordinary demand analysis, first, by relating money to net output or national income rather than the broader category of total transactions, and, second, by shifting from money’s rate of turnover to the proportion of annual income that the public wishes to hold in the form of money. In purely formal terms, there I nothing to choose between the Fisherian transaction approach and the Cambridge cash-balance approach, but the Cambridge formulation held out the potential of a genuine portfolio theory of the demand for money, which potential, however, was never fully exploited. . . .

The Cambridge formulation implies a demand for money equation, D_m = kPY, which contains no variable to represent the opportunity costs of holding cash, namely the rate of interest or the yield of alternative non-money assets, analogous to the relative price arguments of ordinary demand functions.
Yet a straight-forward application of utility-maximizing principles would have suggested that a rise in interest rates is likely to induce a fall in k as people strive to substitute interest-earning assets for passive money balances in their asset portfolios. Similarly, a fall in interest rates, by lowering the opportunity cost of holding money, is likely to cause a rise in k. Strangely enough, however, the Cambridge monetary theory never explicitly recognized the functional dependence of k on either the rate of interest or the rate on all non-monetary assets. After constructing a framework highly suggestive of a study of all the factors influencing cash-holding decisions, the Cambridge writers tended to lapse back to a list of the determinants of k that differed in no important respects from the list of institutional factors that Fisher had cited in his discussion of V. One can find references in Marshall, Pigou and particularly Lavington to a representative individual striking a balance between the costs of cash holdings in terms of interest foregone (minus the brokerage costs that would have been incurred by the movement into stocks and bonds) and their returns in terms of convenience and security against default but such passages were never systematically integrated with the cash-balance equation. As late as 1923, we find the young Keynes in A Tract on Monetary Reform interpreting k as a stable constant, representing an invariant link in the transmission mechanism connecting money to prices. If only Keynes at that date had read Wicksell instead of Marshall, he might have arrived at a money demand function that incorporates variations in the interest rate years before The General Theory (1936).

Moving to pp. 645-46, we find the following under the heading “The Demand for Money after Keynes.”

In giving explicit consideration to the yields on assets that compete with money, Keynes became one of the founders of the portfolio balance approach to monetary analysis. However, it is Hicks rather than Keynes who ought to be regarded as the founder of the view that the demand for money is simply an aspect of the problem of choosing an optimum portfolio of assets. In a remarkable paper published a year before the appearance of the General Theory, modestly entitled “A Suggestion for Simplifying the Theory of Money,” Hicks argued that money held at least partly as a store of value must be considered a type of capital asset. Hence the demand for money equation must include total wealth and expected rates of return on non-monetary assets as explanatory variables. Because individuals can choose to hold their entire wealth portfolios in the form of cash, the wealth variable represents the budget constraint on money holdings. The yield variables, on the other hand, represent both the opportunity costs of holding money and the substitutions effects of changes in relative rates of return. Individuals optimize their portfolio balances by comparing these yields with the imputed yield in terms of convenience and security of holding money. By these means, Hicks in effect treated the demand for money as a problem of balance sheet equilibrium analyzed along the same lines as those employed in ordinary demand theory.

It was Milton Friedman who carried this Hicksian analysis of money as a capital asset to its logical conclusion. In a 1956 essay, he set out a precise and complete specification of the relevant constraints and opportunity cost variable entering a household’s money demand function. His independent variable included wealth or permanent income – the present value of expected future receipts from all sources, whether personal earning or the income from real property and financial assets – the ratio of human to non-human wealth, expected rates of return on stocks, bonds and real assets, the nominal interest rate, the actual price level, and, finally, the expected percentage change in the price level. Like Hicks, Friedman specified wealth as the appropriate budget constraint but his concept of wealth was much broader than that adopted by Hicks. Whereas Keynes had viewed bonds as the only asset competing with cash, Friedman regarded all types of wealth as potential substitutes for cash holdings in an individual’s balance sheet; thus, instead of a single interest variable in the Keynesian liquidity preference equation, we get a whole list of relative yield variables in Friedman. An additional novel feature, entirely original with Friedman, is the inclusion of the expected rate of change in P as a measure of the anticipated rate of depreciation in the purchasing power of cash balances.

This formulation of the money demand function was offered in a paper entitled “The Quantity Theory of Money: A Restatement.” Friedman claimed not only that the quantity theory of money had always been a theory about the demand for money but also that his reformulation corresponded closely to what some of the great Chicago monetary economists, such as H.C. Simons and L. W. Mints, had always meant by the quantity theory. It is clear, however, from our earlier discussion that the quantity theory of money, while embodying an implicit conception of the demand for money, had always stood first and foremost for a theory of the determination of prices and nominal income; it contained much more than a particular theory of the demand for money.

Finally, Blaug remarks in his “notes for further reading” at the end of chapter 15,

In an influential essay, “The Quantity Theory of Money – A Restatement,” . . . M. Friedman claimed that his restatement was nothing more than the University of Chicago “oral” tradition. That claim was effectively destroyed by D. Patinkin, “The Chicago Tradition, the Quantity Theory, and Friedman, JMCB, 1969 .

