Monetary and real aspects of the great divergence between europe and asia, 1500-1800

Stock-flow distinctions and the Cambridge equation

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3. Stock-flow distinctions and the Cambridge equation

The importance of the stock of money can be dealt with by reformulating the quantity theory of money in its modern Cambridge form, as noted by Doherty and Flynn (1989):

M = k.P.Y (2)

In the Cambridge equation, M is now the stock of money, k is the income velocity of circulation and Y is the level of income. An increase in the stock of money, brought about by an inflow of bullion, will increase the price level so long as the income velocity is stable and the level of income remains fixed. However, this formulation now makes clear that it is the stock of money interacting with the demand for money that determines the price level, and a clear distinction is maintained between the flow supply and the existing stock. This stock-flow distinction is important in understanding how disequilibrium was able to persist for some time in the presence of arbitrage opportunities.

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