Subject: Economics

Class: M.A.
Semester: III

Name of the Paper:

Monetary Economics

Topic:
Cash-Balance Approach

Sub-Topic:
Cambridge Approach

Keywords: demand for money, stock of money, Keynes’ quantity equation, financial assets.

Dr. Rajesh Pal

Professor and Head
Department of Economics
Faculty of Social Sciences
Mahatma Gandhi Kashi Vidyapith
Varanasi-02.
Email: [email protected]

Disclaimer: Although the author has made every effort to ensure that the information and knowledge
provided in this chapter is correct and accurate in regard to the subject matter covered. The matter of this
chapter is taken from the author’s book entitled “Issues and Concepts of Economics (2016),” published by
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author assumes no responsibility for errors, inaccuracies, omissions, or any other inconsistencies herein
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Self-Declaration: The content is exclusively meant for academic purposes and for enhancing teaching
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Copyright © 2020 by Rajesh Pal.

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 Cash-Balance Approach or Cambridge Approach

Learning objectives

After studying this chapter, you will be able to:

• Differentiate between Cambridge approach and Fisher’s approach to the quantity theory
of money.
• Expound cash-balance approach to the quantity theory of money.
• Understand the meaning of financial assets.
• Explain demand for money and stock of money.

Introduction

In Fisher’s quantity equation or exchange of equation, we have seen that money is demanded not
for its own sake but for purchasing of goods and services as money serves as a medium of
exchange. Demand for money is equivalent to the value of transactions (PQ). Demand for money
and supply of money in Fisher’s quantity equation are considered over a period of time. The
Cambridge economists (like Marshall, Pigou, Cannan, Robertson, and J.M. Keynes) do not agree
with the view of the Fisher and they establish another version of quantity theory of money,
which is called cash balance approach or Cambridge Approach.

Cash-Balance Approach or Cambridge Approach

The cash balance approach is based on the store value function of money and demand for and
supply of money is considered at a point of time. According to the Cambridge, supply of money
is a stock at a particular point of time rather than flow over a given period of time. The supply of
money and community’s aggregate demand for cash determines the price level or value of
money in the economy. The supply of money at a particular moment comprises all the cash and
bank deposits subject to withdrawal by cheques. According to the Cambridge economists
Fisher’s view on demand for money is unscientific because money is demanded not only to serve
as a medium of exchange but also to keep money in cash balance. According to the Cambridge
economists, demand for money refers to liquidity preference, which individuals and firms keep
with themselves to meet day to day expenses, expected and unexpected future events. There is
direct relationship between the liquidity preference and demand for money. Higher the liquidity
preference, higher will be the demand for money or cash balance and vice versa. The basic
postulates of the cash balance approach are that demand for money or demand for cash balance
arises to meet transactions and precautionary motives. It must be noted here that in cash balance
approach demand for speculative motive is not considered. The quantity theory is often
illustrated using the Cash balance version of the quantity equation or exchange of equation. The
Cambridge equation is derived from equation MV = PY. If we divide (MV = PY) both side by V,
we get

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 M = (1/V) PY, Or (i)

Since V is constant we can replace (1/V) with some constant, k

M = kPY (ii)

Where, k = 1/V. Although it is simply an algebraic reformulation of the basic equation of

exchange, the cash balance approach has the advantage of focussing on k, the percentage of
nominal income held in the form of money, rather than its inverse, the velocity.

Whatever version of the equation of exchange is used, the long-run proportionality of

money and prices is the defining feature of the quantity theory. Differences among quantity
theorists arise over what happens in the short run (Indeed, Keynes himself can be thought of as a
quantity theorist, he believed that money and prices would change in proportion in the long-run.
He criticised the quantity theory on the grounds that the economy was rarely if ever in the long
run; Keynes therefore, concerned himself with the short-run)

The above equation (ii) can be termed as the Marshall’ equation

M = kPY (iii)

Where, M stands for total supply of money comprises total amount of money/ currency and
demand deposits in the banks; k represents the fraction of the real income, which people desire to
hold in the form of money or cash; P refers to the price level; and Y (in Marshall equation refers)
to aggregate real income.

The value of money or purchasing power of money in terms of equation (iii) can be found
out by dividing the total quantity of goods which the public desired to hold of the total income
(kY) by the total supply of the money,M. Thus we have:

P = kY/M (iv)

Where, P represents purchasing power of the money. Marshall believed that the value of money
is not only influenced by changes in the supply of money but also by changes in k.

Pigou has given another version of quantity equation, which is extension of equation (iv):

P = kY/M {C + R (1– C)} (v)

Where, p stands for purchasing power of money. kY/M remain same as in Marshall’s equation,
(v). C is the proportion of money, which people keeps in the form of legal tender. R represents
proportion of cash reserve to deposits held by the bank. (1 – C) implies that proportion of total
money, which is held by the people in the form of bank deposits.

