Sunday, August 3, 2008

Demand for money

Money can be a tricky thing to reason about. I want to briefly regurgitate my understanding of the interaction between the money supply and demand for money.

With a strongly conserved money supply (e.g. gold or a divine fiat money that never increases in supply), prices denominated in money will increase whenever the demand for money goes down. When the demand for money goes down, fewer goods and services must be offered in exchange for money. That is, more money must be offered for the same goods and services. Normally, however, the demand for money goes up, not down.

What determines the demand for money? Population plays a role - as there are more actors demanding the use of the money, the demand for money increases and the prices of everything measured in money decreases. This is why we expect a gradual fall in prices given a rising population. Uncertainty also plays a role. When times are uncertain, the demand for longer-term stores of money for greater deferral of consumption increases and the amount of short-term spending on immediate consumption drops. This is not a reflection of some mysterious "deficiency of demand" as the water-headed Keynesians make out, but a reflection of an increase in the demand for money itself. When people restrict their spending on all goods and services, the prices of goods and services, generally, will tend to go down.

I think that division of labor and consumer choice must also play roles in the demand for money. As the division of labor increases, the price of labor itself goes down, since more labor must be offered to acquire the same amount of money. Similarly, as consumer choice increases, prices must go down since there are more options of how to spend any given amount of money. Those choices are all bidding against one another in competition for the consumer's money. They must continually offer more goods and services in exchange for the consumer's money.

I am irked every time I hear on a documentary or radio program that "an ounce of gold bought such-and-such 2000 years ago and it still buys the comparable such-and-such today." If that is true, then economic progress is an illusion. If the real prices of comparable quality goods and services are not falling, then we are making no headway at all. The reality is that things are constantly falling in price. I paid the equivalent of two gold coins for my pickup truck. It can travel more than 80mph, has A/C and a (really crappy) stereo. It can go into 4WD on backroads and operates for hours and hours on end without fatigue. It is comparatively inexpensive to fuel. 2000 years ago, I could not even have gotten a mode of transportation of this quality. But the best quality transportation I could have gotten (horse and saddle), would have cost far more than two gold coins and a lot more to fuel per mile.

It is frightening just how abysmal our economic literacy must be that people consider it normal that prices are always increasing. Somehow, it is expected that it should always be getting more expensive to get by and harder to make a living. People associate population increase with a rise in prices, when elementary logic tells us to expect the exact opposite. As more people demand the use of money, prices in terms of money should go down. As the division of labor and consumer choice increase, we should also expect prices to go down. And while uncertainty can cause temporary decreases in prices as people defer consumption more than usual, price decreases due to uncertainty should self-correct when the uncertainty dissipates. Conversely, a decrease in population, decrease in the division of labor, decrease in consumer choice or decrease in uncertainty should all result in an increase in real prices, even with a conserved money supply.

No comments: