The Cambridge equation, also known as the Cambridge cash-balances equation, is an economic formula that relates the demand for money to income and interest rates. It was developed by economists at the University of Cambridge in the early 20th century, including John Maynard Keynes.
The equation can be written as:
M = kPY
Where:
M is the total quantity of money in circulation
P is the price level
Y is real national income or output
k is the proportion of income held as cash balances (also known as the income velocity of money)
The equation states that the demand for money is a function of the level of income in the economy, as well as the interest rate. As income rises, people need more money to finance their transactions, and hence the demand for money increases. Similarly, when interest rates rise, people are more likely to hold money rather than invest it, leading to a higher demand for money.
The Cambridge equation is important because it provides a framework for understanding the relationship between the quantity of money and the price level. According to the equation, if the money supply grows faster than real output, the price level will rise, and if the money supply grows slower than real output, the price level will fall. This forms the basis of the quantity theory of money, which suggests that inflation is ultimately a monetary phenomenon caused by excessive money creation.