In this article we will discuss about the superiority of cash balance approach over transactions approach of money.
1. Basis of Liquidity Preference Theory of Interest:
The cash balances approach emphasises the importance of holding cash balances rather than the supply of money which is given at a point of time. It thus led Keynes to propound his theory of liquidity preference and of the rate of interest, and to the integration of monetary theory of value and output.
2. Complete Theory:
The cash balances version of quantity theory is superior to the transactions version because the former determines the value of money in terms of the demand and supply of money. Thus it is a complete theory. But in the transactions approach, the determination of value of money is artificially divorced from the theory of value.
3. Discards the Concept of Velocity of Circulation:
The cash balances approach is superior to the transactions approach because it altogether discards the concept of the velocity of circulation of money which ‘obscures the motives and decisions of people behind it.’
4. Related to the Short Period:
Again the cash balances version is more realistic than the transactions version of the quantity theory, because it is related to the short period while the latter is related to the long period. As pointed out by Keynes, “In the long run we may all be dead.” So the study of the relationship between quantity of money and price level during the long run is unrealistic.
5. Simple Equations:
In the cash balances equations, transactions relating to final goods only are included where P refers to the level of final goods. On the other hand, in the transactions equation P includes all types of transactions. This creates difficulties in determining the true price level. Thus the former equations are simpler and realistic than the latter.
6. New Formulation in the Monetary Theory:
Further, the Cambridge equation regards the cash balances held by the people as a function of the level of income. The introduction of income (Y or R or T or O) in this equation as against V (the velocity of circulation of money) in the transaction equation has made the cash balances equation realistic and led to new formulations in monetary theory. “It points out that changes in the level of money income can come about through changes in the price level, through changes in real output or through both at once.”
7. Explains Trade Cycles:
Hansen regards k in the Cambridge equation superior to V in Fisher’s equation for understanding cyclical fluctuations. According to him, “Drastic and sudden shifts in the desire to hold money, reflected in a change in k, may produce large and quickly moving changes in the level of income and prices. Shifts in the public psychology, in expectations must be taken into account not less than changes in the money supply. In the Cambridge analysis, a shift in k may start an upward or downward movement.” For instance, when k (the fraction of total real income that people wish to hold in cash balances) increases because of low business expectation, the price level falls, and vice versa.
8. Study of Subjective Factors:
As a corollary to the above, V in Fisher’s equation is mechanistic while k in the Cambridge equation is realistic. The subjective factors behind variations in k have led to the study of such factors as expectations, uncertainty, motives for liquidity, and the rate of interest in modern monetary theory. In this sense, it can be justifiably said that, “the Cambridge equation moves us on from the tautology represented by the equation of exchange to a study of economic behaviour.”
9. Applicable under All Circumstances:
Fisher’s transactions approach holds true only under full employment. But the cash balances approach holds under all circumstances whether there is full employment or less than full employment.
10. Based on Micro Factors:
The Cambridge version is superior to the Fisherian version because it is based on micro factors like individual decisions and behaviours. On the other hand, the Fisherian version is based on macro factors like T, total velocity of circulation, etc.