III.
M
ONEY AND
O
VERALL
P
RICES
1. T
HE
S
UPPLY AND
D
EMAND FOR
M
ONEY AND
O
VERALL
P
RICES
W
hen 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
29
Chapter Three.qxp 8/4/2008 11:37 AM Page 29
the price or the purchasing power of the money unit on the Y-
axis.
While recognizing the extreme difficulty of arriving at a meas-
ure, it should be clear conceptually that the price or the purchas-
ing power of the dollar is the inverse of whatever we can con-
struct 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
30
The Mystery of Banking
Chapter Three.qxp 8/4/2008 11:37 AM Page 30
In this case, PPM has been cut in half across the board. The pur-
chasing 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.
Money and Overall Prices
31
F
IGURE
3.1 — S
UPPLY OF AND
D
EMAND FOR
M
ONEY
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 indi-
cating the supply of money in
the country at any given time, with
the falling demand curve for money, will yield the market equilib-
rium 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
Chapter Three.qxp 8/4/2008 11:37 AM Page 31
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 con-
fuses 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 bal-
ances 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 over-
all are very low), the demand
for cash balances is low; but when
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