The Cambridge equation formally represents the Cambridge cash-balance theory, an alternative approach to the classical
quantity theory of money
In monetary economics, the quantity theory of money (often abbreviated QTM) is one of the directions of Western economic thought that emerged in the 16th-17th centuries. The QTM states that the general price level of goods and services is directly ...
. Both quantity theories, Cambridge and classical, attempt to express a relationship among the
amount of goods produced, the
price level
The general price level is a hypothetical measure of overall prices for some set of goods and services (the consumer basket), in an economy or monetary union during a given interval (generally one day), normalized relative to some base set ...
, amounts of money, and how money moves. The Cambridge equation focuses on money demand instead of
money supply
In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circul ...
. The theories also differ in explaining the movement of money: In the classical version, associated with
Irving Fisher, money moves at a fixed rate and serves only as a
medium of exchange
In economics, a medium of exchange is any item that is widely acceptable in exchange for goods and services. In modern economies, the most commonly used medium of exchange is currency.
The origin of "mediums of exchange" in human societies is ass ...
while in the Cambridge approach money acts as a
store of value
A store of value is any commodity or asset that would normally retain purchasing power into the future and is the function of the asset that can be saved, retrieved and exchanged at a later time, and be predictably useful when retrieved.
The mos ...
and its movement depends on the desirability of holding cash.
Economists associated with
Cambridge University
The University of Cambridge is a Public university, public collegiate university, collegiate research university in Cambridge, England. Founded in 1209 and granted a royal charter by Henry III of England, Henry III in 1231, Cambridge is the world' ...
, including
Alfred Marshall,
A.C. Pigou, and
John Maynard Keynes
John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...
(before he developed his own, eponymous school of thought) contributed to a quantity theory of money that paid more attention to money demand than the supply-oriented classical version. The Cambridge economists argued that a certain portion of the money supply will not be used for transactions; instead, it will be held for the convenience and security of having cash on hand. This portion of cash is commonly represented as ''k'', a portion of nominal income (the product of the price level and real income),
). The Cambridge economists also thought wealth would play a role, but wealth is often omitted from the equation for simplicity. The Cambridge equation is thus:
:
Assuming that the economy is at equilibrium (
),
is exogenous, and ''k'' is fixed in the short run, the Cambridge equation is equivalent to the
equation of exchange with
velocity
Velocity is the directional speed of an object in motion as an indication of its rate of change in position as observed from a particular frame of reference and as measured by a particular standard of time (e.g. northbound). Velocity i ...
equal to the inverse of ''k'':
:
Monge (2021) showed that the Cambridge equation comes from a
Cobb-Douglas utility function, which demonstrates that, in classical quantity theory, money has diminishing marginal utility (then, inflation is a monetary phenomenon).
History and significance
The Cambridge equation first appeared in print in 1917 in Pigou's "Value of Money". Keynes contributed to the theory with his 1923 ''
A Tract on Monetary Reform
''A Tract on Monetary Reform'' is a book by John Maynard Keynes
John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics ...
''.
The Cambridge version of the quantity theory led to both Keynes's attack on the quantity theory and the Monetarist revival of the theory. Marshall recognized that ''k'' would be determined in part by an individual's desire to hold liquid cash. In his ''
General Theory of Employment, Interest and Money
''The General Theory of Employment, Interest and Money'' is a book by English economist John Maynard Keynes published in February 1936. It caused a profound shift in economic thought, giving macroeconomics a central place in economic theory and ...
'', Keynes expanded on this concept to develop the idea of
liquidity preference
__NOTOC__
In macroeconomic theory, liquidity preference is the demand for money, considered as liquidity. The concept was first developed by John Maynard Keynes in his book '' The General Theory of Employment, Interest and Money'' (1936) to e ...
,
[Skidelsky, Robert. ''John Maynard Keynes: 1883–1946''. Penguin: 2003. p. 131.] a central Keynesian concept.
References
{{reflist
External links
Cambridge Cash-Balance Approach – History of Economic Thought
Monetary economics