Lesson-16

Cambridge Approach to Demand for Money

Objectives:

After studying this lesson, you will be able to understood,

 The definition of demand for money

 Neo-Classical approach to demand for money
 The difference between quantitative approach and demand for money approach

16.1 Introduction

16.2 Cambridge approach to demand for money

a) Marshall’s Equation
b) Pigou’s Equation
c) Robertson’s Equation
16.3 Summary

16.4 Glossary

16.5 Model Questions

16.6 Further Readings

16.1 Introduction

Demand for money means desire to hold money in the form of currency rather than to invest to
meet their motives in their day to day activities. To identify the determinants/motives of demand
for money, many a number of economists have propounded different theories of demand for
money. Among them, first one is classical school of economists stated that demand for money
from the public is only to meet day to transactions. As we studied in our earlier lesson, classical
assigned medium of exchange character to money, so that as long as there is no store of value
character to money people will spent whatever the money is with them. Thus, in an economy
always there will be equilibrium in the money market. It can be explained by saying that
Demand for money is equal to supply money. Similarly, there are other schools of economic
thought also developed another theory is known as Neo-Classical theory of demand for money or
Cash balances approach to money or Cambridge approach to money. Let us now study about the
motives behind the demand for money according to Cambridge approach.

16.2 The Cambridge Quantity theory:

Cambridge cash balance theory of demand for money was put forward by Cambridge economists
they are:

 Marshall,
 Pigou, and,
 Robertson.

It places emphasis on the function of money as a store of value or wealth instead of Fisher’s
emphasis on the use of money as a medium of exchange. Marshall, Pigou and Robertson focused
their analysis on the factors that determine individual demand for holding cash balances.
Although, they recognized that current interest rate, wealth owned by the individuals,
expectations of future prices and future rate of interest determine the demand for money, they
however believed that changes in these factors remain constant or they are proportional to
changes in individual’s income. Thus, they put forward a view that individual’s demand for cash
balances is proportional to the nominal income. Thus, according to their approach, aggregate
demand for money can be expressed as

Md = kPY ------------(1)

Where,
Y=real national income;
P = average price level of currently produced goods and services;
PY = nominal income;
k = proportion of nominal income (PY) that people want to hold as cash balances
Demand for money in this equation is a linear function of nominal income. The slope of the
function is equal to k, that is, k = Md/Py, thus important feature of cash balance approach is that
it makes the demand for money as function of money income alone. A merit of this formulation
is that it makes the relation between demand for money and income as behavioral in sharp
contrast to Fisher’s approach in which demand for money was related to total transactions in a
mechanized manner.

We can observe the Cambridge approach even by the equations of individual economists.

a) Marshall’s formula is as follows:

M = KY ----------------(2)

Where,

M is the quantity of money,

Y is the total money income and,
K is the co-efficient whole function is to bring the two sides into balance.

b) Pigou expresses the form of an equation as:

P= KR M
------ Or ------ ----------------(3)
M KR
Where P stands for the value of money or its inverse the price level (M/KR), M represents the
supply of money, R the total national income and K represents that fraction of R for which
people wish to keep cash.

Pigou presents the equation in an extended form by dividing cash into two parts: cash with the
public and, deposits which the people consider as cash, therefore:
P = KR/M{C+h (1-c)} -----------------(4)

Where, C denotes cash with the public (1-c) stands for bank deposits and H denotes the
percentage of cash reserve against bank deposits. If we assume the total amount of money in the
community as 1, the public as cash holds the public holds part of it and balance as deposits in
banks. Banks do not keep the entire deposits as cash only a portion or a part of it is kept as cash
and is denoted by ‘h’. Therefore, C+h (1-c) shows the amount of money in the economy at any
time denoting the proportion of cash and h(1-c) denoting it proportion of bank deposits.

Prof D H Robertson’s equation is similar to that of Prof Pigou’s with a little difference.
c) Roberson’s equation is:

M = PKT or P = M/KT -----------------(1)

Where P is the price level, T is the total amount of goods and services K represents the fraction
of T for which people wish to keep cash. Robertson’s equation is considered better than that of
Pigou’s as it is more comparable with that of Fisher. It is the best of all the Cambridge equations,
as it is the easiest.

Glay writes,’ Cambridge approach is conceptually richer than the transactions approach, the
former is incomplete because it does not formally incorporate the influence of economic
variables must mentioned on the demand for cash balances, Keynes attempted to eliminate this
shortcoming.

Another important feature of Cambridge demand for money function is that the demand for
money is proportional function of nominal income. Thus, it is proportional function of both price
level and real income. This implies tow things, first income elasticity of demand for money is
unity and secondly price elasticity of demand for money is also equal to unity so that any change
in the price level causes equal proportionate changes in the demand for money.
 16.3 Summary

Cambridge approach to demand for money model is developed based on the store of value
character of money. Fisher’s approach to demand for money model wherein they assigned
medium of exchange character to money, so that always there will be equilibrium in the money
market or equilibrium between demand for money and supply of money. But in this model, when
there is a scope to save out of total income, people would like to save the part of their incomes
and part of it will be spent to meet their day to day transactions. So that, according to neo-
Classism, demand for money is the function of Income only but for two motives. One is for
transactions motive and another one is for precautionary motive. But cash transactions approach
or Classical approach’s demand for money is the function of income only but motive is only to
meet day to day transactions only.

16.4 Glossary
Demand for money
Supply of money
Transactions motive
Pre-cautionary motive
Real Income
Aggregate Income
Cash Balances
Cambridge Equation
Stock of Money
16.5 Model Questions
Short answer Questions

1. What is Cash Balances approach

2. Distinguish between Transactions and Precautionary motives
3. Define the Demand for Money
Essay answer Questions

1. Critically examine the Cambridge approach to demand for money

2. Compare and contrast Cambridge approach with Classical approach

16.6 Further Readings:

Ackley Gardner: Macro economic theory

Ward R A: Monetary theory and policy
Rana & Verma: Macro economic analysis
Hajela TN: Monetary economics
Ghatak: Monetary economics in developing economies