Cambridge theory of demand for money

By

Group 7

PRESENTED TO: MR. JOSEPH BARASA

A term paper submitted in partial fulfilment of the requirement for the award of Degree in
Bachelor of Commerce to the University of Nairobi

DATE: 11TH November 2019

 Declaration

Declaration by the students.

This research is our original work and has not been presented to any other
examination body. No part of this research should be reproduced without our
consents.

Names Admission numbers Sign

1. KEVIN LEMAYIAN D33/122187/2018

2. HILLOW ALASA IBRAHIM D33/123861/2018

3. FARDUSA ABDULLAHI ABI D33/123697/2018

Declaration by the lecturer.

This research has been submitted with my approval as The University of Nairobi
lecturer.

Name……………………………………..….sign………………..date…………….

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 Abstract

The main focus of this study is to elaborate Cambridge theory of demand for money founded by
Alfred Marshall and his students Arthur Cecil Pigou. It emphasizes the function of money as a
store of value instead of Fisher's emphasis on the use of money as a medium of exchange.

Key determinants of demand for money according to the theorists are the current interest rate,
future interest rate, the wealth owned by an individual and the expectation of future prices.

He made the following assumptions: Changes of those factors are constant and any change will
be of the same proportion, that determinant of demand are a function of individual income,
Income elasticity of demand for money is unitary.

Cambridge theory was criticized on the following grounds: it neglects speculative demand for
money; the theory cannot explain the phenomenon of trade cycle among others

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 Table of content.

Declaration ......................................................................................................................................ii

Abstract ..........................................................................................................................................iii

Introduction ....................................................................................................................................1

Assertion .........................................................................................................................................4

Factors affecting demand for money ..............................................................................................7

Assumptions....................................................................................................................................9

Features of Cambridge theory of money....................................................................................... 11

Similarities between the Two Approaches: ...................................................................................15

Important dissimilarities between the two approaches are discussed below: ................................17

The superiority of the Cash Balance Approach: ............................................................................19

Criticisms:...................................................................................................................................... 21

References .....................................................................................................................................25

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 Introduction

Cambridge theory was founded by

Alfred Marshall (July 26, 1842 – July 13, 1924), was one of the most influential

Economists of his time. He led the British neoclassical school of economics, was responsible for
the emergence of Cambridge University as a centre of economic research in the early twentieth
century. Through his work, applying mathematical principles to economic issues, economics
became established as a scientific discipline. Marshall attempted to bring together the classical
approach, in which value was determined by the cost of production, with the idea of marginal
utility developed both by his British predecessor William Stanley Jevons and the Austrian school
in continental Europe, downplaying the revolutionary nature of their insights. He argued that
supply and demand factors (cost of production and utility respectively) both determine price,
suggesting that their relative importance is mostly a factor of the time period (long run or short
run) under consideration. Although Marshall's views were never completely accepted by all
economists, his ideas were influential in advancing the understanding of economic relationships,
which are fundamental to the successful development and maintenance of a stable, prosperous
society that benefits all its members.

Marshall argued that while classical economists attempted to explain prices solely by the cost of
production, ignoring other factors that play a role in price formation, the marginalists on the
other side went too far in correcting this imbalance by overemphasizing utility and demand,
ignoring supply factors. He, therefore, criticized both sides.

Marshall and his followers (later called Cambridge Neoclassicals or "Marshallians") attempted to
reconcile the "marginalist revolution" of the continental tradition with the British classical
school. Marshall conceived of his position as a continuation of the British classical position,
rather than aligned with the continental schools, hence the name "neoclassical." Marshall thought
that these two sides were more important in different periods—in the short term demand is the
primary determinant of price; in the long term, however, the cost of production is more
important. Thus he saw the classics as more interested in factors involved in the long term.

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However, his attempt to subsume utility factors was not acceptable to the Austrian school, which
did not dispute the "two blades of the scissors" but rather that supply is determined solely as a
cost of production.

Marshall is often regarded as one of the respected fathers of modern economics. Under his
guidance, the University of Cambridge grew into a world-renowned centre for the study of
economics. His students became leading figures in economics, including Herbert Foxwell, John
Neville Keynes (father of John Maynard Keynes), and Arthur Cecil Pigou.

