QUANTITY THEORY OF MONEY

(Cash Balance Approach/Cambridge Version)

There are two main lines of approach to the problem of relationship between the quantity of
money and its value/price level. This has given rise to two types of quantity theories. One is the
Quantity Theory of Money proper, called the Cash Transaction Approach theory which is represented
by Fisher’s Equation. This approach is more popular in America. The other approach known as the
Cash Balance Approach , which has been more popular in Europe, especially in England, is represented
by the Cambridge Equation.

Cash Balance Approach is an improve version of Cash Transaction Approach in the sense that
it is based on the National Income Approach and takes into account the concept of liquidity, both of
which form part of Keynesian Economics. It simply says that the value of money depends on demand
for cash balances and the supply thereof at any given time.

The Cambridge economists, being dissatisfied with Fisher’s analysis, explained this theory in a
new way. The main economists supporting this group are Marshal, Pigou, Cannen, Hartle, Robertson
etc. The main features of Cambridge’s Quantity Theory are as follows:

1) A Part of Income is kept in the Liquid Form: Prof. Fisher has considered money only as a
medium of exchange while analysing 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 view point. 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 of cash remainders kept by the people. So, Cambridge Equations are also called cash
balance equation.
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.

Equation:

The equation is usually put in the form of 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.
Superiority of Cambridge Equation:

Quantity Theory of Money of Cambridge ideology is superior to transaction ideology of Fisher

in the ‘Quality Theory of Money’ for the following reasons:

1) Liquidity Preference: Cambridge equation lays emphasis on Liquidity Preference Theory, the
basic tendency of human beings in place of supply of money. On this bases ‘Liquidity
Preference Theory of Keynes’ developed.
2) Completeness: Cambridge equation of ‘Quantity Theory of Money’ can be called a complete
theory because in it Liquidity Preference Theory, the basic tendency of value of money is
determined through demand and supply.
3) Simplicity: In this equation transactions related to only consumer goods are considered while
in fisher’s equation all kinds of transactions are included. It is very easy to determine price
level in Cambridge equation. So, it can be said an easy equation.
4) Trade Cycle: Cambridge equation protects people from trade cycle. People develop the
tendency of depositing money in this equation.
5) Related to Short-Term: The equation propounded by Prof. Fisher analyses only long-term
changes while Cambridge analysis presents the solution of short-term changes also.
6) Broader Concept: According to Hicks the real causes of demand of goods have been
highlighted in the Cambridge analysis and their affects have also been clarified. With this view,
the concept of demand of money is broad in Cambridge equation. Fisher’s viewpoint is
inactive in this sense.
7) Applicable under all Circumstances: Fisher’s equation is favourable for that economy only
which has the condition of full employment, but Cambridge equation is applicable in all
circumstances. Thus, it is certainly superior.

Criticisms:

The critics have criticised it on the following bases:

1) Prof. Pigou took wheat as an example in his equation. Thus, this equation shows the demand
of money for consumer goods, while in practical life, there is demand of money for many
reasons.
2) Current deposits with banks have been included in the demand of money in this equation.
With current deposits, there are also fixed deposits with bank. But fixed deposit has not been
given any place in this equation.
3) Cambridge equation does not clarify the fact how price level will be changed due to changes
in income and saving.
4) It is also a fault of this theory that it fails to analyse the complex problems of the economy.
The increase in production and income can’t be concluded on the bases of this equation.
5) It has been supposed in this equation that the amount of cash reserve is influenced by k but
in reality the amount of money is influenced both by Y and k.
6) Cambridge equation does not pay attention to speculation demand of money while there is
demand of money for this also.