Well, just a couple of quick comments on Blaug. I don’t entirely agree with everything he says about Cambridge monetary theory, and about the relative importance of Hicks and Keynes in advancing the theory of the demand for money. Cambridge economists may have been a bit more aware that the demand for money was a function of the rate of interest than he admits, and I think Keynes in chapter 17, definitely formulated a theory of the demand for money in a portfolio balance context, so I think that Friedman was indebted to both Hicks and Keynes for his theory of the demand for money.

As for Scott Sumner’s quotation from Hicks’s Mr. Keynes and the Classics, I think the point of that paper was not so much the theory of the demand for money, which had already been addressed in the 1935 paper from which I quoted, as to sketch out a way of generalizing the argument of the General Theory to encompass both the liquidity trap and the non-liquidity trap cases within a single graph. From the standpoint of the IS-LM diagram, the distinctive Keynesian contribution was the case of absolute liquidity preference, that doesn’t mean that Hicks meant that nothing had been added to the theory of the demand for money since Lavington. If that were the case, Hicks would have been denying that his 1935 paper had made any contribution. I don’t think that’s what he meant to suggest.

To sum up: 1) there was no Chicago oral tradition of the demand for money; 2) Friedman’s restatement of the quantity theory owed more to Keynes (and Hicks) than he admitted; 3) Friedman adapted the Cambridge/Keynes/Hicks theory of the demand for money in novel ways that allowed him to develop an analysis of price level changes that was more straightforward than was possible in the IS-LM model, thereby de-emphasizing the link between money and interest rates, which had been a such a prominent feature of the Keynesian models. That of course is a point that Scott Sumner likes to stress. In an upcoming post, I will comment on the fact that it was not just Keynesian models which stressed the link between money and interest rates. Pre-Keynesian monetary models also stressed the connection between easy money and low interest rates and dear money and high interest rates. Friedman’s argument was thus an innovation not only relative to Keynesian models but to orthodox monetary models. What accounts for this innovation?

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8 Responses to “Sumner Sticks with Friedman”


  1. 1 Greg Hill August 11, 2013 at 7:36 pm

    Assuming that blog comments need not be thought all the way through, let me suggest that Keynes’ innovation was not to point out that money holdings vary with the rate of interest (the opportunity cost of holding money), but that the interest rate, itself, is a measure of “the degree of our disquietude.” (The notion of uncertainty seems strangely absent from your excellent posts and from the comments thereon, but it was central to Keynes’ understanding of the demand for money).

  2. 2 sumnerbentley August 11, 2013 at 7:44 pm

    Well if Hicks is really that incompetent of a writer, then why should we believe anything he wrote in 1935? Hicks (1937) says the pre-Keynesian economists had all the pieces of the IS-LM model except the liquidity trap.

    In an earlier post you were dismissive of Friedman’s view that the liquidity trap was the main new theoretical insight of the GT. Now we have Hicks saying the same thing. Why be so critical when Friedman seems to unfairly minimize the importance of Keynes (in your view), but not at all when Hicks makes exactly the same mistake (if it was a mistake?)

    And it’s been a long time since I read the Tract, but surely Keynes did not assume a fixed k during the hyperinflation episodes he examined? Or did he? (Maybe my memory is off.) K fell by close to 99% in Germany. Perhaps another commenter can fill us in on this point. If interwar economists didn’t know that velocity sped up during hyperinflation then that’s a pretty serious oversight. The workers were paid twice a day and went shopping during their lunch break.

  3. 3 David Glasner August 11, 2013 at 8:02 pm

    Scott, I didn’t say Hicks was incompetent. I said that he was writing with different objectives in the two papers. In 1935 he was focusing on the demand for money, in 1937 on the overall macro-model. I agree that there is an inconsistency in saying that Keynes held that in the Tract Keynes held that the demand for money was not responsive to the rate of interest but did acknowledge that the demand for money would be reduced as a result of expected inflation. However, Friedman was guilty of the same inconsistency in his 1956 Restatement paper because he introduced the expected rate of the change in the price level as a separate argument in the demand for money function even thought he already had included the nominal rate of interest. Learning is sometimes a very slow process.

  4. 4 David Glasner August 11, 2013 at 8:03 pm

    Greg, I agree in principle. Uncertainty is very important to Keynes. But I have my hands full without worrying about how to deal with uncertainty. Sorry to disappoint.

  5. 5 Greg Hill August 13, 2013 at 4:17 pm

    David & Scott,

    Keynes did not assume a fixed k during hyperinflations in his Tract on Monetary Reform, nor did he assume that k was unresponsive to changes in interest rates. “The usual method of exercising a stabilizing influence over k and k’ [k' being bank deposits], especially over k’, is the bank-rate” (chap. III, p. 85 in my edition).

    p.s. David, you never disappoint, but it’s very hard to think about Keynes’ liquidity preference theory, the liquidity trap, and Hicks’ eventual “repudiation” of his ISLM without bringing uncertainty into it.

  6. 6 sumnerbentley August 14, 2013 at 6:53 pm

    Greg, If you are right (and I suspect you are) then that’s a pretty serious error in the passage quoted by David.

  7. 7 sumnerbentley August 14, 2013 at 6:55 pm

    I should clarify, error by Mark Blaug, not David.

  8. 8 Tas von Gleichen August 17, 2013 at 5:48 am

    I think the Chicago school must be a must go for any serious economist.


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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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