His most important legacy was creating a respected, academic, scientifically-founded profession
for economists in the future that set the tone of the field for the remainder of the twentieth
century. His economic theories involving supply and demand, the price elasticity of demand, and
even the concept of consumer surplus, are still alive today.

Marshall wrote in a style accessible to the layman, limiting the complex mathematical reasoning
to footnotes and appendices. Thus, his publications brought sophisticated economic concepts to a
broader readership. However, his attention to detail and his desire to cover all aspects of
economics reduced his output, and his second volume of Principles was never completed.

He was succeeded by Arthur Cecil Pigou.

Arthur Cecil Pigou (November 18, 1877 – March 7, 1959) was an English economist, known
for his work in many fields and particularly in welfare economics. He served on a number of
royal commissions including the 1919 commission on income tax.

However, A.C. Pigou’s fame stems from being responsible for the famous distinction between
private and social marginal products and costs and the idea that government can, via a mixture of
taxes and subsidies, correct such market failures—or "internalize the externalities." This "Pigou
Effect," as it has become known, refers to the stimulation of output and employment caused by
increased consumption as a result of government action. Pigou contributed significantly to the
understanding of unemployment, often in disagreement with John Maynard Keynes, whose work
revolutionized economic thinking in the twentieth century. Although theoretically opposed, often
vehemently, Pigou maintained a warm and lasting personal friendship with Keynes, to their
mutual benefit.

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Pigou's goal was not to simply contribute to economic theory, his desire was to understand and
thus solve the problems of poverty that plagued society. He believed that government has a
fundamental responsibility to ensure the welfare of its people, and he strove to uncover the
economic principles that would guide policies to that end. Although he did not achieve complete
success, his work is an important stepping stone in our understanding of the economic and social
forces that operate in society.

Assertion

 According to Cambridge theory, the value of money depends upon the demand for money. But
the demand for money arises not on account of transactions but on account of its being a store of
value.

Thus, according to the advocates of this theory the real demand for money comes from those
who want to hold it on account of various motives and not from those who simply want to
exchange it for goods and services: just as the real demand for houses comes from those who
want to live in them and not from those who simply want to construct and sell them.

This type of demand for money arises from the fact that holding of money has great utility, as
when it is held (hoarded) it acquires wealth value. Hence, instead of interpreting the ‘demand for
money’ with reference to its ‘medium of exchange’ function as is done in the transactions
approach; it is interpreted with reference to the ‘store of value’ function of money in the cash
balance. It is, thus, the demand for ‘money sitting’ rather than money ‘on wings’ that matters.

It may, however, be made clear that in determining the amount of these cash balances the
individuals and institutions are guided only by their real value. Thus, an individual is concerned
with the extent of his liquid command over real resources. The community's total demand for
money balances constitutes a certain proportion of its annual real national income which the
community seeks to hold in the form of money (liquid cash).

The community’s demand for real cash balances in this sense varies from time to time. Thus,
given the state of trade (T) and the volume of planned transactions over a period of time, the
community’s total demand for real money balances can be represented as a certain fraction (K)

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of the annual real national income (R). The following lines from Marshall explain clearly the
substance of the cash-balance version of the quantity theory, “In every state of society there is
some fraction of their income which people find it worthwhile to keep in the form of currency; it
may be a fifth or a tenth or a twentieth.”

The holding of money involves sacrifice because when we hold (save), we spend less. To have
too little holding of money may mean inconvenience, to have too much may mean unnecessary
stinting. Somewhere between the two extremes every person, every family, every community
fixes the amount of money it will keep. "It is convenient to think of this amount as a given
proportion of the person's or the family's or the community's annual income."

Whatever this proportion may be, it is always the result of a deliberate decision; none of us has
the money holding, we have, quite by accident. This is, in the most real sense, the demand for
money. Suppose at one time people want to possess cash balances worth one-tenth of the annual
income. Now, they want to have cash balances representing one-seventh of the national income.
This means they want to have more cash with them, which is possible only by curtailing
expenditure on goods and services, which, in turn, means less demand for them and hence a fall
in their prices. Similarly, if they want to have fewer cash balances, they will spend more and the
prices will be pushed up.

