Milton Friedman was one of the most regarded economists of our time. He was well known as a prominent monetary theorist, as well as opponent to much of what Keynes had to say. In their arguments over quantity theory, which Friedman adamantly fought for, both Friedman and Keynes looked at the quantity theory of money and came up with different conclusions concerning inflation and the velocity of money. While Keynes argued that velocity does largely fluctuate and have a strong effect on inflation, Friedman argued the opposite. Here I focus on why Friedman might just have been wrong about quantity theory, particularly regarding velocity, by looking at Venezuela and its most recent hyperinflation. As to why Venezuela violates Friedman’s theory, I look at its status as a developing country and its instability in relation to the long-term uncertainties that affect velocity.
According to Milton, “inflation is always and everywhere a monetary phenomenon”. Looking at the quantity theory of money equation, P = VM/Y, his claim makes sense – money supply is clearly proportional to inflation. However, while Keynes believed velocity significantly contributes to inflation, Friedman’s claim implies velocity is held constant. However, Venezuela might beg to differ. According to Bloomberg’s data from Venezuela’s central bank, money supply last year was approximately 130%, (assuming no manipulations from the government on the bank’s report). The country’s GDP level was estimated to be -10%. With velocity held as constant, Venezuela’s inflation should have been 140%. However, it had reached up to 475.8%. If in practice velocity in not constant, as this most recent hyperinflation seems in indicate, it is a point against Friedman’s case on the validity of quantity theory.
To be fair, Milton thought velocity as stable when the demand for money, the reciprocal of velocity, was stable. Milton saw it as always stable. Demand for money, so he said, was based on long term factors, such as expected income, which generally did not change dramatically. Therefore, velocity was constant. While this is more apparent in strong, stable economies, such as the United States where citizens have a good expectation of how much they expect to have in the future, it does not hold for economically weaker countries such as Venezuela. Milton had either decided to focus on the economies of developed countries or simply forgot to consider developing countries. The difference between the two is that while developed countries are more stable in terms of their government and economy, and thus why their citizens experience lower levels of uncertainty, developing countries do not have that luxury. Venezuela, though once a rich country due to its oil reserves, has for the past couple of decades experienced a lot of corruption and instability in their government. The stability of a nation’s government is a significant factor in how that nation’s citizens perceive their future stability to look like. Thus, a developing country such as Venezuela will experience higher levels of uncertainty in their long-term expectations, affecting factors such as their demand for money. By no means is Venezuela’s demand for money currently stable when its value is so low it has practically become meaningless paper.
Milton Friedman contributed much to economic thought with wicked reasoning, but like all economists he could not have gotten everything spot on. He had flaws in his theories and in his quantity theory on money one fault was his perception of the long-term stability of the demand for money, and thus velocity, particularly in developing countries. Venezuela’s hyperinflation gives a point to Keynes.