INSTITUTE: USB

DEPARTMENT: COMMERCE
Bachelors of Commerce
International Monetary Economics 21CMT-307
By- Ravneet Kaur
Video Lecture-6

Cambridge’s Cash Balance Theory DISCOVER . LEARN . EMPOWER

1
 International
Monetary
Economics
Course Outcome
CO Title Level
Number
Will be covered in this
CO1 The students would be able to Understand why people Understand lecture
hold money and why it is used in the trading process

CO2 The students would be able to Apply to comprehend the Apply

international developments
CO3 The students would be able to Analyze the theoretical Analyze
building blocks that are needed for an understanding of
the monetary theory
CO 4 The students would be able to Evaluate the issues in the Evaluate
present-day monetary policy implementation faced by the
central banks.
CO 5 The students would be able to Create the main channels Create
of the monetary transmission mechanism, through which
monetary policy can have real effects on the economy.
2
 Contents
• Objective: To provide conceptual understanding of Service Marketing.

• The following topics are covered in upcoming slides:

1. Introduction to Cambridge’s Cash Balance Theory.

2. Assumptions of Theory.
3. Criticism of the theory

3
 Cambridge’s Cash balance Theory
• An alternative version, known as cash balance version, was developed by a group of Cam­bridge economists like
Pigou, Marshall, Robertson and Keynes in the early 1900s. These economists argue that money acts both as a
store of wealth and a medium of exchange. Here, by cash balance and money balance we mean the amount of
money that people want to hold rather than savings.
• According to Cambridge economists, people wish to hold cash to finance transactions and for security against
unforeseen needs. They also sug­gested that an individual’s demand for cash or money balances is proportional to
his in­come. Obviously, larger the incomes of the individual, greater is the demand for cash or money balances.

• Thus, the demand for cash balances is specified by:

• Md = kPY …(4.6)
• where Y is the real income, P is the average price and k is the proportion of national output or income that people
want to hold. Let us assume that the supply of money, M S’ is determined by the monetary authority, i.e.,
• MS = M …(4.7)
4
• 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

• Monetary equilibrium Cambridge cash balance approach is shown in the following figure
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 .

5
• Now, if supply of money fixed by the Government (or the
Central Bank) is equal to M 0, the demand for money KPY
equals the supply of money, M0 at price level P0. Thus, with
supply of money equal to M0 equilibrium price level P0 is
determined. Suppose money supply is increased to M 1 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 the figure that with the
increase in money supply to M1 new equilibrium between
demand for money and supply of money is attained at point
https://images.app.goo.gl/LwHLSeWE9kzccpbG8
E1 on the demand for money curve KPY and price level has
risen to P1. 6
• 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.
• Now rearranging the equation we get that, P = M/KY, Now, Cambridge economists also
assumed that k remains constant. Further, due to their belief that wage-price flexibility ensures
full employment of resources, the level of real national income was also fixed corresponding to
the level of aggregate output produced by full employment of resources.
• Thus, from above equation it follows that with k and Y remaining constant price level (P) is
deter­mined by the quantity of money (M); changes in the quantity of money will cause
proportionate changes in the price level.

7
 Assumptions
• This theory is based in short-run.
• Money is used as function of exchange and store of value both.
• K is the constant of money income public want to hold
• K (proportion of holdings) and Y (income level of people) remains
constant in an economy.
• Assumption of full employment situation in the economy.

8
 Criticism Of Cambridge’s Theory
1. Ignored various motives to hold cash: Although this approach was evolved and
popularized by Keynes, the theory does not to take into consideration various motives for
holding money. Cambridge approach to the quantity theory ignored the speculative demand
for money which turned out to be one of the most important determinants for holding
money. Ignoring the speculative demand for money meant that the linkage between the
theories of the rate of interest and the level of income through the demand for money was
not complete.
2. Although Cambridge equation brought into the picture the level of income, yet it ignored
other elements, like productivity, liquidity preference—all necessary in a comprehensive
theory of the value of money.
3. Cambridge approach like Fisher’s approach also assumes K and Y as constant, thus, it
becomes subject to those criticisms, which were leveled against Fisher’s approach. 9
4. The Cambridge approach does not furnish an adequate monetary theory which could be
utilized to explain and analyze the dynamic behavior of prices in the economy, as it does not
tell us by how much price and output shall change as a result of a given change in money
supply in short period.
5. The cash balances approach fails to assign an explicit role to the rate of interest thereby
creating an impression that changes in the supply of money are directly related to the price
level. A realistic theory of prices can hardly ignore the vital role of the rate of interest.
6. The cash balance theory does not explain the real forces which account for the price level. It
ignores such important variables as income, saving and investment. It explains that changes in
the demand for money may bring about changes in the value of money, but it does not explain
clearly the factors which cause change in the demand for money, which in turn, are very many
and more so in a complex dynamic economy.
7. This theory takes unrealistic assumption of full employment which does not exist in real
life.

