FIGURE 2.8 — INCREASE OF SUPPLY
Supply increases from 10 to 14 million pounds or from S to S’. But this means that at the old equilibrium price, $3, there is now an excess of supply over demand, and 4 million pounds will remain unsold at the old price. In order to sell the increased product, sellers will have to cut their prices, and as they do so, the price of coffee will fall until the new equilibrium price is reached, here at $1 a pound. Or, to put it another way, businessmen will now have to cut prices in order to induce consumers to buy the increased product, and will do so until the new equilibrium is reached.
In short, price responds inversely to supply. If supply increases, price will fall; if supply falls, price will rise.
The other factor that can and does change and thereby alters equilibrium price is demand. Demand can change for various reasons. Given total consumer income, any increase in the demand for one product necessarily reflects a fall in the demand for another. For an increase in demand is defined as a willingness by buyers to spend more money on—that is, to buy more—of a product at any given hypothetical price. In our diagrams, such an “increase in demand” is reflected in a shift of the entire demand curve upward and to the right. But given total income, if consumers are spending more on product A, they must necessarily be spending less on product B. The demand for product B will decrease, that is, consumers will be willing to spend less on the product at any given hypothetical price. Graphically, the entire demand curve for B will shift downward and to the left. Suppose that we are now analyzing a shift in consumer tastes toward beef and away from pork. In that case, the respective markets may be analyzed as follows:
We have postulated an increase in consumer preference for beef, so that the demand curve for beef increases, that is, shifts upward and to the right, from D to D’. But the result of the increased demand is that there is now a shortage at the old equilibrium price, 0X, so that producers raise their prices until the shortage is eliminated and there is a new and higher equilibrium price, 0Y.
FIGURE 2.9 — THE BEEF MARKET: INCREASE IN DEMAND
On the other hand, suppose that there is a drop in preference, and therefore a fall in the demand for pork. This means that the demand curve for pork shifts downward and to the left, from D to D’, as shown in Figure 2.10:
FIGURE 2.10 — THE PORK MARKET: DECLINE IN DEMAND
Here, the fall in demand from D to D’ means that at the old equilibrium price for pork, 0X, there is now an unsold surplus because of the decline in demand. In order to sell the surplus, therefore, producers must cut the price until the surplus disappears and the market is cleared again, at the new equilibrium price 0Y.
In sum, price responds directly to changes in demand. If demand increases, price rises; if demand falls, the price drops.
We have been treating supply throughout as a given, which it always is at any one time. If, however, demand for a product increases, and that increase is perceived by the producers as lasting for a long period of time, future supply will increase. More beef, for example, will be grown in response to the greater demand and the higher price and profits. Similarly, producers will cut future supply if a fall in prices is thought to be permanent. Supply, therefore, will respond over time to future demand as anticipated by producers. It is this response by supply to changes in expected future demand that gives us the familiar forward-sloping, or rising supply curves of the economics textbooks.
FIGURE 2.11 — THE BEEF MARKET: RESPONSE OF SUPPLY
As shown in Figure 2.9, demand increases from D to D’. This raises the equilibrium price of beef from 0X to 0Y, given the initial S curve, the initial supply of beef. But if this new higher price 0Y is considered permanent by the beef producers, supply will increase over time, until it reaches the new higher supply S’’. Price will be driven back down by the increased supply to 0Z. In this way, higher demand pulls out more supply over time, which will lower the price.
To return to the original change in demand, on the free market a rise in the demand for and price of one product will necessarily be counterbalanced by a fall in the demand for another. The only way in which consumers, especially over a sustained period of time, can increase their demand for all products is if consumer incomes are increasing overall, that is, if consumers have more money in their pockets to spend on all products. But this can happen only if the stock or supply of money available increases; only in that case, with more money in consumer hands, can most or all demand curves rise, can shift upward and to the right, and prices can rise overall.
