Cambridge Theory of Money also known as the Cambridge Cash Balance Approach

Concept, Assumptions, Equations and Criticism of the theory

1. CAMBRIDGE THEORY OF MONEY  Submitted By: Alka Rathi

2. CONCEPT The Cambridge Monetary Theory, also known as the Cambridge Cash Balance Approach, is an economic theory that emphasizes the role of money in the economy. The theory was developed by a group of economists at Cambridge University in the early 20th century, including John Maynard Keynes, and it has been influential in shaping modern macroeconomic theory.

3. According to the theory, the demand for money is a key determinant of economic activity. People hold money not only to facilitate transactions, but also as a store of value. Therefore, the demand for money is influenced by income levels, interest rates, and the level of prices in the economy. The theory argues that if the money supply grows faster than the demand for money, inflation will occur. Conversely, if the money supply grows more slowly than the demand for money, deflation or recession may occur. The theory also emphasizes the role of the central bank in controlling the money supply. The central bank can use monetary policy tools such as open market operations, changes in the discount rate, and changes in reserve requirements to influence the money supply and interest rates in the economy. The theory suggests that the central bank should aim to maintain stable prices and full employment in the long run

4. What is Cash Balance Equation ? According to Cash Balance Equation, value of money is determined by the demand for and supply of money . At any particular point of time, supply of money remains constant , hence changes in demand for money have more influence on the value of money (or price-level). This theory lays more emphasis on the demand for money than its supply . It is therefore also referred to as Demand Theory of Money . Supply of money = Notes + Coins + Demand Deposits Demand of money = Cash Balances According to this equation, if Supply of money remains constant, increase in demand for money or cash balance will lead to fall in prices, because people will desire to hold large parts of their income in the form of cash and so will have less demand for goods and services . And if demand of money decreases there will be more demand for goods and services and hence price level will rise.

5. ASSUMPTIONS Money is neutral in the long run . Money is non-neutral in the short run . There is a stable demand for money . Money supply is endogenous The economy is in a state of constant disequilibrium

6. Equations Marshall's Equation: M = KY+ K ’ A (Here, M = quantity of money; Y = Monetary income; K = that part of income which people desire to hold in cash; A = Wealth, K ’ = that part of wealth which people desire to keep cash) Here Y=PO (Monetary Income=production*price level) Robertson ’ s Equation : P=M/KT (Here, P = price-level; M = quantity of money; T = quantity of goods and services purchased during one year, K = that portion of T which people want to keep cash) Keynes ’ s Equation: N= P( k+rk ’ ) (Here, n = total quantity of money; P = price-level; k = that proportion of consumption goods which people wish to keep cash; r = proportion of cash reserve to bank deposits; K' = that proportion of consumption goods which people wish to keep as bank deposit.)

7. Equations Pigou ’ s Equation: P=KR/M (Here, M = total quantity of money; R = total real income; K= that portion of real income which people wish to keep in cash; P= Value of Money) Modified equation M=KR/P ( c+h (1-c)) (c: cash with people; 1-c: bank deposits; h: cash reserve ratio (held by the bank))

8. CRITICISMS The theory assumes stable demand for money, but empirical evidence shows that changes in technology and payment systems can impact the demand for money. The assumption that the economy is always at full employment in the long run has been criticized by Keynesian economists. The theory does not address the issue of income distribution and inequality . The theory does not account for the impact of financial intermediaries on the economy.

9. Incomplete theory (gives importance only to current income in determining cash reserves) Ignores the effect of rate of interest Ignores the influence of real factors Fails to explain trade cycles

10. The theory does not account for the impact of international trade and capital flows on the economy. The theory assumes that investment and consumption are solely determined by interest rates , but other factors such as changes in technology and regulations can also impact investment and consumption. The theory does not consider the impact of fiscal policy on the economy.