The Mystery of Banking

38
The Mystery of Banking
1
Why 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.
Chapter Three.qxp 8/4/2008 11:37 AM Page 38

---

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. 
Money and Overall Prices
39
F
IGURE
3.6 — A
N
I
NCREASE IN THE
D
EMAND FOR
M
ONEY
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 bal-
ances 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 bal-
ances have remained the same in nominal terms, but in 
real
terms,
Chapter Three.qxp 8/4/2008 11:37 AM Page 39

---

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. 
40
The Mystery of Banking
F
IGURE
3.7 — A F
ALL IN THE
D
EMAND FOR
M
ONEY
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. 
Chapter Three.qxp 8/4/2008 11:38 AM Page 40

---

So prices, overall, can change for only two reasons: If the sup-
ply 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.