YASH CLASSES ECO FY SEM –II

MONEY
Q.1 What is a barter System? What are the inconveniences of barter
exchange ?
Ans. (1) A BATER ECONOMY
Barter system was prevalent in the oldest method exchange. Even today, in
some of the interior parts of African countries and in backward regions of India,
especially in some rural and Adivasi areas, barter system is in operation.
There is no use of money or any medium of exchange in a barter economy.
“Barter” means direct exchange of good – goods exchanged against goods. House may
be exchanged for horses, lemons for oranges, milk for bananas, shoes for shirts and so
on. In the barter system thus, one has to give some kinds of goods to get some other
kinds of goods.
The barter system is not as simple and smooth a system of exchange as its
meaning shows. Many difficulties and inconvenience are inherent in a simple barter. As
a society becomes more difficult and complicated.

(2) Difficulties of Barter System

A few major difficulties of the barter system may be traced below :

1. Want of Coincidence :
The first difficulty in the barter system of exchange is that there
has to be a double coincidence of wants. Two persons can have barter exchange
only if their disposable possessions mutually suit each other’s needs. So in
barter trading, two parties must agree on their mutual exchange, That means ,
one party must be wanting a commodity which the other party wants to dispose
off. In practice, it is difficult to have such double coincidence of wants and,
therefore, there are delays in transactions, and a considerable amount of time
and effort is wasted in such exchanges. Trade and business cannot develop
rapidly in a barter economy. Barter as such is a high barriers to economic
progress.

2. Lack of a Common Measure of :

Another serious difficulty of the barter is that it lack any common
measures of account, in a barter, the values of goods are measured in a
relative sense ; hence there is no absolute measurement of value. Under
such conditions, no meaningful accounting system can be evolved.
3. Wants of Means of Sub–division :
Barter exchange also suffers from a service inconvenience on
account of indivisibility of many kinds of goods. One can easily portion
out a bag of food grains, a basket of fruits, etc. which are divisible goods
and can give more or less in exchange for what is wanted. But, the real
difficulty arises in the process of exchange between indivisible and
divisible goods.

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For instance, a horse is not divisible and cannot be

exchanged in parts against different divisible goods like rice, sugar,
potatoes, etc.
In a barter system, smooth exchange operations are impossible for want
of a means of sub – dividing and distributing value according to people’s
varying requirements.
4. Lack of Standard of Deferred Payments :
Another drawback of barter is that it lacks a standard of deferred
payments, so that contracts involving future payments or loan
transactions, cannot take place with ease in such a system. Credit
transactions cannot be promoted smoothly under barter trading.
Chances of controversy about the quality of goods or services to be
repaid can arise.
5. Lack of Efficient Store of Value :
Perhaps, a major problem of the barter is the lack of facility to
store value or the lack of existence of a generalized purchasing power.
Under barter, people can store value for future use by storing wealth, but
the difficulty arises when wealth consists of perishable goods. Moreover,
the store of value in terms of real wealth involves cost and further, the
problem of storing the goods arises.

Q.2 What is Money explain its main functions?

Ans. (1) What is money ?
Money is in fact one of the greatest inventions of Men. Since
money represents generalized purchasing power it has been the object of
mans desired thoughts the ages.
Money has been defined differently by different economists.
(1) According to Robertson
“Money is a commodity which is used to denote anything
which is used to denote anything which is widely accepted in payment for
goods”
(2) Crowther’s words
“Anything that is generally acceptable as a means of
exchange and that at the same time acts as a measure and as a store of
value. ”
(3) Seligman’s word’s
“Money as a things that possesses general acceptability ”
In other words the commodity chosen as money must be
universally acceptable with community in exchange for goods and
services or in payment of debt.

