Page 117 - DECO402_Macro Economics

Macroeconomic Theory

Notes Criticism
In the words of A.C.L. Dey, “Although the Cambridge version of the Quantity Theory represented
a big advance on the Fisher version, it is not in itself an adequate monetary theory. Its weakness
is that it is too simple to deal adequately with the complexities of economic system."
Main criticisms of Cambridge equation are as follows:
1. Unrealistic assumptions: In this theory, some factors like k and T are considered to be
constant. But in actual life, neither k, T nor R or O remain constant, they keep changing.
2. Ignores speculative demand for money: This theory does not completely explain the demand
for money. According to it demand for money is done only for transactions and precautionary
purposes. In this theory, demand for money for speculative purposes has been ignored.
3. Circular reasoning: In cash balance theory, fault of circular reasoning is found. As per this
theory, at one side price level (P) or value of money is determined by cash balance (k) but
at the other side, price level or value of money, determines cash balance (k). Hence in this
theory, fault of circular reasoning is found, till where, value of money determines cash balance
and cash balance determines value of money. It has been unsuccessful in establishing causal
relationship.
4. Incomplete theory: Cash balance theory is an incomplete theory. This theory, in determining
the cash treasuries (k), gives importance to just one factor , i.e. income (R). But in reality, cash
treasury depends on many other factors such as price level, monetary habits, professional
structure etc. in this theory, these factors are ignored.
5. It ignores the effect of rate of interest: The assumption of cash balance theory that a direct
relation is found between quantity of money and price level, is wrong. In reality, on changes
happening in quantity of money, first rate of interest changes. Because of change in rate of
interest, quantity of investment changes. Because of change in quantity of investment, cost of
production changes and because of change in cost of production, changes happen in prices.
But in this theory, there is no mention of this reasonable process of change.
6. Ignores the influence of real factor: according to this theory, cause of change in value of
money is change happening in demand for money. But many other real factors such as
savings, investment, income etc also have an influence on value of money. This theory
ignores these real factors.
7. Lack of Integration of Theory of Value and Theory of Money: As per Don Patinkin, in cash
balance equation, lack of integration is found in theory of value or level prices and theory of
money or general price level. This theory has made the theory of value completely discreet
from theory of money. In reality, mutual dependence is found among both the theories. This
mutual dependence is determined by real balance effect. By real balance effect, it is meant
that due to change in price level, change takes place in the real income of the people. It has
an effect on demand and supply of goods. Thereby, it also affects the level prices. Hence
theory of value and theory of money may be integrated through real balance. But the above
mentioned theory ignores this integration.

Self-Assessment
State whether the following statements are True or False:
7. By quantity of money, it is meant, the gross quantity of money.
8. Money is demanded because it works as a medium of exchange.

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