The Cambridge School of Monetary Theory: an Empirical Analysis for Italy

This paper investigates the monetary theory of the Cambridge School, which emerged from the contributions of Alfred Marshall and Arthur Cecil Pigou between the late 19th and early 20th century. While still grounded in Fisher's quantity equation, the Cambridge School brought significant innovations to monetary theory. It emphasized the various functions of money beyond its role as a means of payment, which was the key insight of the quantity theory of money. The Cambridge School paved the way for new developments, eventually leading to John Mainard Keynes' 'A Treatise on Money' and 'The General Theory'. Specifically, Pigou examined the sum of currency and demand deposits as a ratio to nominal GDP, known as the k ratio. The Cambridge k is influenced by the current state of the economy and expectations regarding the purchasing power of money. Our analysis uses yearly time series data from Italy, spanning from its unification in 1861 to the introduction of the euro. We test the relationship between the k ratio and nominal interest rates. Our findings indicate that k follows a non-stationary process, challenging the notion of a stable velocity of circulation. However, when combined with two nominal non-stationary interest rates, we detect a cointegrating relationship which can be interpreted as a long-term equilibrium. The result of a Vector Error Correction Model (VECM) estimated over the entire time span supports the theoretical predictions of the Cambridge School.