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Cambridge Classics

CAMBRIDGE APPROACH TO MONEY DEMAND

While Fisher was developing his quantity theory approach to the demand for money, a group of classical economists in Cambridge, England, which included Alfred Marshall and A. C. Pigou, were studying the same topic. Although their analysis led them to an equation identical to Fisher’s money demand equation (Md = k x PY), their approach differed significantly. Instead of studying the demand for money by looking solely at the level of transactions and the institutions that affect the way people conduct transactions as the Breitling Replica key determinants, the Cambridge economists asked how much money individuals would want to hold, given a set of circumstances. In the Cambridge model, then, individuals are allowed some flexibility in their decision to hold money and are not completely bound by institutional constraints such as whether they can use credit cards to make purchases. Accordingly, the Cambridge approach did not rule out the effects of interest rates on the demand for money.

 

The classical Cambridge economists recognized that two properties of money motivate people to want to hold it: its utility as a medium of exchange and as a store of wealth.

Because it is a medium of exchange, people can use money to carry out transactions. The Cambridge economists agreed with Fisher that the demand for money would be related to (but not determined solely by) the level of transactions and that there would be a transactions component of money demand proportional to nominal income.

 

That money also functions as a store of wealth led the Cambridge economists to suggest that the level of people’s wealth also affects the demand for money. As wealth grows, an individual needs to store it by holding a larger quantity of assets — one of which is money. Because the Cambridge economists believed that wealth in nominal terms is proportional to nominal income, they also believed that the wealth component of money demand is proportional to nominal income.

 

The Cambridge economists concluded that the demand for money would be proportional to nominal income and expressed the demand for money function as where k is the constant of proportionality. Because this equation looks just like Fisher’s (Equation 3), it would seem that the Cambridge group agreed with Fisher that interest rates play no role in the demand for money in the short run. However, that is not the case.

 

Although the Cambridge economists often treated k as a constant and agreed with Fisher that nominal income is determined by the quantity of money, their approach allowed Omega Replica individuals to choose how much money they wished to hold. It allowed for the possibility that k could fluctuate in the short run because the decisions about using money to store wealth would depend on the yields and expected returns on other assets that also function as stores of wealth. If these characteristics of other assets changed, k might change too. Although this seems a minor distinction between the Fisher and Cambridge approaches, you will see that when John Maynard Keynes (a later Cambridge economist) extended the Cambridge approach, he arrived at a very different view from the quantity theorists on the importance of interest rates to the demand for money.

 

To summarize, both Irving Fisher and the Cambridge economists developed a classical approach to the demand for money in which the demand for money is proportional to income. However, the two approaches differ in that Fisher’s emphasized technological factors and ruled out any possible effect of interest rates on the demand for money in the short run, whereas the Cambridge approach emphasized individual choice and did not rule out the effects of interest rates.

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