This theory of money demand was postulated by Cambridge economists.
Cambridge economists argued that a certain portion of money supply (Ms) where the equilibrium condition Money supply (Ms) = Money demand (Md) hence the portion of money supply will not be used for transactions but instead be held for convenience and security of having cash on hand
This portion of cash is usually represented as the K portion of nominal income
Cambridge economists also thought that wealth will play a significant role but wealth is omitted from the equation for simplicity purposes
Cambridge’s cash balances approach differs from Fisher’s transactions approach in that it places emphasis on the store of value function of money instead of the latter’s emphasis on the medium of exchange
Cambridge’s cash balances approach focused its analysis on the factor that determines individual demand for holding cash
Although they recognized that the current rate of interest, the wealth owned by individuals, the expectation of future prices and the future rate of interest determine money demand money, they believed that these factors remain constant and they are proportional to changes in individual income. They thus put forward a view that individuals’ demand for cash balance is proportional to their nominal income.
This can be expressed as Md= kPy
Where:
y: Real national income
P: Average price level of currently produced goods and services
Py: Nominal national income
k: Proportion of nominal income that people want to hold as cash balances.
Md: money demand
Assuming the economy is at equilibrium the Md = m
Whereby m= quantity of money in circulation
In this case, y is taken to be exogenous
K is fixed in the short run
m=KPy p=1/k x(m/y)
if m doubles the price doubles
1/k in this equation = V in the equation of exchange
If K decreases V of money increases which causes an increase in price level and a fall in the value of money and vice versa
Although they recognized the role of other factors which play a part in the determination of money demand, these factors were not systematically and formally incorporated in their analysis of money demand. Accordingly, these factors determine the proportionality of the constant (K)
The Cambridge approach is richer than the Fisher’s transactions approach because the former is incomplete since it does not incorporate the influence of economic variables measured. Another important feature is that money demand is a proportional function of nominal income i.e. both price level and real income. This implies two things; income elasticity of demand for money is unitary and the price elasticity of demand for money is unitary meaning that any change in price causes an equal proportionate increase in money demand.
Example
Suppose the money supply in cash and bank deposits is Ksh. 20,000, and the total annual national income is 10,000 units. The goods (income) that the community wants to hold in money (k), is one-fifth of the total. Calculate the nominal value of national income.
Md= kPy
But Md = Ms
20000=(1/5P) x10000
100000=10000P
P = ksh 10
Py = 10 x 10,000
Py = 100,000
Now suppose that P increases to Ksh. 20, how will money demand change?
Md= kPy
Md= (1/5) x 20 x 10000
Md= 40000
Money demand has doubled. This proves that price elasticity of demand for money is unitary meaning that any change in price causes an equal proportionate increase in money demand.
Weaknesses of the Cambridge Cash Balance Approach
It is argued that other influencers such as the rate of interest, wealth, expectations regarding future interest rate and price were not formally introduced in this theory though they remained in the background of the theory.
Income elasticity of demand for money may be far from unitary. No theoretical reason was provided for equating it with unity and there is no empirical evidence supporting unitary elasticity. Changes in price may well be non-proportional to changes in money demand
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