Question

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

Short answer

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 ($\mathrm{\Pi }$) affect the demand for real cash balance. The overall demand for real cash balance can be modeled as $L=L_1(Y)+L_2(r)+L_3(\mathrm{\Pi })$, 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 $L_3(\mathrm{\Pi })$, where $L_3$ denotes the demand for real cash balance as a function of the inflation rate, $\mathrm{\Pi }$.

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: $$L=L_1(Y)+L_2(r)+L_3(\mathrm{\Pi })$$ Where $L$ denotes the real cash balance demand, $Y$ represents nominal income, $r$ is the rate of return on alternative assets, and $\mathrm{\Pi }$ is the inflation rate.

Key concepts

Nominal Income

Nominal income represents the total earnings of an individual or household without adjusting for inflation. It reflects the gross amount of money earned over a specific period, like a month or a year. When talking about nominal income's impact on real cash balance, it's essential to understand its role in influencing spending and savings habits.
Nominal income impacts real cash balance as it directly correlates with the need for holding money for transactions. The higher the nominal income, the greater the potential demand for cash balances because more transactions typically require more funds.
This concept is vital in understanding Milton Friedman's work on the demand for money, as he posited that an increase in nominal income generally leads to a rise in the demand for real cash balances. People feel more comfortable holding more money because they expect to use it for more purchases.

Rate of Return

The rate of return is a crucial factor in financial decision-making, particularly in investment and savings strategies. It refers to the financial gain or loss on an investment relative to the money invested.
In terms of demand for real cash balance, the rate of return on alternative investments can significantly influence how much cash people choose to hold.

• When the rate of return on investments like stocks or bonds is high, individuals might prefer to invest rather than hold cash since they can earn more by doing so.
• A lower rate of return on such alternatives might make holding cash a more attractive option.

Friedman noted that as the rate of return on alternative assets increases, the demand for real cash balance might decrease, as people shift their money to profit from higher returns.

Inflation Rate

The inflation rate measures the rate at which the general level of prices for goods and services is rising, and subsequently, how purchasing power is eroding. It's a key concept in economics impacting both personal finances and broader economic policies.
Inflation's influence on real cash balances is significant because it directly affects the buying power of the cash held by individuals. When prices increase, the same amount of nominal money buys less, effectively reducing its real value.

• To preserve the purchasing power, individuals may need to adjust their real cash balances.
• High inflation can lead people to hold less cash and invest in assets that hedge against inflation.

Understanding the inflation rate is critical when thinking about real cash balances, as retaining too much cash in times of high inflation can lead to losses in real value.

Milton Friedman

Milton Friedman was an influential American economist known for his work on monetary economics. His theories and ideas have profoundly shaped modern economic policy and thought.
Friedman's work particularly emphasized the role of money supply in economic stability and the importance of government control over it. He believed in monetarism, a school of thought that argues variations in money supply have major influences on national output.
In the context of real cash balance, Friedman's model sought to explain how different factors like nominal income, inflation, and rate of return impact money demand. His equation for the demand for money has become a foundational element in economics studies and forms the basis of many fiscal policy decisions.
Friedman's concepts are instrumental in understanding why people hold money and how they react to economic changes.

Demand for Money

The demand for money refers to the desired holding of financial assets in the form of money (cash or bank deposits) rather than investing it elsewhere. This concept is essential in financial economics as it reveals preferences for liquidity. In Friedman's framework, the demand for money is influenced by several factors:

• Nominal income: as income goes up, so does the need for cash for transactions.
• Rate of return: higher potential returns on investments can decrease the demand for holding cash.
• Inflation rate: high inflation typically reduces the attractiveness of holding cash because of its decreasing real value.

Understanding the demand for money helps economists and policymakers formulate strategies to control money supply, stabilize economies, and promote growth. It also sheds light on consumer behavior concerning spending, saving, and investing.