Thus, according to the cash balance approach, the value of money depends upon the demand for
money to be kept as cash. If one puts the problem as one of the amount of money an individual
will choose to hold, the framework of this approach that suggests itself is one in which
constraints and opportunity costs are the central factors, interacting with individual's tastes.

As far as the Cambridge approach is concerned, the principal determinant of people's taste for
money holding is the fact that it is a convenient asset to have, being universally accepted in
exchange for goods and services. The more transactions an individual has to undertake the more
cash will be he wants to hold.

To this extent, the approach is similar to Fisher's, but the emphasis is on want to hold, rather than
on have to hold. This is the basic difference between the Cambridge monetary theory and

4
Fisher's framework. The essence of this theory is that the demand for money, in addition to
depending on the volume of transactions that an individual might be planning to undertake.

Factors affecting demand for money

1. Current interest rate

The quantity of money people hold to pay for transactions and to satisfy precautionary and
speculative demand is likely to vary with the interest rate, when the interest rises relative to
the rate that can be earned on money deposits, people hold less money

2. Wealth owned by individual

The wealth effect on individuals money demand is examined within the inventory theoretical
framework involving stochastic cash needs, a positive wealth effect arises if an increase in
wealth increases the individuals planned expenditure beyond his expected receipts or if the
marginal yield on earning assets is diminishing or marginal penalty cost is increasing.

3. Future interest rate

The higher the inflation the more interest is likely to arise this occurs because lenders will
demand higher interest as compensation for the decrease in purchasing power of the money
they are paid in the future. The government has a say in how interest rates are affected.

4. The expectation of future prices

Expectations about future price levels also affect the demand for money; a higher price level
means that people expect the money they are holding to fall in value, given that expectation,
they are likely to hold less of it on anticipation of a jump in prices.

Demand for money is a function of;

 Current interest rate

 Wealth owned by individuals

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  Future interest rate
 The expectation of future price

ASSUMPTIONS

1. Changes of those factors are constant and any change will be of the same proportion.
2. That determinant of demand are a function of individual persons income

Current Interest rate=f(y)

Wealth=f(y)

Future interest rate=f(y)

Expectation of future prices=f(y)

DEMAND FOR

MONEY MD

(PY)NOMINAL INCOME

MD=KPY

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 WHERE: K-the proportion of nominal income people want to hold

PY- Nominal income (average price of currently produced goods*Real income.

3. Money demand is a linear direct function of nominal income.

4. Income elasticity of demand for money is unitary.

5. Price elasticity of demand is also unitary, so any price level causes an equal proportionate
change in the demand for money.

Features of Cambridge theory of money

1) A Part of Income is kept in the Liquid Form:

Prof. Fisher has considered money only as a medium of exchange while analyzing the 'Quantity
Theory of Money.' In other words, money is demanded to purchase goods and services. But the
Cambridge economists do not agree with this viewpoint. They have the opinion that nobody
knows what is hidden in future. So everybody wants to keep a part of his present income in the
form of cash or liquid so that if there is a sudden need it can be fulfilled.

This is the thought not only of individuals but also commercial institutions and government.
Thus, the value of money is determined by the demand for cash remainders kept by the people.
So Cambridge Equations are also called cash balance equation. Thus, according to Cambridge
Economists, "The amount of money which is kept by the individual, commercial institutions and
government to meet their day to day needs is called demand of money."

The Cambridge Economists have presented separate equations in the favour of cash balance
equation.

Marshall’s Equations:
Prof. Marshall has given his equation in the following way:
M = KY + K’A

Here

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M = toted money in circulation and deposits with the bank

Y = Total monetary annual income.

K = the part of the income which people keep in liquid form for future use

K' = the part of the property which is kept in the form of money

A = the total value of property

There are two parts of the above equations of Prof. Marshall—”Income part and Property part.
However, both part of the equation may be theoretically correct but it is seen in practice that
people bring only their income into consumption.”

Thus, the amended form of this equation was given as follows:

M = KPY

Where,

M = Supply of Money

P = Price Level

Y = Total Real Income

K = the part of real income which people want to keep with them in the form of cash.

