Comparison between Keynesian and Friedman Perspective:

Now we shall discuss one issue which makes for the crucial distinction between the Keynesian approach and Friedman's approach, this concerns the stability of the demand function for money.  By stability, in this case, we mean that the functional relationship between money demanded and the variable influencing it, is not subject to frequent changes.

According to the monetarist approach, lead by Friedman, the classical demand for money function MV = PY is quite stable.  In other words, the velocity of money V is relatively stable.  Given the stability of the value of V, the supply of money determines PY in the short run.  Indeed, the essence of monetarism is that a change in money supply is the major determinant of nominal income (PY) growth.  Monetarism, like the Keynesian multiplier theory (which you studied in earlier units - unit 6) is a theory of determination of aggregate demand.  However, according to the monetarists, crudely speaking, "Only money matters" in determining aggregate demand while fiscal policy does not.  For, given V, it is M that determines nominal income.  Suppose V were not stable but an upward rising function of the cost of holding money so that people want to minimise their cash balances. In other words, velocity of circulation of a unit of currency increases per period of time.  The government's fiscal policy, by stimulating public expenditure may partially reduce the induced private investment by driving up the rate of interest.  This results in an increase in 'V' and hence,
correspondingly, in the level of nominal income (i.e. PY).  Thus, even without an increase in M, fiscal policy can raise nominal income if V is an increasing function of the rate of interest.  The constancy of V as assumed by the monetarists, rules out any importance of the fiscal policy.

However, the volatility of the value of V and the existence of liquidity trap, led the Keynesians to raise doubts about the  importance of monetary policy. The simple Keynesian system does away with money completely and provides exclusive importance to the fiscal policy in determining the level of aggregate demand of the economy. This is to be expected from a theory which was primarily trying to understand the phenomenon of 'Great Depression' and providing solutions to correct it. In recessionary situations the rate of interest is likely to be quite low due to the demand constraint and if country follows a monetary policy then there is a real danger of getting in the problem of liquidity trap (as Japan has been realizing in the recent times) .

The Keynesian policy makers were at their hey-day in the fifties and sixties. It is sometimes called 'the golden age of capitalism'. The resurgence of inflation in the seventies, however, gave the monetarists certain respectability.  The controversy between the Keynesian and the monetarist theories and policies, however, still continues.  However, Samuelson and Nordhaus note that there has been convergence to a certain degree "from disagreement into the synthesis of modern mainstream macroeconomics".