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( 2) Functions of Money

(1) Main Functions : -

(i)Money is a Medium of Exchange.
This may be considered as the most basic function of
money. Money has the quality of general acceptability. As such, all
exchange take place in terms of money, It was on account of the
difficulties of barter money came into existence. In the modern money-
exchange system, the prices of goods and services are expressed in terms
of money.
Since money is a medium of exchange, its holder can demand
marketable goods and services at his own option whenever he needs
them. If the individual concerned has no money, he may have to borrow
it to acquire the necessary goods and services for his own benefit.
(ii) Money is a Measure of Value.
The second important function of money is that it measures the
value of goods and services. In other words, the prices of all goods and
services are expressed in terms of money. Money is, thus, looked upon as
a collective measure of values. Since all values are expressed in terms of
money, it is easier to determine the rate of exchange between various
types of goods and services in the community..
In view of its function as a measure of value, money also serves as
a unit of account. All records are kept and maintained in terms of the
monetary unit, e.g., Rupee, Dollar, Pound Sterling, Yen, Mark etc.
(iii) Money is a Standard of Deferred Payments.
Borrowing and lending were difficult problems under
the barter system. but the modern money economy has greatly
facilitated the borrowing and lending process. Now both, borrowing as
well as lending, are done in terms of money. In other words, money now
acts as the standard of deferred payments. Money has proved to be a
suitable standard of deferred payments for the following three reasons :
(a) The value of money is stable compared to the value of other
commodities. (b) Money is more durable compared to other
commodities. (c) Money has the quality of general acceptability. Hence, it
continues to be always desirable.
.
(iv) Money is a Store of Purchasing Power.
As is well known, savings were discouraged under the
barter system. But with the invention of money, this difficulty has now
disappeared. Savings are now done in terms of money. Money also
serves as an excellent store of wealth, as it can be easily converted into
other marketable assets, such as, land, machinery, plant etc.
(v) Money is a Means of Transferring Purchasing Power.

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Money performed this function easily and quickly. Since money

possesses the quality of general acceptability, a person can dispose of his
property at one place and buy new property at another place.
Furthermore, borrowing and lending also take place in terms of money. It
is on account of the general acceptability of money that purchasing
power can be transferred from one person to another.

(2) Contingent Functions.

(i) Money is the Basis of Credit.
In recent years, the importance of credit has increased
in all the countries of the world. Credit instruments are used on an
extensive scale. The use of cheques, bills of exchange, etc. has gone up
particularly in the developed countries of the West. It should however, be
remembered that money is the basis of credit. Without money, credit
instruments cannot circulate.
(ii) Money increase Productivity of Capital.
Capital is to be found in several forms, but money is the most liquid type
of capital. In other words, capital in the form of money can be put to any
use. It is on account or this liquidity of money that capital can be
transferred from the less productive to the more productive uses. The
mobility of capital has also increased on account of the liquidity of
money.
(3) Other Functions.
(i) Money help to maintain Repayment Capacity.
Money, as already pointed out, possesses the quality
of general acceptability. So to maintain its repayment capacity.

(ii) Money given Liquidity to Capital.

Money is the most liquid form of capital. Capital in the form
of money can be put to any use. Money is highly important from this
point of view. It is essential to keep capital in a liquid form for a variety of
motives, as mentioned below, according to J. M. Keynes.
(a) Income Motive.
(b) Transaction Motive.
(c) Precautionary Motive .
(d) Speculative Motive.

Q. 3 MONEY AND NEAR – MONEY (Short Note)

In a modern economy, money is a complex phenomenon. Money as a
means of payment, in a broad logical sense, should cover all financial media that
are used in the exchange transactions of the modern economic system.
The modern concept of money, thus, confines itself to currencies (legal tender)
and demand deposit of commercial banks (the money viewed in traditional sense),

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as well as to a multitude of securities or financial assents such as bonds,

government securities, debentures, time deposits with banks, equity shares, etc.,
which serve as a store of value. As such, Professor Hick’s view is that, money and
securities are close substitutes. To him, money may be defined as “nothing else
but the most perfect type of security.” A majority of economists, however, draw a
distinction between money and near-money by treating cash and chequeable
demand deposit with banks as a pure form of money, and financial assets as only –
money.

Types of Near - Money

A modern community holds various kinds of financial assets to store value.
Money, however, is the most liquid of all assets. Other financial assets do not command
cent per cent liquidity which money does. They are referred to as quasi – money
instrument or near-money. Instruments of near-money are, in fact, claims, excluding
demand deposits, against banks and other financial instruments, intermediaries, and the
Central Government. The following items are generally considered as near-money :
 Time deposit and saving deposit with commercial banks and other banks ;
 Bill of exchange ;
 Bankers’ acceptances ;
 Redeemable and marketable government securities
 Cash – surrender values of life insurance policies
 Treasury Bills
 Saving bonds and certificates
 Repurchasable shares in saving and loan associations
 Deposit of building societies
 Traveller’s cheques
 Postal Saving deposit
 Saving in Unit of Unit Trust
 Share of investment trusts
 Share of joint-stock companies
 Negotiable credit instruments