Robertson’s Equation:
Robertson has given his equation in the following way:

M = PKT

Or P = M/KT

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In this equation, the definitions of M, P and T have been taken the same as those in Fisher's
equation and K has been taken from Marshall's equations.

If the value of 1 unit of money is presented in this equation it would be like this:

P = KT/M

Pigou’s Equation:
Prof. Pigou’s Equation is considered to be the easy form of Prof. Marshall’s equation.

Prof. Pigou’s equation is as follows:

P = KR/M

Where,

P = Common Price level

M = Total amount of money

R = Total real income of society.

K = the part of real income which is kept in the form of money.

2) The Demand of Money Depends on the Liquidity Preferences:

An individual wants to save a part of the amount obtained as his income. He can consume this
saved money in many ways. He can invest money in fixed assets by purchasing land, building
etc. or he can purchase shares or debentures of any company. They can also keep this sum
deposited with banks.

But all these investments are not called liquid. Fixed assets can't be sold instantly to obtain cash.
So it can't be called liquid money. Shares and debentures can be converted into cash instantly. So
these are called liquid money. Similarly, money deposited with banks is called extremely liquid.
Thus, more will be the liquid preference in people; the more will be the demand for money.

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 Similarities between the Two Approaches:

Fishers and Cambridge approaches.

1. Similar Equations:

Robertson's cash-balance equation, P = M/KT is quite similar to that given by Fisher; P = MV/T.
Both the equations use the same symbols with the same meanings. The only difference lies in V
and K which are, in fact, reciprocal to each other; V refers to the rate of spending and K refers to
the extent of holding or not spending.

FISHERS ROBERTSON

MV=PT M=KPT

V=PT/M K=M/PT

V=1/K K=I/V

It means when people want to hold more money (higher the K), they want to spend less or the
velocity of circulation of money will be less (lower the V). Thus, by substituting 1/V for K and
1/K for V, the two equations can be reconciled.

2. Same Conclusions:

Both the approaches lead to the same conclusions, i.e., the price level or the value of money
depends upon the money supply. In other words, there is a directly proportionate relationship
between the money supply and the price level and inverse proportionate relationship between the

10
money supply and the value of money. If the money supply is doubled, the price level is also
doubled and the value of money is halved.

3. Same Phenomenon of Money:

MV + M’V’ of Fisher’s equation, M of Robertson’s and Pigou’s equation and n of Keynes’

equation, all refer to the same thing, i.e., the total supply of money.

4. V and K-Two Sides of the Same Phenomenon

Fishers and Cambridge approaches are not fundamentally different from each other because they
represent two sides of the same phenomenon. The Fishers approach emphasizes money as stock,
while the Cambridge approach stresses money as flow.

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Important dissimilarities between the two approaches are discussed below:
1. Relative Stress of Supply and Demand for Money:
Fisher’s approach stresses the supply of money, whereas, the Cambridge approach lays more
emphasis on the demand for money to hold cash.

2. Definition of Money:

The two approaches use different definitions of money. The Fisherian approach emphasizes the
medium of exchange function of money, whereas the Cambridge approach stresses the store of
value function of money.

3. Flow and Stock Concepts:

The Fishers approach regards money as a flow concept; money is considered in terms of the flow
of money expenditures. The Cambridge version regards money as a stock concept; money supply
refers to a given stock at a particular point of time.

4. Transaction and Income Velocities:

Fishers approach emphasizes the importance of the transaction velocity of circulation (i.e., V).
The Cambridge Version, on the contrary, lays stress on the income velocity of the part of income
which is held in the cash balance (i.e., K).

5. Nature of P:

In both approaches, the price level (P) is not used identically. In Fisher’s version, P is the
average price level of all goods. On the contrary, in the Cambridge version. P refers to the price
of consumer goods.

6. Factors Affecting V and K:

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Fisher is concerned about the institutional and technological factors governing how fast
individuals can spend their money (i.e., V). The Cambridge School, on the other hand, is
concerned about the economic factors determining what portion of their wealth the public desires
to hold in the form of money (i.e., K).

