Cambridge Cash Balance Theory of Demand for Money –
Cambridge cash balance theory of demand for money was given by Cambridge economists, Marshall and Pigou. It places emphasis on the function of money as a store of value instead of Fisher’s emphasis on the use of money as a medium of exchange. The exchange function of money solves the problem of double coincidence of wants faced in the barter system. While the function of money as a store of value lays stress on holding money as a general purchasing power by individuals over a period of time for the sale and purchase of goods or services and subsequent transactions in the future.
Marshall and Pigou focused their analysis on the factors that determine individual demand for holding money in form of cash.
They also recognized that current interest rate, wealth owned by individuals, expectations of future prices and future rate of interest determine the demand for money. They also believed that changes in these factors remains constant or they are proportional to changes in individual’s income.
So, they put forward a view that individual’s demand for money in form of cash balances is proportional to the nominal income.
According to their approach, aggregate demand for money
Md = kPY
Md = Demand for money
Y = Real national income
P = Aggregate price level of currently produced goods and services
PY = Nominal Income
k = Proportion of nominal income that people want to hold as cash balances
Demand for money in this theory is a linear function of nominal income. The slope of the function is equal to k, (k = Md/PY).
The important feature of this theory is that it makes the demand for money as a function of money income alone. A merit of this formulation is that it makes the relation between the demand for money and income as behavioural while in Fisher’s approach demand for money was related to transactions in a mechanical manner.
Another important feature of this approach is that the demand for money is proportional function of nominal income (Md = kPY). Which makes it proportional function of both price level (P) and real income (Y). This gives (or implies) two thing, First, income elasticity of demand for is unity and second, price elasticity of demand for money is also equal to unity so that any changes in the price level causes equal proportionate changes in the demand for money.
The factors which influences the demand for money such as rate of interest, wealth, expectations about future prices and rate of interest have not been formally introduced into this theory.
Another criticism is that the income elasticity of demand for money may well be different from unity, they did not provided any theoretical reason for it being equal to unity. Nor is there any empirical evidence supporting it.
Price elasticity of demand is also not necessarily equal to unity, changes in price may cause non proportional changes in the demand for money.