To put it another way: a continuing, sustained inflation—that is, a persistent rise in overall prices—can either be the result of a persistent, continuing fall in the supply of most or all goods and services, or of a continuing rise in the supply of money. Since we know that in today’s world the supply of most goods and services rises rather than falls each year, and since we know, also, that the money supply keeps rising substantially every year, then it should be crystal clear that increases in the supply of money, not any sort of problems from the supply side, are the fundamental cause of our chronic and accelerating problem of inflation. Despite the currently fashionable supply-side economists, inflation is a demand-side (more specifically monetary or money supply) rather than a supply-side problem. Prices are continually being pulled up by increases in the quantity of money and hence of the monetary demand for products.
III.
MONEY AND OVERALL PRICES
1. THE SUPPLY AND DEMAND FOR MONEY AND OVERALL PRICES
When economics students read textbooks, 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,
PPM = 1/P
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.
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FIGURE 3.1 — 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 3.1. The supply of money, M, is conceptually easy to figure: the total quantity of dollars at any given time. (What constitutes these dollars will be explained later.)
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 3.2.
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.
FIGURE 3.2 — DEMAND FOR MONEY
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.
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 3.3, 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.
FIGURE 3.3 —DETERMINATION OF THE PURCHASING POWER OF MONEY
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 greater than 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 facto rises, 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 power of 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.
2. WHY OVERALL PRICES CHANGE
Why does the price level ever change, if the supply of money and the demand for money determine the height of overall prices? If, and only if, one or both of these basic factors—the supply of or demand for money—changes. Let us see what happens when the supply of money changes, that is, in the modern world, when the supply of nominal units changes rather than the actual weight of gold or silver they used to represent. Let us assume, then, that the supply of dollars, pounds, or francs increases, without yet examining how the increase occurs or how the new money gets injected into the economy.
Figure 3.4 shows what happens when M, the supply of dollars, of total cash balances of dollars in the economy, increases.
FIGURE 3.4 — INCREASE IN THE SUPPLY OF MONEY
The original supply of money, M, intersects with the demand for money and establishes the PPM (purchasing power of the dollar) and the price level at distance 0A. Now, in whatever way, the supply of money increases to M’. This means that the aggregate total of cash balances in the economy has increased from M, say $100 billion, to M’, $150 billion. But now people have $50 billion surplus in their cash balances, $50 billion of excess money over the amount needed in their cash balances at the previous 0A prices level. Having too much money burning a hole in their pockets, people spend the cash balances, thereby raising individual demand curves and driving up prices. But as prices rise, people find that their increased aggregate of cash balances is getting less and less excessive, since more and more cash is now needed to accommodate the higher price levels. Finally, prices rise until PPM has fallen from 0A to 0B. At these new, higher price levels, the M’—the new aggregate cash balances—is no longer excessive, and the demand for money has become equilibrated by market
forces to the new supply. The money market—the intersection of the demand and supply of money—is once again cleared, and a new and higher equilibrium price level has been reached.
Note that when people find their cash balances excessive, they try to get rid of them, but since all the money stock is owned by someone, the new M’ cannot be gotten rid of in the aggregate; by driving prices up, however, the demand for money becomes equilibrated to the new supply. Just as an increased supply of pork drives down prices so as to induce people to buy the new pork production, so an increased supply of dollars drives down the purchasing power of the dollar until people are willing to hold the new dollars in their cash balances.
What if the supply of money, M, decreases, admittedly an occurrence all too rare in the modern world? The effect can be seen in Figure 3.5.
FIGURE 3.5 — A FALL IN THE SUPPLY OF MONEY
In the unusual case of a fall in the supply of money, then, total cash balances fall, say, from $100 billion (M) to $70 billion (M’). When this happens, the people find out that at the old equilibrium price level 0A, aggregate cash balances are not enough to satisfy their cash balance needs. They experience, therefore, a cash balance shortage. Trying to increase his cash balance, then, each individual spends less and saves in order to accumulate a larger balance. As this occurs, demand curves for specific goods fall downward and to the left, and prices therefore fall. As this happens, the cash balance shortage is alleviated, until finally prices fall low enough until a new and lower equilibrium price level (0C) is established. Or, alternatively, the PPM is at a new and higher level. At the new price level of PPM, 0C, the demand for cash balances is equilibrated with the new and decreased supply M’. The demand and supply of money is once again cleared. At the new equilibrium, the decreased money supply is once again just sufficient to perform the cash balance function.
The Mystery Of Banking Page 4