7. Relationship between M and P:

The Fishers approach maintains that any change in the money supply produces proportional
changes in the price level. This is because Fisher believes that both velocity and real income are
in the long run independent of each other and of supply of money.

In the Cambridge approach, the price level may change by more or less than the money supply; it
depends upon what happens to the stock of non-monetary assets and their expected yields on
which the Cambridge economists believed the desired cash balances depend.

8. Different Approaches to Monetary Theory:

Both Fisher and Cambridge School led to the development of two different approaches to the
monetary theory. Fisher's approach has given rise to an inventory theory of money holding
largely for transactions purposes. On the other hand, the Cambridge approach has been
developed into a portfolio or capital theoretic approach to monetary demand.

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 The superiority of the Cash Balance Approach:
The Cambridge version is superior to the Fishers version on the following grounds:
1. Realistic Theory:
The Fishers approach is mechanical in the sense that it maintains a mechanical, i.e., direct and
proportional relationship between the supply of money and the price level. The Cambridge
approach, on the contrary, provides a realistic analysis. By emphasizing K, it introduced the role
of human motives in the determination of the price level.
2. Complete Theory:
Fisher's approach is one-sided because it considers the quantity of money to be the only
determinant of the value of money or the price level. In the Cambridge approach, both the
demand for and the supply of money are recognized as real determinants of the value of money.
3. Broader Theory:
The Cambridge approach is broader and comprehensive because it takes into account the income
level as well as changes in it as an important determinant of the price level. The Fishers approach
ignored the income level and makes the price level dependent upon the quantity of money and
the total number of transactions.
4. More Useful:
According to Kurihara, the Cambridge equation, P = M/KT, is analytically more useful than the
Fishers equation, P = MV/T, in explaining money value. It is easier to know the number of cash
balances of an individual than to know his expenditure on various types of transactions.
5. Causal Process:
According to Fisher, changes in the price level are caused by changes in the quantity of money.
But according to the Cambridge economists, the price level may change even without a change
in the quantity of money, if K changes. Given the quantity of money, a desire to keep fewer
money balances will raise the price level and vice versa.
6. Explanation of Cyclical Fluctuations:
The variable K in the Cambridge equation is more significant in explaining the trade cycles than
the variable V in Fisher's equation. During inflation, people decrease their cash balances (K) and
as a result, the value of money falls and the price level rises. On the contrary, during the
depression, the desire to hold money (K) rises and, as a consequence, the value of money rises
and the price level falls.
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7. Basis of Liquidity Preference Theory:
The Cambridge approach, by stressing on the motives for the demand for holding money,
provided a foundation for the development of Keynes ‘liquidity preference theory of interest,
Liquidity preference theory is a significant constituent of the modem theory of income and
employment and its emergence has raised the importance of fiscal policy in controlling business
cycles.
8. Nature of Variables:
Various variables in the Cambridge equation are defined in a better and more realistic manner
than those in the Fishers equation. T in Fisher’s version refers to the total transactions, whereas
in the Cambridge equation, T refers to only the final goods and services. Similarly, P in Fisher’s
version stands for the average price level of all goods transacted in a period of time, but in
Cambridge version, P is the general price level of only final goods.
9. General Demand Analysis:
The Cambridge approach is preferred by economists because it applies the general demand
analysis to the special case of money. It enquires into the utility of money, the nature of the
budget constraint facing the individual and the opportunity cost of holding money as against the
other assets.
The cash balances approach to the quantity theory of money has been criticized on the
following counts:

1. Price Level does not Measure the Purchasing Power:

Keynes in his A Treatise on Money (1930) criticized Pigou’s cash balances equation and also his
own real balances equation. He pointed out that measuring the price level in wheat, as Pigou did
or in terms of consumption units, as Keynes himself did, was a serious defect. The price level in
both equations does not measure the purchasing power of money. Measuring the price level in
consumption units implies that cash deposits are used only for expenditure on current
consumption. But in fact that they are held for “a vast multiplicity of business and personal
purposes.” By ignoring these aspects the Cambridge economists have committed a serious
mistake.

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2. More Importance to Total Deposits:

Another defect of the Cambridge equation “lies in its applying to the total deposits
considerations which are primarily relevant only to the income-deposits.” And the importance
attached to к “is misleading when it is extended beyond the income deposits.”