Distinction between Money and Near - Money

Distinction between money and near-money may be explained as follows :
(1)Money, for all practical purposes, refers to coins, currency notes and demand deposit
of banks in a modern economy.
Near-money, on the other hand, refer to the financial
assents like time deposits, bills of exchange, government bonds, shares, etc.
(2)Money, in a conventional sense, bears 100 per cent liquidity. Pure Money, i.e. cash, is
a readily and immediately acceptable means of payment.
Near-money lacks such 100 per cent liquidity characteristics.
(3)Holding of pure money is regarded as cash balances which earns no interest. Thus,
money is not an income- earning asset.
Near-money is an income-earning asset.

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MONEY SUPPLY
OUE: 1 Discuss the components and methods of measuring supply of
money by R.B.I. and also discuss the factors affecting supply of
money.
THE SUPPLY OF MONEY
The Supply of Money plays an important part in the determination of the Value of
Money. The supply of money means total stock of money in the economy at particular
point of time. The total stock of money generally described as the quantity of money.
Hence, the supply of money at a ‘point of time’ means the quantity of money in
existence at that time.
In modern economy, the total quantity of money held by the public generally includes:
(a) Currency money, that is, coins and paper notes in circulation issued by
the government or the central bank.
(b) Demand deposits of the commercial banks.
(a)Currency with the Public :
In order to know the total money supply held by the public, we must deduct from the
total quantity of paper currency and coins in circulation that part which is lying as cash
on hand with the banks.
(b)DEMAND DEPOSITS OF THE COMMERCIAL BANKS:
Bank deposits are considered as money because in a modern economy they act as a
medium of exchange and are generally acceptable in the discharge of debts and
obligations. It should, however, be noted that the time deposits of commercial banks
are not money as they can be withdrawn only at the end of affixed period or by
incurring a penalty. At best they can be treated as ‘quasi money’. They are no doubt
liquid assets but they are not liquid enough to rank as money. Thus while the demand
deposits have the status of money, time deposits have the status of quasi-money or
near money.

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In short, the total money supply with the public consists of currency
money (coins and paper notes) and the demand deposits with the banks.

MEASURES OF MONEY SUPPLY IN INDIA

Reserve Bank of India has identified four measures of money stock viz. M 1 , M 2 ,

M 3 and M 4 . They can be presented according to descending order of liquidity.

(a) M1 - This includes the following items:

(i) C - Currency notes and coins with the public (excluding cash with the
banks)
(ii) DD – Demand deposits with all commercial banks and co-operative
banks (excluding inter banking deposits)
(iii)OD – Other deposits with Reserve Bank of India. By adding (i) and (ii)
items we get demand or deposit money (DM)

In this way, M 1 = C + DM.

DM = DD + OD.
M 1 = C + DD + OD.

(b) M 2 – This measures the supply of money which includes

(i) M 1 and

(ii) SD – Savings Banks deposits with post offices therefore

M 2 = M 1 + SD

(c) M 3 - Which includes the following items

(i) M 1 And

(ii) TD – It includes the time deposits of all commercial and

Co-operative banks (excluding inter banking deposits).

Therefore M 3 = M 1 + TD.

(d) M 4 - Includes the items given under

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(i) M 3 And

(ii) TDP – It includes time deposits with the post offices

(Excluding National Saving Certificates)

Therefore M 1 = M 3 + TDP.

FACTORS AFFECTING MONEY SUPPLY

The following are the main factors which affect the total money supply in the economy.
(1) Bank Credit to the Government or Governments’ Borrowing from the Banking
Sector:
In order to meet the deficit in the governments’ budget, the government
borrows from the central bank either by running down its cash balances with it
or by the creation of new money. This technique is known as deficit financing
which leads to an increase in the money supply with the public.
(2) Bank Credit to the Private Sector:
The leading operations of the commercial banks through the process of credit
creation adds to the total money supply in the economy. In a modern economy a
large part of money supply is created by the banking system through its lending
and investment activities and the variations in the stock of money are generally
caused by the fluctuations in the volume of bank credit and investment.
(3) Balance of Payment Situation:
This is also a factor which affects the total money supply in the economy. When
there is an adverse balance of payments(i.e., when the country’s total imports
are more than its exports) the government tries to meet it by drawing on its past
accumulation of foreign exchange reserves in order to make payment to the
foreign exporters. To that extent, therefore, the total money supply in the
economy diminishes. If, however, the deficit in the balance of payments is me by
external assistance, money supply will not diminish.
(4) Velocity of Circulation of Money :

