Quantity Theory of Money

Fisher's Quantity Theory of money represents what is called the Cash Transaction theory of money. A second variety of the Quantity Theory has been evolved by the Cambridge economists like Marshall, Pigou, Keynes and Robertson. This theory is known as the Cash Balance approach.

The essence of the cash balance approach has been clearly stated by Marshall thus, in every state of society there is some fraction of income which the people find it worthwhile to deep in the form of currency. A large command of resources in the form of currency renders their business easy and smooth and puts them at an advantage in bargaining; but on the other hand it locks up in a barren form resource that might yield an income if invested. Every man finds the appropriate fraction after balancing one against another; the advantage of a further ready command and the disadvantages of putting more of his resources into a form in which they yield him no income or other benefit.

Let us suppose that inhabitants of a country find it just worth their while to keep with them, on the average, ready purchasing power to the extent of a tenth part of their annual income together with a fifteenth part of their property; then the aggregate value of the currency of the country will tend to be equal to the sum of these amounts.

Expressed algebraically, the demand for money, according to Marshall, would be
M = KY + K'A
where M is the demand for money, K is the fraction of income Y which people would like to hold as cash and K’ is the fraction of their assets A which they like to keep in cash.

The later Cambridge economists ignored the assets component (K'A)of Marshall's theory and expressed and demand for money as only a function of their income. The demand for money equation, thus became
M = KY

Now, Since total annual money income Y is equal to the value of annual output, i.e., O multiplied by the price level P, we can express the equation as
M = KPO
or P = M/KO

In other words, the price level P, depends upon the quantity of money M divided by the proportion K of the output O which people want to hold as cash. With the proportion of output KO which People want to hold in cash remaining constant, any increase in the quantity of money M would push up the price while any decrease in M would push down the price level P.