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# Cash balance approach of quantity theory of money

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# Cash balance approach of quantity theory of money

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### Cash balance approach of quantity theory of money

1. 1. hbj Cash Balance Approach of Quantity Theory of Money
2. 2. Introduction: • The Cambridge cash balance approach is a version of quantity theory of money. • It is popular in Europe especially in England. Quantity theory of money: • Developed in 19th and 20th centuries. Cambridge Cash balance approach: • It is explained and developed by four Cambridge economists.
3. 3. Cambridge Equation of Cash Balance Approach: • Equation of Marshall : M=kPY • Equation of Pigou: P=kR/M • Equation of Robertson: P=M/kT • Equation of Keynes: n=pk
4. 4. Fisher’s transactions approach: This approach emerged in fishers book the purchasing power of money 𝑀𝑉𝑡 =PT Pigou’s illustration of the quantity theory: A.C Pigou formally introduce for the first time (collared,2002,p,xxv), the Cambridge equation for the demand for real cash balance.
5. 5. Continued… The simplified fisher`s equation Mv = 𝑃𝑛 T----------(1) But Pigou’s notion of price does not concern the national price level. Pigou’s also present the real price of money as the dependent variable 𝑃 𝑤 = 𝑇/𝑉𝑀-----------(2)
6. 6. Continued.. But Pigou’s basic contention is that 𝑃^𝑤 depends on the demand for real balances 𝑃 𝑤= (𝐾𝑅 𝑤)/𝑀----------(3) Pigou suggested that the right hand side of equation 2 & 3 both represent the value of real balances When equation 2&3 are expressed as percentage changes and we get %∆𝑃 𝑤= -%∆M-------(4)
7. 7. Graphical Presentation of Pigou’s Theory:
8. 8. Advantages of Cambridge Equation of Cash Balance Approach: • Basis of liquidity preference • Complete theory • Discards the velocity of money • Based on macroeconomic factors • Simple equation • Applicable under all circumstances
9. 9. Keynes’s cash balance approach: • Value of money depends on supply and demand of money • Liquidity preference • Keynesian theory of demand for money • Keynes quantity theory of money
10. 10. Cash Balance Plan: • Sections of cash balance approach -Cash balance method and Cash balance plan • Functions of cash balance plan A cash balance plan provides a participant with a periodic pay credit and prescribes an interest crediting rate, usually tied to a constant maturity bond or a Consumer Price Index, that defines how the accumulation of pay credits will evolve over time
11. 11. Cash balance plan for organizations: Cash balance plans are easier than traditional defined benefit plans for employees to understand, they have been well received by many organizations. • Applicability of cash balance plan • Inapplicability of cash balance plan
12. 12. Traditional benefit in Cash balance plan: The cash balance plan is not suitable for every employer. Several considerations from the point of view of an employer and employee are- • Employee advantages • Employer advantages
13. 13. Deciding if a cash balance plan is right for certain organizations: • Employer with younger, more mobile workforce • Cost control • Acquisition tool
14. 14. Traditional defined benefits plan: Understanding cash balance plan • A benefit plan • Having plan feature characteristics • A defined contribution plan Traditional defined benefits plans • Normal retirement age 65
15. 15. Comparison among traditional defined benefit, cash balance and defined contribution plan designs: • Amount of benefit • Guaranteed benefits by employer • Responsibility for benefits • Form of payment • Investment risk
16. 16. Cost Method: Cost method define the rate of growth of the cash balance account and the accrued pattern. Cost method have been used to calculate the plans normal cost and accrued liability
17. 17. Entry age normal method: Entry age normal method is a level of percentage of salary entry age until retirement age. When, Accrued liabilities =Accumulated value of normal cost
18. 18. When, Cash balance age in ‘w’ =Accumulated value of pay credit At age w, Lump Sum Cash balances=Accrued liability at age w
19. 19. Pros & Cons: • Cash balance plan is more frontloaded this appeal to the younger and more mobile workforce • Cash balance plan will cost more than traditional design • When many companies shift traditional plan to cost balance plan may adversely affect on mid and later career employees
20. 20. Money-Back Guarantee: The money-back guarantee can be viewed as equivalent to a put option that is owned by the plan participant and underwritten by the plan sponsor
21. 21. Enhanced Money-Back Guarantee: The enhanced money back guarantee can also be viewed as equivalent to a put option except that the strike price is slightly different because the guarantee compounds over time
22. 22. Minimum Annual Interest Rate Guarantee: • In this guarantee, participants must receive at least the sum of their pay credits with up to 3.0% interest • Applied each year until benefit commencement
23. 23. Money supply and demand framework: Marshall in his book, Economics of Industry, he accomplished two tasks. These are: • The theory of price level determination as a part of the general theory of value • He adopted coordinated and refined quantity theory namely some core proposition essential to the theory
24. 24. Money supply and demand framework: These referred to: • Equal proportionality of money and prices • Long run neutrality • short run non neutrality of money • Money stock exogeneity
25. 25. The Transmission Mechanism: The transmission mechanism depends on the change in stock of money .Generally for the change in money supply price level will change. There are direct and indirect mechanism of this change Direct mechanism: PT = MV + M`V` Bank deposit is a direct mechanism of raising price level
26. 26. Indirect mechanism: Fisher demonstrated that the emergence of inflation would result in a divergence between the real and nominal rates of interest 𝑅 𝑡 = 𝑟 𝑡 + ∆ 𝑝 𝑒t In short run mechanism may increase only the number of transaction. But in long run price level will rise for both direct and indirect mechanism
27. 27. Optimal Cash Balance Approach: The optimal cash balance c* is defined as; Where, c*=optimum amount of cash to be raised by selling marketable securities or by borrowing
28. 28. Superiority of Cambridge Quantity theory: Theme of Difference Cambridge Version Fisher’s Version 1. Humanistic approach It emphasize K or cash balance and consider human motives as an important factors affecting the price level. It does not explain how changes in the volume of money bring about 2. Mode of thinking It is concerned with the level of income. It is concerned with the total number of transaction 3. Realistic approach It emphasizes the psychological factors or subjective valuation as chief determinants of demand for money It emphasizes on the institutional objective and technological factors only. 4. Convenience of equation Cambridge equation p=KT/M The cash transaction approach p= MV/T 5. Foundation of theory The cash balance theory has shown the seeds of the Keynesian liquidity preference. It only shows the precautionary and transaction motives.
29. 29. Pitfalls of Cash Balance Approach: • Price Level does not Measure the Purchasing Power • More Importance to Total Deposits • Neglects other Factors • Neglect of Saving Investment Effect • k and Y not Constant • Fails to Explain Dynamic Behavior of Prices
30. 30. Pitfalls of Cash Balance Approach: • Neglects Interest Rate • Neglect of Goods Market • Neglects Real Balance Effect • Elasticity of Demand for Money not Unity • Neglects Speculative Demand for Money
31. 31. Conclusion: • The popularity of cash balance approach is attributable, in part, to the simplicity of the benefit accrual. • Corporate sponsors are increasingly turning to cash balance plans as a means of providing attractive retirement benefits to employees while avoiding the drawbacks of traditional DB plans. • It is very easy for employees to understand the annual growth in their account balance. • The cash balance funding method would apply the same • Commonsense approach to the funding and expensing of the pension plan.