Model Answer
0 min readIntroduction
The Quantity Theory of Money (QTM) posits an inverse relationship between the quantity of money and the price level. It attempts to explain the determinants of inflation and the role of money in the economy. Two foundational approaches to QTM are Irving Fisher’s Transactional Theory and the Cambridge Cash Balance Approach. While both aim to explain the same phenomenon, they differ in their assumptions about the velocity of money and the motives for holding money. Understanding these differences and their respective criticisms is crucial for comprehending modern monetary economics.
Fisher’s Theory of Quantity Theory of Money
Irving Fisher’s theory, developed in his book ‘The Purchasing Power of Money’ (1911), is based on the ‘Equation of Exchange’: M x V = P x T, where:
- M = Money Supply
- V = Velocity of Money (the average number of times a unit of money is spent in a given period)
- P = Price Level
- T = Volume of Transactions
Fisher assumed that V is stable and determined by institutional factors, and T is directly related to national income (Y). Therefore, changes in M directly affect P. He emphasized the transactional motive for holding money – people hold money to facilitate transactions.
Cambridge Cash Balance Approach
Developed by economists like Alfred Marshall, A.C. Pigou, and John Maynard Keynes (before his General Theory), the Cambridge approach modifies Fisher’s equation. It focuses on the demand for money and expresses the relationship as: M = kY, where:
- M = Money Supply
- k = The proportion of income people want to hold in the form of money (1/V)
- Y = National Income
The Cambridge approach views k as relatively stable, determined by the motives for holding money – transactional, precautionary, and speculative. Unlike Fisher, it doesn’t explicitly focus on the volume of transactions (T) but directly links money supply to income.
Comparison between Fisher’s and Cambridge Approaches
| Feature | Fisher’s Theory | Cambridge Cash Balance Approach |
|---|---|---|
| Equation of Exchange | M x V = P x T | M = kY |
| Focus | Supply-side (Money Supply) | Demand-side (Demand for Money) |
| Velocity (V) | Assumed stable and determined by institutions | Implied by ‘k’ (1/V), also assumed relatively stable |
| Transactions (T) | Explicitly considered | Implicitly linked to income (Y) |
| Motives for holding money | Primarily transactional | Transactional, precautionary, and speculative |
Criticism of Fisher’s Theory
- Instability of V: The assumption of a stable velocity of money has been repeatedly challenged, especially during periods of financial innovation and economic crises. For example, the velocity of money in the US declined significantly after the 2008 financial crisis.
- Ignoring Demand for Money: Fisher’s theory largely ignores the demand side of the money market, focusing solely on the supply side.
- Difficulty in Measuring T: Accurately measuring the volume of transactions (T) is a complex task.
Criticism of Cambridge Cash Balance Approach
- Stability of ‘k’: The assumption of a stable ‘k’ has also been questioned. Changes in financial markets, interest rates, and expectations can influence the demand for money.
- Ignoring Supply Side: The Cambridge approach focuses heavily on the demand for money, potentially underestimating the impact of monetary policy.
- Simple Motives: The categorization of motives (transactionary, precautionary, speculative) is somewhat simplistic and doesn’t fully capture the complexities of money demand.
Relevance in the Present Context
In the present context, the Cambridge Cash Balance Approach is arguably more relevant. The modern economy is characterized by financial innovation, complex financial instruments, and fluctuating expectations. These factors significantly impact the demand for money, making the assumption of a stable velocity (as in Fisher’s theory) less plausible.
Central banks today heavily rely on managing the demand for money through interest rate adjustments and other monetary policy tools. The Cambridge approach, with its focus on the motives for holding money, provides a better framework for understanding the impact of these policies. For instance, Quantitative Easing (QE) policies implemented by central banks after the 2008 crisis aimed to increase the money supply but their effectiveness depended on influencing the demand for money and expectations about future inflation.
However, it’s important to note that both theories offer valuable insights. Fisher’s emphasis on the long-run relationship between money supply and price level remains relevant, particularly in economies experiencing hyperinflation.
Conclusion
Both Fisher’s and Cambridge approaches to the Quantity Theory of Money have contributed significantly to our understanding of the relationship between money, prices, and economic activity. While Fisher’s theory provides a foundational framework, the Cambridge approach, with its emphasis on the demand for money and the motives for holding it, is more applicable in the complex financial landscape of the 21st century. Modern monetary policy operates largely by influencing the demand for money, making the Cambridge framework a more useful tool for analysis and policymaking.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.