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By velocity of circulation of money mean the average number of times

each unit of money circulates and is used for transactions. Now each time a coin
or a paper note or a bank cheque changes hands for buying goods, it adds to the
supply of money.
The supply of money over a period of time, therefore, is determined by
the total amount of money in circulation – both legal tender and bank money –
multiplied by its velocity of circulation. We can put it in the form of an equation
as follows. Total money supply over a period of time - = MV + M’V’ where.
(i) M denotes total quantity of legal tender money, (coins, paper
notes, etc.)
(ii) V denotes the velocity of circulation of legal tender money.
(iii) M’ represents credit money or bank money.
(iii) V’ refers to the velocity of circulation of credit money or bank
money
Thus the velocity of money also influence the total supply of money.

Changes in the relative importance of the components of the money

supply:
Money supply has increased continuously in India during the planning period. It has
increased by 50 per cent during 1950-1960, by two times during 1960-1970, by three
times during 1970-1980, by four times during 1980-1990 and by three and a half times
during 1990-2001.

Money supply 1970-71 1980-81 1990-91 2000-01 2006-07

(Rs. Crore)
1. Currency money 4371 13426 53048 209562 483470
2. Demand deposits of the banks 3002 9998 39844 170229 481730
(including other deposits of RBI)
3. Mx (1 + 2) 7373 23424 92892 379791 965200
4. Saving deposits of the post
office savings banks 990 2334 4205 5041 5040
5. M2 (3 + 4) 8363 25758 97097 384832 970240
6. Time deposits of the banks 3646 32350 172936 931792 2345080
7. M3 (3 + 6) 11019 55724 265878 1311583 3310280
8. Total deposits of the post

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office savings banks 1184 6632 14681 25969 25970

9. M4 (7 + 8) 12202 62406 280509 1337552 3336250

2. Short note : High powered money

In the context of supply of money, the concept of high powered money is prevalent.
There arc two types of money:
(i) High powered money
(ii) Low powered money.
High powered money has capacity of purchasing the supply of money. The purchasing
power of the people depends on growth rate and volume of the supply of money. From this point of
view, in the supply of money, besides the supply of currencies and bank money, its velocity and
money multiplier are considered. In the total supply of money, in a given period of time, the
number of transactions with that money is taken into account, e.g. If the RBI has issued 100 crore
rupees legal money but if during the year it is used thrice as means of transaction, the total
supply of money indicates the 100 x 3 = 300 crore purchasing power.
This is called money multiplier by modern economists. Money multiplier is as important as
the supply of money. Suppose if the government pays. D.A. to the employees in cash, the
purchasing power in economy increases. But if the amount is deposited with P.F. or in the form
fixed deposits, the growth rate of supply of money becomes less. If people get loans from P.F. or
get credit or advances against deposits for trade or industries, the supply of money increases
In short, the volume of money that creates less purchasing power is low powered
money and money that creates more purchasing power is high powered money. The country
that Wishes to attain both development and stability must consider the high powered money.
This type of money can be called Reserve money or Base money.
The components of High Powered Money : The following are the main
components of high powered money.
(1) Currency in motion
(2) Public deposits with RBI
(3) Cash Reserves of the Banks.
The banks have two forms of deposits - deposits to maintain routine
transactions of the banks. They keep some percents of deposits in cash e.g. Banks
on the basis of their experience keep 10% deposits so that they can lend Rs. 90
against the deposit of Rs. 100. In the same way. banks have to place some percents of
their deposits with the Central Bank compulsory. It is known as CRR. Suppose CRR is
5%, Rs.5 has to be kept as reserve with the Central Bank. Thus, out of the deposit of
Rs. 100 (10+5) = Rs. 15 is kept reserve and the high powered money obtains
purchasing power of Rs. 85/- If such cash reserve is increased, the capacity of the
banks to create credit reduces and thus their capacity to increase the supply of
money also reduces. On the other hand, if CRR is reduced, the capacity of the banks
to create credit increases and high powered money supply increases.

