Cambridge version of quantity theory of money:
Statement:
Cambridge economists, Marshall and Pigou, in a form different from Irving Fisher, have stated the equation of exchange. Cambridge economists explained the determination of value of money in line with the determination of value in general.
Value of a commodity is determined by demand for and supply of it and likewise, according to them, the value of money (i.e., its purchasing power) is determined by the demand for and supply of money. As studied in cash-balance approach to demand for money Cambridge economists laid stress on the store of value function of money in sharp contrast to the medium of exchange function of money emphasized by in Fisher’s transactions approach to demand for money.
According to cash balance approach, the public likes to hold a proportion of nominal income in the form of money (i.e., cash balances). Let us call this proportion of nominal income that people want to hold in money as k.
Then cash balance approach can be written as:
Md =kPY ….(1)
Y = real national income (i.e., aggregate output)
P = the price level PY = nominal national income
k = the proportion of nominal income that people want to hold in money
Md = the amount of money which public want to hold
Now, for the achievement of money-market equilibrium, demand for money must equal worth the supply of money, which we denote by M. It is important to note that the supply of money M is exogenously given and is determined by the monetary policies of the central bank of a country. Thus, for equilibrium in the money market.
M = Md
As Md =kPY
Therefore, in equilibrium M = kPY …(2)
Monetary equilibrium Cambridge cash balance approach is shown in Fig. 20.2 where demand for money is shown by a rising straight line kPY which indicates that with k and Y being held constant demand for money increases proportionately to the rise in price level. As price level rises people demand more money for transaction purposes.
Now, if supply of money fixed by the Government (or the Central Bank) is equal to M0, the demand for money APK equals the supply of money, M0 at price level P0. Thus, with supply of money equal to M0 equilibrium price level P0 is determined. If money supply is increased, how the monetary equilibrium will change? Suppose money supply is increased to M1 at the initial price level P0 the people will be holding more money than they demand at it.
Therefore, they would want to reduce their money holding. In order to reduce their money holding they would increase their spending on goods and services. In response to the increase in money spending by the households the firms will increase prices of their goods and services.
As prices rise, the households will need and demand more money to hold for transaction purposes (i.e., for buying goods and services). It will be seen from Fig. 20.2 that with the increase in money supply to M1 new equilibrium between demand for money and supply of money is attained at point E1 on the demand for money curve kPY and price level has risen to P1.It is worth mentioning that k in the equations (1) and (2) is related to velocity of circulation of money V in Fisher’s transactions approach. Thus, when a greater proportion of nominal income is held in the form of money (i.e., when k is higher), V falls. On the other hand, when less proportion of nominal income is held in money, K rises. In the words of Crowther, “The higher the proportion of their real incomes that people decide to keep in money, the lower will be the velocity of circulation, and vice versa.
It follows from above that k = 1/V. Now, rearranging equation (2) we have cash balance approach in which P appears as dependent variable. Thus, on rearranging equation (2) we have
P = 1/k.M/Y…………(3)
| The Cambridge cash balances approach to the quantity theory of money is superior to Fisher’s transaction approach in many respects. They are discussed as under: | | --- |