Page 113 - DECO402_Macro Economics

Macroeconomic Theory

Notes 9. It ignores the effect of rate of interest: This theory ignores the effect of rate of interest on
prices. As per Lord Kez, Hawtrey and Prof. Hayek the assumption of this theory that there
is a direct relation between quantity of money and price level, is wrong. Actually, changes
happening in quantity of money influence the rate of interest and changes happening in rate
of interest create changes in price level. Hence there is an indirect and not a direct relation
between quantity of money and price level:

Change in Changes Changes in Changes in Change Change
quantity of  in Rate of  quantity of  income and  in cost of  in Price
money interest Investment employment production

As per Mrs Joan Robinson, “Changes in the quantity of money are of great significance. Their
importance lies in their effect on the rate of interest. But a theory of money that makes no mention of
rate of interest is not worthy of being called money theory.”
10. Difficult to measure velocity in Fisher’s equation: It is very difficult to measure the velocity
of money. It is not possible to count that in a specific period, how many hands does a unit
of money goes into. Apart from this, to know the total quantity of money it is important to
know the money collected in personal treasuries. In countries like India, Black money is also
found in circulation. It is difficult to measure the net quantity and velocity of such money.
other than this, in short term, velocity may be presumed to be constant but in long term,
velocity definitely changes.
11. It ignores the effect of non-monetary factors: This theory ignores the effect of non monetary
factors on price level. Not only does the quantity of money affect the price level but many
non monetary factors such as political and psychological factors also have an influence. These
factors are not studied in this theory.
Full Employment–a precondition of the classical assertion of one to-one relation between
supply of money and price level.
Classical economists had the opinion that full employment is a natural incident in a free market
economy. This assertion is actually a precondition of their belief that price level changes in the same
proportion in which quantity of money changes. Once this pre-condition is fulfilled, proportionate
relation between quantity of money and price level becomes a reality that may not be challenged.
But the question arises that whether full employment is a self happening event in a free economy?
The great depression of the decade of 1930, as a historical proof, does not support this opinion.

Cash Balance or Cambridge Equation

Many economists like Marshall, Pigou, Robertson (initially kenes also) of Cambridge university have
demonstrated cash balance equation of quantity theory of money. It is also known as Cambridge
equation. As per cash balance equation value of money is determined by its demand and supply. At
a definite point of time, supply of money remains constant, hence changes in demand of money have
more effect on value of money (or price level). Hence this theory give more importance to demand
for money instead of supply of money. That is why this theory is also known as Demand theory of
money. For completely understanding this equation, it is important to study concepts relating to
demand and supply of money.
1. Supply of Money: As per cash balance equation, Supply of money at a particular point of time
is the sum total of all the notes and coins with the public and the demand deposits. Hence,

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