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In India, the currency money is issued by the RBI. It is issued on the principle
of minimum reserve in India. Coins and notes of Rs. 2 and above are issued by the
RBI. In RBI. public deposits have been quite low.

The importance of High Powered Money: In modern economy, high

powered money is very important.
 To understand the changes in economy and to regulate them and to
frame financial policy, it is necessary to know high powered money.
 To control undesirable changes like inflation, depression (recession)
etc. and to attain development with stability, the financial institutions
of the country must keep watch over the supply of such high powered
money and regulate it.
 In economy, it is necessary to frame financial policy (monetary policy) to
regulate the supply of high powered money according to the demand
of money to attain economic development with stability.

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Q-3 Explain Fisher’s Quantity Theory of Money

Introduction:

Classical economists have tried to explain with the help of Quantity theory of money,
the determination of general level of prices and the factors causing changes in the value of
money. Here we shall confine to the explanation given by Fisher.

Quantity Theory of Money:

If the argument of the Quantity theory is put in its simplest form, it states with the
increase in the Quantity of money, the price level increases proportionately and so the
purchasing power of money or value of money diminishes. Similarly, if the Quantity of money is
decreased, the price level also decreases proportionately and value of money increases.

In 1911, Prof. Irving Fisher in his book ‘The Purchasing Power of Money’ presented this
theory very systematically and scientifically in the form of equation. The discussion here is with
reference to Fisher’s equation.

According to Fisher, “if other things being equal, there is direct and proportionate
relationship between Quantity of money and price level, whereas, there is inverse and
proportionate relationship between Quantity of money and value of money”.
This implies that, if there is 10% increase in Quantity of money, there will be 10% rise in
the price level and the value of money reduces to have; and if Quantity of money is reduced to
10%, the price level also reduced to 10% and the value of money doubles.
The direct and proportionate relationship between Quantity of money and price level is
presented in the following diagram.

Y This theory can be started briefly

in the following two points:
(1) The changes in the general
price level is only due to changes in
(Price Level)

the quantity of money. The factors

do not change and therefore do
not influence price level.
P1
(2) Changes in the price level is
P proportional to Quantity of money.

O
x

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M M1

Explanation of the theory with the help of equation of exchange:

If in the monetary economy, all the commodities are purchased only by money and money is
used only in purchase of goods than the payment by the people will be equal to the monetary
value of goods and services. In other words.

Monetary payments = Monetary value of goods and services – (1)

 Quantity of money X Velocity of money = Transactior of goods X

Average price level (2)

 Average price level = QUNTITIY OF MONEY x VELOCITY

TRANSACTION OF GOODS

This can also be stated with the help of following abbreviations.

MV = Pt where;
M= Quantity of legal money with the people during the year.
V= Velocity of legal money (velocity of money implies the average exchange of money during a
year).
T= Transaction of goods during the year.
P= Genera price level
Prof. Fisher was aware of bank money and so he modified the equation as follows:
Mv + M1V1 = PT

 P = MV+M’V’
T
Where
M’ = Quantity of Bank money
V1 = Velocity of bank money

With the help of this equation of exchange, Fisher tried to prove that the monetary
transaction of goods is equal to Quantity of money.

Let- us understand this by the following example.

Suppose, the Quantity of legal money (M) is Rs.1000/-, Quantity of bank of money is
Rs.5000/- velocity of legal money is 5, velocity of bank money is 2, transaction of goods is
30000,
 P = MV+M’V’
T
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10000 X 5 + 5000 X 2 60000

= =2
= 30000 30000
 P=2

Assumptions of the Theory : The relationship between Quantity of money and price
level is dependent on following assumptions.
(1) Fisher assumes that in the short-run, V and V1 remain constant, because the
factors which affect Velocity of money do not change, for example

 Peoples habit of consumption and payment.

 The regularity between the receipt of income and expenditure.
 Payment system
 Banking habit
 Transportation communication facilities.

