The Mystery of Banking

deflationary expectations
, then, the demand for money will rise,
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since people will hold on to more of their money at any given
price level, as they are expecting prices to fall shortly. This rise in
the demand for money (shown in Figure 3.6) would cause prices
to fall immediately. In a sense, the market, by expecting a fall in
prices, 
discounts
that fall, and makes it happen right away instead
of later. Expectations speed up future price reactions.
On the other hand, suppose that people anticipate a large
increase in the money supply and hence a large future increase in
prices. Their deflationary expectations have now been replaced
by 
inflationary expectations.
People now know in their hearts that
prices will 
rise
substantially in the near future. As a result, they
decide to buy now—to buy the car, the house, or the washing
machine—instead of waiting for a year or two when they know
full well that prices will be higher. In response to inflationary
expectations, then, people will draw down their cash balances,
and their demand for money curve will shift downward (shown
in Figure 3.7). But as people act on their expectations of rising
prices, their lowered demand for cash pushes up the prices now
rather than later. The more people anticipate future price
increases, the faster will those increases occur. 
Deflationary price expectations, then, will lower prices, and
inflationary expectations will raise them. It should also be clear
that the greater the spread and the intensity of these expectations,
the bigger the shift in the public’s demand for money, and the
greater the effect in changing prices. 
While important, however, the expectations component of
the demand for money is speculative and reactive rather than an
independent force. Generally, the public does not change its
expectations suddenly or arbitrarily; they are usually based on the
record of the immediate past. Generally, too, expectations are
sluggish in revising themselves to adapt to new conditions; expec-
tations, in short, tend to be conservative and dependent on the
record of the recent past. The independent force is changes in
the money supply; the demand for money reacts sluggishly and
reactively to the money supply factor, which in turn is largely
The Demand for Money
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determined by government, that is, by forces and institutions out-
side the market economy. 
During the 1920s, Ludwig von Mises outlined a typical infla-
tion process from his analysis of the catastrophic hyperinflation in
Germany in 1923—the first runaway inflation in a modern,
industrialized country. The German inflation had begun during
World War I, when the Germans, like most of the warring
nations, inflated their money supply to pay for the war effort, and
found themselves forced to go off the gold standard and to make
their paper currency irredeemable. The money supply in the war-
ring countries would double or triple. But in what Mises saw to
be Phase I of a typical inflation, prices did not rise nearly propor-
tionately to the money supply. If M in a country triples, why
would prices go up by much less? Because of the psychology of
the average German, who thought to himself as follows: “I know
that prices are much higher now than they were in the good old
days before 1914. But that’s because of wartime, and because all
goods are scarce due to diversion of resources to the war effort.
When the war is over, things will get back to normal, and prices
will fall back to 1914 levels.” In other words, the German pub-
lic originally had strong deflationary expectations. Much of the
new money was therefore added to cash balances and the Ger-
mans’ demand for money rose. In short, while M increased a
great deal, the demand for money also rose and thereby offset
some of the inflationary impact on prices. This process can be
seen in Figure 5.3. 
In Phase I of inflation, the government pumps a great deal of
new money into the system, so that M increases sharply to M
′
.
Ordinarily, prices would have risen greatly (or PPM fallen
sharply) from 0A to 0C. But deflationary expectations by the pub-
lic have intervened and have increased the demand for money
from D to D
′
, so that prices will rise and PPM falls much less sub-
stantially, from 0A to 0B. 
Unfortunately, the relatively small price rise often acts as
heady wine to government. Suddenly, the government officials
see a new Santa Claus, a cornucopia, a magic elixir. They can