THE SUPPLY AND DEMAND FOR MONEY AND OVERALL PRICES - The Mystery of Banking

When economics students read text books, they learn, in the “micro” sections, how prices of specific goods are determined by supply and demand. But when they get to the “macro” chapters, lo and behold! supply and demand built on individual persons and their choices disappear, and they hear instead of such mysterious and ill-defined concepts as velocity of circulation, total transactions, and gross national product. Where are the supply-and-demand concepts when it comes to overall prices?

In truth, overall prices are determined by similar supply-and demand forces that determine the prices of individual products.

Let us reconsider the concept of price. If the price of bread is 70 cents a loaf, this means also that the purchasing power of a loaf of bread is 70 cents. A loaf of bread can command 70 cents in exchange on the market. The price and purchasing power of the unit of a product are one and the same. Therefore, we can construct a diagram for the determination of overall prices, with the price or the purchasing power of the money unit on the Y axis.

While recognizing the extreme difficulty of arriving at a measure, it should be clear conceptually that the price or the purchasing power of the dollar is the inverse of whatever we can construct as the price level, or the level of overall prices. In mathematical terms,

where PPM is the purchasing power of the dollar, and P is the price level.

To take a highly simplified example, suppose that there are four commodities in the society and that their prices are as follows:
eggs $.50 dozen butter$ 1 pound
shoes $20 pair TV set$ 200 set

In this society, the PPM, or the purchasing power of the dollar, is an array of alternatives inverse to the above prices. In short, the purchasing power of the dollar is:

either 2 dozen eggs
or 1 pound butter
or 1/20 pair shoes
or 1/200 TV set

Suppose now that the price level doubles, in the easy sense that all prices double. Prices are now:
eggs $1 dozen butter$ 2 pound
shoes $40 pair TV set$ 400 set

In this case, PPM has been cut in half across the board. The purchasing power of the dollar is now:

either 1 dozen eggs
or 1/2 pound butter
or 1/40 pair shoes
or 1/400 TV set

Purchasing power of the dollar is therefore the inverse of the price level.

SUPPLY OF AND DEMAND FOR MONEY

Let us now put PPM on the Y-axis and quantity of dollars on the X-axis. We contend that, on a complete analogy with supply,demand, and price above, the intersection of the vertical line indicating the supply of money in the country at any given time, with the falling demand curve for money, will yield the market equilibrium PPM and hence the equilibrium height of overall prices, at any given time.

Let us examine the diagram in Figure above. The supply of money, M, is conceptually easy to figure: the total quantity of dollars at any given time.

We contend that there is a falling demand curve for money in relation to hypothetical PPMs, just as there is one in relation to hypothetical individual prices. At first, the idea of a demand curve for money seems odd. Isn’t the demand for money unlimited? Won’t people take as much money as they can get? But this confuses what people would be willing to accept as a gift (which is indeed unlimited) with their demand in the sense of how much they would be willing to give up for the money. Or: how much money they would be willing to keep in their cash balances rather than spend. In this sense their demand for money is scarcely unlimited. If someone acquires money, he can do two things with it: either spend it on consumer goods or investments, or else hold on to it, and increase his individual money stock, his total cash balances. How much he wishes to hold on to is his demand for money.

Let us look at people’s demand for cash balances. How much money people will keep in their cash balance is a function of the level of prices. Suppose, for example, that prices suddenly dropped to about a third of what they are now. People would need far less in their wallets, purses, and bank accounts to pay for daily transactions or to prepare for emergencies. Everyone need only carry around or have readily available only about a third the money that they keep now. The rest they can spend or invest. Hence, the total amount of money people would hold in their cash balances would be far less if prices were much lower than now. Contrarily, if prices were triple what they are today, people would need about three times as much in their wallets, purses, and bank accounts to handle their daily transactions and their emergency inventory. People would demand far greater cash balances than they do now to do the same “money work” if prices were much higher. The falling demand curve for money is shown in Figure below.

Here we see that when the PPM is very high (i.e., prices overall are very low), the demand for cash balances is low; but when PPM is very low (prices are high), the demand for cash balances is very high.

We will now see how the intersection of the falling demand curve for money or cash balances, and the supply of money, determines the day-to-day equilibrium PPM or price level.

DEMAND FOR MONEY

Suppose that PPM is suddenly very high, that is, prices are very low. M, the money stock, is given, at $100 billion. As we see in Figure below, at a high PPM, the supply of total cash balances, M, is greater than the demand for money. The difference is surplus cash balances—money, in the old phrase, that is burning a hole in people’s pockets. People find that they are suffering from a monetary imbalance: their cash balances are greater than they need at that price level. And so people start trying to get rid of their cash balances by spending money on various goods and services. But while people can get rid of money individually, by buying things with it, they can’t get rid of money in the aggregate, because the$100 billion still exists, and they can’t get rid of it short of burning it up. But as people spend more, this drives up demand curves for most or all goods and services. As the demand curves shift upward and to the right, prices rise. But as prices overall rise further and further, PPM begins to fall, as the downward arrow indicates. And as the PPM begins to fall, the surplus of cash balances begins to disappear until finally, prices have risen so much that the $100 billion no longer burns a hole in anyone’s pocket. At the higher price level, people are now willing to keep the exact amount of$100 billion that is available in the economy. The market is at last cleared, and people now wish to hold no more and no less than the $100 billion available. The demand for money has been brought into equilibrium with the supply of money, and the PPM and price level are in equilibrium. People were not able to get rid of money in the aggregate, but they were able to drive up prices so as to end the surplus of cash balances. Conversely, suppose that prices were suddenly three times as high and PPM therefore much lower. In that case, people would need far more cash balances to finance their daily lives, and there would be a shortage of cash balances compared to the supply of money available. The demand for cash balances would be greaterthan the total supply. People would then try to alleviate this imbalance, this shortage, by adding to their cash balances. They can only do so by spending less of their income and adding the remainder to their cash balance. When they do so, the demand curves for most or all products will shift downward and to the left, and prices will generally fall. As prices fall, PPM ipso factorises, as the upward arrow shows. The process will continue until prices fall enough and PPM rises, so that the$100 billion is no longer less than the total amount of cash balances desired.

Once again, market action works to equilibrate supply and demand for money or cash balances, and demand for money will adjust to the total supply available. Individuals tried to scramble to add to their cash balances by spending less; in the aggregate, they could not add to the money supply, since that is given at $100 billion. But in the process of spending less, prices overall fell until the$100 billion became an adequate total cash balance once again.

The price level, then, and the purchasing power of the dollar, are determined by the same sort of supply-and-demand feedback mechanism that determines individual prices. The price level tends to be at the intersection of the supply of and demand for money, and tends to return to that point when displaced.

As in individual markets, then, the price or purchasing powerof the dollar varies directly with the demand for money and inversely with the supply. Or, to turn it around, the price level varies directly with the supply of money and inversely with the demand.