3. Neglects other Factors:

Further, the cash balances equation does not tell about changes in the price level due to changes
in the proportions in which deposits are held for income, business and savings purposes.

4. Neglect of Saving Investment Effect:

Moreover, it fails to analyze variations in the price level due to saving-investment inequality in
the economy.

5. K and Y not Constant:

The Cambridge equation, like the transactions equation, assumes к and Y (or R or T) as constant.
This is unrealistic because it is not essential that the cash balances (к) and the income of the
people (K) should remain constant even during a short period.

6. Fails to Explain Dynamic Behavior of Prices:

The theory argues that changes in the total quantity of money influence the general price level
equal-proportionally. But the fact is that the quantity of money influences the price level in an
"essential erratic and unpredictable way." Further, it fails to point out the extent of change in the
price level as a result of a given change in the quantity of money in a short period. Thus it fails to
explain the dynamic behaviour of prices.

7. Demand for Money, not Interest Inelastic:

The neglect of the rate of interest as a causative factor between the quantity of money and the
price level led to the assumption that the demand for money is interest inelastic. It means that

16
money performs only the function of a medium of exchange and does not possess any utility of
its own, such as a store of value.

8. Neglect of Goods Market:

Further, the omission of the influence of the rate of interest in the cash balance approach led to
the failure of neoclassical economists to recognize the interdependence between the commodity
and money markets. According to Patinkin, they laid an undue concentration on the money
market corresponding neglect of the commodity markets, and a resulting 'dehumanizing’ of the
analysis of the effects of monetary changes.”

9. Neglects Real Balance Effect:

Patinkin has criticized the Cambridge economists for their failure to integrate the goods market
and the money market. This is borne out by the dichotomy which they maintain between the two
markets. The dichotomization implies that the absolute price level in the economy is determined
by the demand and supply of money, and the relative price level is determined by the demand
and supply of goods. The cash balances approach keeps the two markets rigidly

For instance, this approach tells that an increase in the quantity of money leads to an increase in
the absolute price level but exercises no influence on the market for goods. This is because of the
failure of Cambridge economists to recognize “the real balance effect.” The real balance effect
shows that a change in the absolute price level does influence the demand and supply of goods.
The weakness of cash balances approach lies in ignoring this.

10. The elasticity of Demand for Money not Unity:

The cash balances theory establishes that the elasticity of demand for money is unity which
implies that the increase in the demand for money leads to a proportionate decrease in the price
level. Patinkin holds that “the Cambridge function does not imply uniform elasticity.”

According to him, this is because of the failure of Cambridge economists to recognize the full
implications of the “real balance effect”. Patinkin argues that a change in the price level will
cause a real balance effect. For instance, a fall in the price level will increase the real value of

17
cash balances held by the people. So when there is excess demand for money, the demand for
goods and services is reduced. In this case, the real balance effect will not cause a proportionate
but non-proportionate change in the demand for money. Thus the elasticity of demand for money
will not be unity.

11. Neglects Speculative Demand for Money:

Another serious weakness of cash balances approach is its failure to consider the speculative
demand for money. The neglect of the speculative demand for cash balances makes the demand
for money exclusively dependent on money income thereby again neglecting the role of the rate
of interest and the store of value function of money.

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 References

1. Patinkin, Don (1 November 1984). Anticipations of the General Theory? And Other Essays on
Keynes. University of Chicago Press. p.  171. ISBN 978-0-226-64874-3.

2. Froyen, Richard T. Macroeconomics: Theories and Policies. 3rd Edition. Macmillan

Publishing Company: New York, 1990. p. 70–71.

3. Skidelsky, Robert. John Maynard Keynes: 1883–1946. Penguin: 2003. p. 131.

4. Tobin, James (1987), "Fisher, Irving (1867–1947)", The New Palgrave Dictionary of

Economics: 369–376, doi: 10.1057/9780230226203.0581

5.  Humphrey, Thomas M. "Fisher and Wicksell on the Quantity Theory - Economic Quarterly,
Fall 1997 - Federal Reserve Bank of Richmond". Www.richmondfed.org. Retrieved 15 July
2016.

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