(2) Like V and V1, T (volume of transaction) also remain constant in the short-run. This is
because, methods of production, Supply of factors of production, transportation, monetary and
banking system, etc. do not change in short-run.
(3) Proportion of M and M1 remain constant. Fisher States that with given industrial and
technological development the proportion between legal money and bank money remain
constant.
(4) Money is used only for purchase of goods and Services, meaning thereby that people
spent all the money they have. That is to say money is not saved.
(5) There is full employment in the economy. In this situation, the increase in money will
proportionately increase price level.
(6) International trade does not take place between the countries.

Limitations of the Theory:

 Mathematical Inconsistency in the Equation:.

 The Relationship between Quantity of money and Price Level is not simple
 Neglect of Mutual Independence of the variables:
 Due to Neglect of other Functions of Money,
 Equation Does not Give Explanation for Relative Price Level:
 Neglect of Non-monetary Factors:
 Price Increase will Also Affect Quantity of Money:
 Unrealistic Assumption of Full Employment:
 Theory is not helpful in formulation of economic policy:
 Elasticity of demand for money is not unity:

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Q.2 Explain Cash Balance Theory of Quantity Theory of Money

OR
Explain Cambridge Equation of Quantity Theory of Money.

Introduction:
Money does two important things in the modern economy. (1) as medium of exchange
and (2) as store of value. Economists have used the different approaches for explaining the
value of money. Fisher emphasized only exchange value, whereas Cambridge economists
emphasized store value function for explaining the value of money.
Value of Money Based on the Demand for and Supply Money;
For explaining the Quantity theory, Economists like Pigou, Robert son believed that like the
prices of commodities, value of money depends on the demand for and supply of money. After
the value of money is once determined, change in it are the result of demand and supply of
money. If the Quantity of money is held constant, the increase in the demand for money
increases its value, in other words, the price level decline
There is inverse relationship between value of money and price level and the decrease
in the demand for money would lead to fall in the value of money, that is price level increases).

Nature of Demand for Money:

People do not spend their entire income. To west certain requirements and for
other reason, people keep certain amount of income in liquid form. Money by itself does not
have any utility value, but because of its liquidity, goods and services can be purchased by the
liquid money. Thus, the amount of real income which the people desires to keep on hand is
called the demand for cash balances or liquidity. The demand for Cash balances mainly
governed by three factors, namely
(1) Transactive motive
(2) Precautionary motive and
(3) Speculative motive.
The cash balance theory neglects speculative demand for money.
Explaination Of The Theory by Equation:
In this theory, demand for money is presented as a part of real income. Each individual
prefers to hold a part of his real income in form of cash balances.
The relationship between the demand for and supply of money has been represented by
Pigou in the form of following equation.
M
P = KR
where,
P = value of money or prices level
K = Portion of real income which people desires in the form of cash
balances
R = Real income
M = Quantity of money

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Let us understand the equation with an illustration.

Suppose real income in the form what is 5000 Quintal of wheat, Quantity of money is
1 1
worth Rs.25000, if people hold 3 of their real income ( 5 of 5000 means 1000 quintal
wheat) in the form of cash balances. To find out the price level, let us put all the values in the
equation.

M 25000
P = KR = 1 /5 X 5000 = 25 Rs.

Cash balance theory thus takes into account the effect on prices of changes in the
demand for money along with the supply of money. If the Quantity of money remains constant,
the increase in the demand for money leads to a fall in the price level, the value of money goes
up. On the contrary, the fall in demand for money increases the price level and leads to fall in
the value of money. This is because, when the demand for money increases, it implies that the
people desires to hold larger portion of their real income in the form of cash balances and have
low inclination for holding commodities. As a result of this, the supply of commodities increases
in relation to their demand and so the price level declines. In the reverse situation, the fall in
the demand for money will increase the price level.
Later on, bank money was also included in the equation. This is because, the people do
not keep all the money in the liquid form, but keep some portion of this in the form of bank
deposits. Banks also keep some portion of their deposits in cash reserve, and the rest the keep
for lending.
The revised form of the equation after inclusion of bank money is stated as follows.
M
P = KR [c + h (1-c)] where,

P, M, K, R are same as in the earlier equation.

c= Proportion of cash balances which people desire to hold in the form of liquid
money.
1 – c = the proportion of cash balances kept in the bank in the form of deposits.
h = Cash reserve which banks have to maintain on their deposits.
Pigou assumes K, R, c and h as constant, as a result of which proportionate
relationship between M and P can be established.