10
Superiority of Cash balance approach over
Fisher’s Approach
• Superiority of Cash Balances Version:
1. Realistic Theory: The Fisherman 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 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
income level as well as changes in it as important determinant of the price level. The Fisherman approach
ignored income level and makes the price level dependent upon the quantity of money and the total number
of transactions. 11
4. More Useful: the Cambridge equation, P = M/KT, is analytically more useful than the Fisherman
equation, P = MV/T, in explaining money value. It is easier to know the amount of cash balances
of an individual than to know his expenditure on various types of transactions.

5. 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 depression, the desire to hold money (K) rises and, as a consequence,
the value of money rises and the price level falls.

6. 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.
12
 Difference between Cambridge and Fisher
Theory
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 Fisherman
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 Fisherman approach regards money as a flow concept; money is
considered in terms of 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: Fisherman 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).
13
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 Cambridge version. P
refers to the price of consumer goods.
6. Factors Affecting V and K: 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 Fisherian 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.
14
 Similarities between Cambridge and
Fisher approach
1. Same Conclusion: The Fisher and Cambridge versions lead to the same conclusion that there is a direct
and proportional relationship between the quantity of money and the price level and an inverse
proportionate relationship between the quantity of money and the value of money.

2. Similar Equations: The two approaches use almost similar equations. Fisher’s equation P = MV/T is
similar to Marshall’s equation P = M/KY However, the only difference is between the two symbols V
and k which are reciprocal to each other, (as Y (income ) and T (Trade) in respective equations are
stated to be constant because of full employment assumption). Whereas V = (1/k) k = (1/V) Here V
refers to the rate of spending and k the amount of money which people wish to hold in the form of cash
balances of do not want to spend. As these two symbols are reciprocal to each other, the differences in
the two equations can be reconciled by substituting 1/V for k in Marshall’s equation and 1/k for V in
Fisher’s equation.

15
3. Money as the Same Phenomenon: The different symbols given to the total quantity of
money in the two approaches refer to the same phenomenon. As such MV+M’V of
Fisher’s equation, M of the Cambridge's equations.

4. Assumption of Full Employment Situation in Economy: Both the theories i.e. of

Fisher and Cambridge economists propounded the theories under the impression of full
employment situation prevailing in economy, hence making real factors of employment
and output generation to be stable.

16
 Summary Of The Topic
• Students will get a clear picture of the concept of Theories of demand for Money.
• This conceptual understanding will help them in gaining an insight into the monetary economics.

17
 Assessment Pattern
Sr. No. Type of Assessment Task Weightage of actual Frequency of Task Final Weightage in Internal Remarks
conduct Assessment
1. Assignment* 10 marks of each One Per Unit 10 marks As applicable to course
assignment types depicted above.

2. Time Bound Surprise 12 marks for each test One per Unit 4 marks As applicable to course
Test types depicted above.

3. Quiz 4 marks of each quiz 2 per Unit 4 marks As applicable to course

types depicted above.

4. Mid-Semester Test** 20 marks for one MST. 2 per semester 20 marks As applicable to course
types depicted above.

5. Presentation*** Non Graded: Engagement Task Only for Self Study MNG
Courses.
6. Homework NA One per lecture topic [ of 2 Non-Graded: Engagement Task As applicable to course
questions] types depicted above.

7. Discussion Forum NA One per Chapter Non Graded: Engagement Task As applicable to course
types depicted above.

8. Attendance and Engagement NA NA 2 marks

Score on BB

18
 APPLICATION
• Application of International Monetary Economics can be as follows:
1. Better understanding of concept of theory of demand for money.
2. Better Strategic Planning is possible.
3. Helps in analyzing various features, classification and importance of money and demand for
money.

19
 REFERENCES
• Reference Books:
"Monetary Economics" by Jagdish Handa, Volume- 2009/2nd Edition PDF link for the book
ishttp://data%20backup%2006012022/Desktop/Chandigarh%20University/IME%20(Jan-DEc
%202020)/IME%20PPT/international%20Monetary%20Economics.pdf , book can also be
purchased from Amazon and link for same is https://www.amazon.in/Monetary-Economics-
Jagdish-Handa/dp/0415199255.

"A Guide to International Monetary Economics", Third Edition: Exchange Rate Theories,
Systems and Policies by Hans Visser, Edward Elgar Publishing, 2006, PDF link for the book is
https://www.yumpu.com/en/document/read/41781471/a-guide-to-international-monetary-
economicspdf, book can also be purchased from Amazon and link for same is
https://www.amazon.in/Guide-International-Monetary-Economics-Third/dp/1845426932.

20
 THANK YOU

For queries:
Email: ravneet.usb@cumail.in

21