The Mystery of Banking

Conceived
in Liberty
(New Rochelle, N.Y.: Arlington House, 1975), vol. II, p. 130n.
11
See ibid., pp. 123–40.
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the same denominations—a supply issued and clearly determined
by the government. While the production and supply of gold is
therefore “endogenous to” (produced from within) the market,
the supply of paper dollars—being determined by the govern-
ment—is “exogenous to” (comes from outside) the market. It is
an artificial intervention into the market imposed by government. 
It should be noted that, because of its great durability, it is
almost impossible for the stock of gold and silver actually to
decline
. Government paper money, on the other hand, can decline
either (a) if government retires money out of a budget surplus or
(b) if inflation or loss of confidence causes it to depreciate or dis-
appear from circulation. 
We have not yet come to 
banking
, and how that affects the
supply of money. But before we do so, let us examine the demand
for money, and see how it is determined, and what affects its
height and intensity. 
58
The Mystery of Banking
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V.
T
HE
D
EMAND FOR
M
ONEY
L
et’s analyze the various elements that constitute the public’s
demand for money. We have already seen that the demand
curve for money will be falling in relation to the purchasing
power of money; what we want to look at now is the cause of
upward or downward shifts in that demand curve. 
1. T
HE
S
UPPLY OF
G
OODS AND
S
ERVICES
Before money can be 
held
in one’s cash balance, it must be
obtained in exchange. That is, we must sell goods and services we
produce in order to “buy” money. However, if the supply of
goods and services increases in the economy (i.e., supply curves
shift to the right), the demand for money in exchange will also
increase. An increased supply of goods produced will raise the
demand for money and also therefore lower the overall level of
prices. As we can see in Figure 3.6, as the demand for money
rises, a shortage of cash balances develops at the old equilibrium
price level, and prices fall until a new equilibrium, PPM, is
achieved. 
59
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Historically, the supply of goods and services has usually
increased every year. To the extent it does so, this increase in the
demand for money will tend to lower prices over a period of
time. Indeed, so powerful has this force been for lowering prices,
that they fell from the mid-eighteenth century until 1940, with
the only exception being during periods of major wars: the
Napoleonic Wars, War of 1812, the Civil War, and World War I.
Paper money was increasing the money supply during this era, but
increases in M were more than offset by the enormous increases
in the supply of goods produced during the Industrial Revolution
in an unprecedented period of economic growth. Only during
wartime, when the governments ran the printing presses at full
blast to pay for the war effort, did the money supply overcome
the effects of increasing production and cause price levels to
zoom upward.
1
2. F
REQUENCY OF
P
AYMENT
The demand for money is also affected by the frequency with
which people are paid their wages or salaries. Suppose, for exam-
ple, that Mr. Jones and Mr. Smith are each paid an income of
$12,000 a year, or $1,000 per month. But there is a difference:
Jones is paid every week, and Smith every month. Does this make
any difference to their economic situation? Let us first take Smith,
and find out what his cash balance is on each day. Let us assume,
to keep things simple, that each man is paid on the first day of the
wage period, and then spends money at an even rate until the last
day, when his money is exhausted (and we assume that each man’s
income equals his expenditures for the relevant time periods). 
Smith receives $1,000 on the first of the month, and then
draws down his $1,000 cash balance at an even rate until the end
of the month by a bit more than $33 a day. 
60
The Mystery of Banking
1
The only exception was the period 1896–1914, when new gold dis-
coveries caused moderate increases in the price level.
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What is Smith’s 
average
cash balance for the month? We can
find out by simply adding $1,000 on Day 1, and 0 on Day 30, and
dividing by 2: the answer is $500. 
Let us now compare Smith to Jones, who has the same total
income, but receives his paycheck once a week. Figuring four
weeks to the month to simplify matters, this means that Jones gets
a check of $250 at the beginning of each week and then draws it
down steadily until he reaches a cash balance of zero at the end
of the week. His monetary picture will be as follows: 
The Demand for Money
61
Smith: Income and Cash Balance
Income
Cash Balance
Day 1
$1,000
$1,000
Day 2
0
967
Day 3
0
934
. . .
Day 30
0
0
Day 1
$1,000
$1,000
F
IGURE
5.1 — C
ASH
B
ALANCE
: M
ONTHLY
I
NCOME
Jones: Income and Cash Balance
Income
Cash Balance
Day 1
$250
$250
Day 2
0
215
Day 3
0
180
. . .
Day 7
0
0
Day 1
$250
$250
F
IGURE
5.2 — C
ASH
B
ALANCE
: W
EEKLY
I
NCOME
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Jones gets a check for $250 at the beginning of each week,
and then draws down his cash balance each day by approximately
$35 until he reaches zero at the end of the week. His income is
the same as Smith’s; but what is his 
average
cash balance? Again,
we can arrive at this figure by adding $250, at the beginning of
each week, and 0 and dividing by 2: the result is $125. 
In short, even though their incomes are identical, Smith, who
gets paid less frequently, has to keep an average cash balance four
times that of Jones. Jones is paid four times as frequently as
Smith, and hence has to keep a cash balance of only 1/4 the
amount. 
Cash balances, therefore, do not only do work in relation to
the level of prices. They also perform work in relation to the fre-
quency of income. The less frequent the payment, the higher the
average cash balance, and therefore the
greater 
the demand for
money, the greater the amount, at any price level, that a person
will seek to keep in his cash balance. The same cash balances can
do more money work the greater the frequency of payment.
In my salad days, I experienced the problem of frequency of
payment firsthand. I was working on a foundation grant. My
income was fairly high, but I was getting paid only twice a year.
The result was that the benefits of my respectable income were