Criticism of Cash Balance Equation:

 Very narrow concept of value of money:

 The demand for cash balances does not depend only on income:.
 Some unrealistic assumptions:.
 Does not give full explanation for relationship between demand for money and value of
money:.

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 Unrealistic assumption of full employment:

Thus, there are limitations of this equation. However, from analytical point of view
Pigou’s equation is superior to Fisher’s equation.

Q.3 Compare Fisher and Cambridge equations.

OR
“Cash balance theory is definitely superior to Quantity theory, but it also does not
explain fully and relationship between quantity of money and prices.” Explain.

Introduction:
According to American School, represented by Fisher’s Quantity theory, the value of
money is determined by the Quantity of money, whereas in Cambridge School, represented by
Pigou’s cash balance theory, the demand for money is very important in determining the value
of money. However, in these two ideologies, the explanation for value of money is approached
differently and therefore, it is necessary to understand the similarities and differences between
these two theories.

Points of Similarities:
(1) Value of money is related to the Quantity of money: In these two equations,
crude form of Quantity theory is valid, that is the value of money is determined by the Quantity
of money.
(2) No difference between P and M in two equations: In both the equations, P presents
price level and M presents Quantity of money.
(3) V in Fisher’s equation and K in Cambridge’s equation are mutually related: V in
Fisher’s equation shows velocity of money, whereas K in Cambridge’s equation shows
proportion of real income which people desire to hold in the form of cash balances. In other
words, it shows the demand for money. If the demand for money increases, that is the demand
for commodities decreases and so velocity of money also decreases. Thus, the demand for cash
balances and velocity of money are inversely related.
1
v= k
(4) Similarity between T and R in two equations: Transactions, T in Fisher’s equation and
real R in Pigou’s equation are fundamentally equal. Volume of transactions in Fisher’s equation
is in one way indicates real income, because volume of transaction in the economy-exchange of
goods is dependent on production of goods i.e. real income. Thus, T and R are identified.
Because of similarities between the two equations, one equation can be transformed
from the other.
M
P = KR

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M
1 1
T
 P= v ( ∵ K = v and R = T)
Mv
 P= T
 PT = Mv
Thus, Pigou’s equation can be transformed into Fisher’s equation as above.

Points of dissimilarities between two equations :

(1) The important difference between the two equation is that in Fisher’s equation
money is considered as a flow whereas in cash balance equation it is taken as a stock. Fisher
explains the value of money in the context of average quantity of money during the year,
whereas, cash balance equation explains the value of money in the context of stock of money
at a point of time. In Robertson’s who Fisher talks of money on the wings, whereas Cambridge
equation talks of money on the sitting.
(2) In Fisher’s equation demand for money arises only for transaction purposes and
in Cambridge equation it is shown for the purposes of storage.
(3) In Fisher’s equation P shows general price level, whereas in Pigou’s equation P
indicates prices of only consumer goods.
(4) In Fisher’s equation value of money is explained in terms of Quantity of money,
whereas in Cambridge equation value of money is considered in terms of demand for money
and Quantity of money.
(5) There is also difference between V and K. In Fisher’s equation V shows velocity of
money in terms of transaction of goods and services, whereas in Cambridge equation K shows
income velocity of money. Velocity of money considers only institutional factors, whereas K
depends on the habits and behaviour of the people.

Superiority of Pigou’s Equation Over Fisher’s Equation :

(1) Pigou’s equation is more real: Fisher’s equation shows proportionate

relationship between Quantity of money and price level, but it does not explain how value of
money is influenced with the change in desire of the people to hold their wealth in form of
money; cash balance theory takes into account human motives as an important factor
influencing the value of money.
(2) Cambridge equation explains the effect of changes in the demand for money on
output, income and employment: Fisher’s theory considers the effect of changes in the
Quantity of money on price level, whereas Cambridge equation takes into account the effect of
changes in the Quantity of money and demand for money on output, employment and income
along with effect on price level.
(3) Cambridge equation is simple compared to Fisher’s equation: In Fisher’s equation, in
order to know the value of money we are required to know the number of transactions, which

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is impossible. Inversely, in Cambridge equation, we are required to know only cash balances of
the people to explain the value of money.
In the context of the above discussion, we can say that Cambridge equation is a definite
improvement over Fisher’s equation at least from analytical point of view, if not form
theoretical point of view.

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