Question

Define the Cambridge money demand function and Fisher’s income version of the equation of exchange. In classical thinking, what crucial assumption leads to the conclusion that the money stock determines the price level?

Answer 1

The Cambridge money demand function us given by the formula:

M(d) = k.PY

where M(d) = money demand, k= proportion of nominal income (PY) people wish to hold as cash, = average price level, Y= real national income, thus, PY= nominal income.

The Cambridge money demand function explains that individual's demand for cash balances is lroportional to the nominal income.

The Fisher's income version is given by:

MV= PT

where M= quantity of money in curculation, V= transaction velocity, P= average price and T= total number of tramsactions.

The Fisher equation is an identity, and states that in any given period, the value of all goods and services must be equal to the number of tramsactions multiplied by the average price (PT).

The classical assumption that the velocity of money (V) and the volume of transactions (T) are constant in the short run leads to the conclusion that money stock determines the price level.