In the above equation, (v), purchasing power of money or value of money varies directly with k
and Y and inversely with M.

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 The above equation can be used to find out price level as in the transactions equation,
then Pigou’s equation can be restated as

P = M/KY (vi)

Robertson has given another version of quantity equation,

P = M/kQ (vii)

Where, P is the price level; M refers to supply of money; k indicates that proportion of Q which
the people desire to hold in the form of cash; and Q refers to transactions of all goods and
services during one year. The Robertson’s cash balance, P = M/kQ is looking similar to Fisher’s
transaction quantity equation, P = MV/Q. In both equations P. M and Q are more or less similar
to each other except V. In Robertson equation k is the reciprocal of 1/V or V = 1/k. There is,
however, a fundamental difference between the two equations. Fisher’s quantity equation
considers money as a medium of exchange while Robertson version of quantity equation
considers money as a store of value.

Keynes’ version of quantity equation is known as the real balance quantity equation in his book,
A tract on Monetary Reforms, it is as follows:

n = pk or p = n/k (viii)

where,

n is the total supply of money in circular;

p is the general price level of consumption goods;

k indicates those consumption units for which the purchasing power is kept in the form of
cash, which is referred to the real balance.

Assuming k to be constant, a change in n causes a direct proportional changes in

p. Keynes extended his equation to include bank deposit in money supply. The extended
form of Keynesian equation is as follows

n = p (k + rk’) (ix)

p= (x)
′

where, r is the ratio of bank’s cash reserves to their deposits; k’ represents those consumption
units for which the purchasing power is kept by the public in the form of bank deposits.

Keynes had, in fact, assumed that in the short period, k, k’ and r generally remained
constant so that change in price results in a direct proportion to the change in the supply of
money,n. In the long-run, however, k, k’ and r may not remain constant and changes in n may

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not result a proportionate change in p because change in n may influence k, k’ and r. In this
respect, Keynes equation differs from Pigou.

Demand for Money and Stock of Money

The monetarist theory of demand for money can be illustrated with the Cambridge cash balance
approach to the equation of exchange: M = kPY. The Cambridge equation can be interpreted as
the demand for money. We then write the equation as

Md = kPY (xi)

Where, Md is demand for money. The demand for money is the willingness of people to hold
money; k represents the fraction of income people wish to hold in the form of money; P is the
price level, and Y is output.

According to monetarists people demand for money for variety of reasons including store
of value, transaction motive, and precautionary motive. The money stock (Ms) is set by
monetary authority like The Reserve Bank of India.1 The equilibrium occurs in all markets,
where the quantity demanded equals the quantity supplied, or

Md = Ms (xii)

There are five major factors that affect the demand for money is:

1. Wealth: The relationship between wealth and demand for money is directly related. Rich
people hold more assets than poor people. Money is just one type of asset. Greater the
transactions, greater the demand for money. Thus, more the wealth, more the demand for
money.
2. Rate of interest: Money held in the form of currency and coins earns no interest. If rate of
interest is low, demand for money (in cash) will be high and vice versa. The cost of
holding money is the interest rate foregone by not holding other assets. As the rate of
return on bonds, equities, and bank deposits rises; the demand for money decreases
because the cost of holding money increases. This shows that demand for money is
inversely related to the interest rate.
3. The price level: The price level refers to prices of commodities. If price level goes up,
people will need to hold more money balances to carry out the same amount of
transactions. Consequently, demand for money balances rises when the price level rises
and declines when the price level declines. In essence, people adjust their nominal money
balances, M, in order to achieve their desired level of real money balances. Real money
balances means quantity of money in terms of the quantity of goods and services it can
buy. This amount, M/P, is called real money balances. Real money balances measures the
purchasing power of the stock of money. For example, if price of a loaf of bread is Rs.5

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 and the quantity of money is Rs. 200, then real money balances are 40 loaves of bread.
That is at current prices, the stock of money in the economy is able to buy 40 loaves of
bread.
4. The expected rate of inflation: Inflation reduces the value of money balances. If rate of
inflation exceeds the nominal rate of interest on money, it will reduce the purchasing
power of their current money holdings. People will therefore reduce their holdings of
money if the expected rate of inflation goes up. This indicates that demand for money is
inversely related to the expected rate of inflation.
5. Institutional factors: The expected future stability of the economy will influence the
demand for money. Besides, prevailing pattern of bill payments and wage payments
affects the demand for cash balances. Demand for money will rise when economic
condition is unstable and vice versa.

A money demand function is an equation that shows what determines the quantity of real
money balances people wish to hold. A simple money demand function is,

(M/P)d = kY (xiii)

Where, (M/P)d is demand for real money balances and k tells us how much money people want
to hold for every Rs. of income (Y). This equation states that the quantity of real money balances
demanded is proportional to real income.

