Chapter 11: Problem 407

Which factory affects a person's demand for real cash balance, and how ? (Friedman).

Short Answer

Expert verified

According to Milton Friedman, three primary factors determine an individual's demand for real cash balance: nominal income, the rate of return on alternative assets, and the rate of inflation. An increase in nominal income (\(Y\)), higher returns on alternative assets (\(r\)), and the inflation rate (\(\Pi\)) affect the demand for real cash balance. The overall demand for real cash balance can be modeled as \(L = L_1(Y) + L_2(r) + L_3(\Pi)\), where \(L\) denotes the real cash balance demand.

Step by step solution

Introduction to Real Cash Balance

Real cash balance is the amount of money held by an individual or a firm after adjusting for inflation. It represents the real purchasing power of the money held, as opposed to the nominal cash balance, which is the face value of the money without considering inflation. Milton Friedman, a prominent economist, studied the factors that influence an individual's demand for real cash balance.

Understanding Friedman's Arguments

Milton Friedman argued that the demand for real cash balance can be determined by three primary factors: nominal income, the rate of return on alternative assets, and the rate of inflation. Let's examine each factor in more detail.

1. Nominal Income

Nominal income refers to the total income earned by an individual or a household before considering the effects of inflation. Friedman's argument is that a higher nominal income results in a higher demand for real cash balance. As one's income increases, the need to hold money for transactions also increases. This relationship can be represented as \(L_1(Y)\), where \(L_1\) denotes the demand for real cash balance as a function of nominal income \(Y\).

2. Rate of Return on Alternative Assets

The demand for real cash balance can also be affected by the rate of return on alternative assets like bonds, stocks, and term deposits. If alternative assets offer a higher return, individuals may reduce their real cash balance to invest in these alternatives. This can be represented as \(L_2(r)\), where \(L_2\) denotes the demand for real cash balance as a function of the rate of return on alternative assets, \(r\).

3. Rate of Inflation

Lastly, the rate of inflation plays a crucial role in determining the demand for real cash balance. Inflation erodes the purchasing power of money, reducing its real value. To maintain the real value of cash holdings, individuals may need to adjust their real cash balance due to changes in the inflation rate. This relationship can be represented as \(L_3(\Pi)\), where \(L_3\) denotes the demand for real cash balance as a function of the inflation rate, \(\Pi\).

Overall Demand for Real Cash Balance

Milton Friedman's theory states that the overall demand for real cash balance can be modeled as a function of the three factors discussed previously. The equation for an individual's demand for real cash balance can be written as: \[L = L_1(Y) + L_2(r) + L_3(\Pi)\] Where \(L\) denotes the real cash balance demand, \(Y\) represents nominal income, \(r\) is the rate of return on alternative assets, and \(\Pi\) is the inflation rate.

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