The Mystery of Banking

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.

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.

Or, put another way, at the lower money supply people scramble to increase cash balances. But since the money supply is set and outside their control, they cannot increase the supply of cash balances in the aggregate.1 But by spending less and driving down the price level, they increase the value or purchasing power of each dollar, so that real cash balances (total money supply corrected for changes in purchasing power) have gone up to offset the drop in the total supply of money. M might have fallen by $30 billion, but the $70 billion is now as good as the previous total because each dollar is worth more in real, or purchasing power, terms.

An increase in the supply of money, then, will lower the price or purchasing power of the dollar, and thereby increase the level of prices. A fall in the money supply will do the opposite, lowering prices and thereby increasing the purchasing power of each dollar.

The other factor of change in the price level is the demand for money. Figures 3.6 and 3.7 depict what happens when the demand for money changes.

FIGURE 3.6 — AN INCREASE IN THE DEMAND FOR MONEY

The demand for money, for whatever reason, increases from D to D’. This means that, whatever the price level, the amount of money that people in the aggregate wish to keep in their cash balances will increase. At the old equilibrium price level, 0A, a PPM that previously kept the demand and supply of money equal and cleared the market, the demand for money has now increased and become greater than the supply. There is now an excess demand for money, or shortage of cash balances, at the old price level. Since the supply of money is given, the scramble for greater cash balances begins. People will spend less and save more to add to their cash holdings. In the aggregate, M, or the total supply of cash balances, is fixed and cannot increase. But the fall in prices resulting from the decreased spending will alleviate the shortage. Finally, prices fall (or PPM rises) to 0B. At this new equilibrium price, 0B, there is no longer a shortage of cash balances. Because of the increased PPM, the old money supply, M, is now enough to satisfy the increased demand for cash balances. Total cash balances have remained the same in nominal terms, but in real terms, in terms of purchasing power, the $100 billion is now worth more and will perform more of the cash balance function. The market is again cleared, and the money supply and demand brought once more into equilibrium.

Figure 3.7 shows what happens when the demand for money falls.

FIGURE 3.7 — A FALL IN THE DEMAND FOR MONEY

The demand for money falls from D to D’. In other words, whatever the price level, people are now, for whatever reason, willing to hold lower cash balances than they did before. At the old equilibrium price level, 0A, people now find that they have a surplus of cash balances burning a hole in their pockets. As they spend the surplus, demand curves for goods rise, driving up prices. But as prices rise, the total supply of cash balances, M, becomes no longer surplus, for it now must do cash balance work at a higher price level. Finally, when prices rise (PPM falls) to 0B, the surplus of cash balance has disappeared and the demand and supply of money has been equilibrated. The same money supply, M, is once again satisfactory despite the fall in the demand for money, because the same M must do more cash balance work at the new, higher price level.

So prices, overall, can change for only two reasons: If the supply of money increases, prices will rise; if the supply falls, prices will fall. If the demand for money increases, prices will fall (PPM rises); if the demand for money declines, prices will rise (PPM falls). The purchasing power of the dollar varies inversely with the supply of dollars, and directly with the demand. Overall prices are determined by the same supply-and-demand forces we are all familiar with in individual prices. Micro and macro are not mysteriously separate worlds; they are both plain economics and governed by the same laws.

• 1Why doesn’t an excess demand for cash balances increase the money supply, as it would in the case of beef, in the long run? For a discussion of the determinants of the supply of money, see chapter IV.