The money demand function is just like the demand function for a particular good. Here,
the “good” is the convenience of holding real money balances2. Just as owning a owning a
automobile makes it easier for a person to travel, holding money makes it easier to make
transactions (see Fisher, approach). Therefore, high income leads to a greater demand for
automobiles, higher income also leads to a greater demand for real money balances ((M/P)d.

This money demand function offers another way to view the quantity equation. To see
this, add to the money demand function the condition that the demand for real money balances
(M/P)d must equal the supply of money. Therefore,

M/P = kY (xiv)

M/P = 1/V(Y) (since k = 1/V)

MV = PY (xv)

The equation (xv) is derived from equation (xiv). The V and K are inversely related to each other
because when people want to hold more money (K) for each Rs. of income (Y), there will be less
transaction means less velocity of circulation of money (V). Holding more money of income (k
is large), money changes hands infrequently (V is small) and holding less money of income (k is
small), money changes hands frequently (V is large).

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Now, come to the equation (xii)

Md = Ms

If The Reserve Bank of India increases the money stock to Ms1, then desired money balances
will be less than the actual money balances. This may be shown as,

Md < Ms1

Because of increase in stock of money, people spend more, prices level will go up in the short-
run (because classical economists assumed full employment in the short-run). Increase in price
level (P) will reduce real money balances (M/P). The rising price level3 increase the demand for
money balances until people become willing to hold the new, higher stock of money. In terms of
Cambridge equation, P is pushed up until Md = kPY is once again equal to the stock of money
(Ms1),

Md = kPY = Ms1 (xvi)

In actual economy, the transmission from money to prices is somewhat more complex. When
supply of money increases, people and businesses try to reduce their money balances in more
ways than simply increasing purchases of goods and services. They will also purchase other
financial assets (financial assets or claims are generally subdivided into two heads of primary or
direct securities and secondary or indirect securities. The former are financial claims against real
sector units such as bills, bonds, and equities. They are created by real sector units as ultimate
borrowers for raising funds to finance their deficit spending. The secondary securities are
financial claims issued by financial institutions or intermediaries against themselves to raise
funds from the public. For examples the Reserve bank currencies, bank deposit, and life
insurance policies etc.4. The increased demand for financial assets pushes down the rate of
interest on those asserts and thereby increases planned investment spending. This leads to
temporarily increase in output and employment. As firms attempts to purchase more labour and
other factors of production; prices of inputs increases. Consequently, increase in prices of input
leads to a rise in output prices – inflation. the economy reaches long-run equilibrium when MV =
PY (see equation (xiv) and (xv) at the original level of real national income. The rise in M
ultimately leads only to a rise in P.

Terminology

• Wealth: The relationship between wealth and demand for money is directly related. Rich
people hold more assets than poor people. Money is just one type of asset. Greater the
transactions, greater the demand for money. Thus, more the wealth, more the demand for
money.
• Expected Rate of Inflation: Inflation reduces the value of money balances. If rate of
inflation exceeds the nominal rate of interest on money, it will reduce the purchasing

7
 power of their current money holdings. People will therefore reduce their holdings of
money if the expected rate of inflation goes up. This indicates that demand for money is
inversely related to the expected rate of inflation.
• Institutional Factors: The expected future stability of the economy will influence the
demand for money. Besides, prevailing pattern of bill payments and wage payments
affects the demand for cash balances. Demand for money will rise when economic
condition is unstable and vice versa.

Important Points

• The cash balance approach is based on the store value function of money and demand for
and supply of money is considered at a point of time.
• The monetarist theory of demand for money can be illustrated with the Cambridge cash
balance approach to the equation of exchange: M = kPY.
• According to monetarists people demand for money for variety of reasons including store
of value, transaction motive, and precautionary motive.
• Financial assets or claims are generally subdivided into two heads of primary or direct
securities and secondary or indirect securities. The former are financial claims against
real sector units such as bills, bonds, and equities. They are created by real sector units as
ultimate borrowers for raising funds to finance their deficit spending. The secondary
securities are financial claims issued by financial institutions or intermediaries against
themselves to raise funds from the public. For examples the Reserve bank currencies,
bank deposit, and life insurance policies etc.

Check Your Progress

1. Explain cash-balance approach to the quantity theory of money.

2. Differentiate between cash-balance approach and Fisher’s transaction approach to the
quantity theory of money.
3. What are financial assets?
4. Discuss monetarist’s theory of demand for money and stock of money.

References

1. Mankiw, Gregory, N, 2003, Macroeconomics, Worth Publishers: 84.

2. Kamerschen, David, R; et al. 1989. “Economics.” Houghton Mifflin Company:37.
3. Kamerschen, et al, op. cit,: 37.
4. Gupta, Suraj, B, 1982, Monetary Economics: Institutions, Theory and Policy, S. Chand
and Company Ltd: 21.