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  • Supply and Demand, Part II: The Money Supply

    My recent post explained why President Obama’s newly proposed $447 billion spending package aimed at boosting total demand is doomed to fail. Some commenters offered a challenge to that assertion.

    The basis for assessing the spending package: Economic growth is determined by the supply side of the economy, beginning with productivity and labor supply. Recessions result from an external shock (for example, rapidly rising oil prices) combined with a structural distortion produced by a significant public policy (for example, encouraging rapid increases in home ownership by reducing loan requirements), that leaves production below full capacity. In other words, the natural state of the economy is one of growth, and recessions are only inevitable insofar as external shocks are beyond control and public policy is left at the mercy of human error.

    But it is production that drives economic growth and creates with it an equal flow of demand. Successfully growing an economy, then, requires targeting production, not aggregate demand. The President’s plan addresses the wrong problem.

    This comment challenged these basics:

    You leave too much unaddressed here. Your example of “the supply of a farmer’s crops constitutes his ability to demand an automaker’s automobile” is true if we operate in a barter economy. Once you introduce money into an economy, all of a sudden you can have supply and demand for something that isn’t a good or service—money. If everyone, in the aggregate, decides to demand more money, then everyone must therefore be choosing to demand less goods and services. And if everyone chooses to demand less goods and services (and more money), then whatever is produced (supply) is greater than what is consumed (demand); hence, supply does not create its own demand.

    There are a couple points to take away from this comment. First, if it’s true that people demand to hold more money, then “money demand” can be addressed through monetary policy, which controls the money supply. By increasing the money supply, however, there could be risk of stoking inflation, which would increase money demand as people seek to hold more cash in the face of rising prices.

    How the President’s plan could affect the money supply. On one hand, President Obama’s new spending proposal would not alter the money supply, since it would be financed by borrowing money from the private economy (and would later be “repaid” by increasing taxes). On the other hand, the President’s plan risks stoking inflation and increasing the demand for money. Even though the money supply would be left unchanged, if people expect prices to rise because of unrestrained government spending, these expectations could make inflation a reality. Businesses could raise prices expecting wages (labor costs) to rise. Again, this would result in people demanding to hold more cash. So not only would the President’s plan leave unaddressed any money demand problem that may exist, but it could actually make money demand worse.

    Production still drives the economy. Money demand does not change the fact that production ultimately drives supply and demand. When people demand to hold more money, it means money velocity (the speed at which a given dollar changes hands through economic transactions) slows. But it doesn’t change the fact that whatever is produced at a given time will be applied as demand somewhere in the economy.

    Here’s why: Any dollar of income an individual produces gives that individual the choice of either spending that dollar on a good or service, or saving that dollar by putting it in the bank. Either choice affects economic output equally. Spending the dollar contributes to gross domestic product (GDP). Saving the dollar allows the bank to loan it to someone else to spend—also contributing to GDP. When people are hesitant to spend and banks hesitant to loan and thus total savings increase, banks invest savings in T-bonds to earn interest. This channels savings toward someone who will spend them on goods or services, again equally contributing to GDP.

    In sum, the Federal Reserve, through monetary policy, has the tools to deal with problems relating to money demand. This is unrelated to and does not negate the fact that production creates demand and determines economic output. Short-term economic fluctuations are therefore caused by shocks to productivity, resulting from external factors combined with major public policy errors. The President’s stimulus plan targets the superficial problem of depressed aggregate demand rather than the fundamental problem of lower productivity, and therefore it will not stimulate economic growth.

    Posted in Economics [slideshow_deploy]

    2 Responses to Supply and Demand, Part II: The Money Supply

    1. Tim says:


      Your posts continue to utterly confuse me. In your original post you concede that excess supply (ie, overproduction) is possible, which means Say’s Law is false. My comment was only meant to explain the conditions under which Say’s Law is violated. But in this post you continued to claim that, “…it is production that drives economic growth and creates with it an equal flow of demand…” But you just said that supply doesn’t always create its own demand. So which is it?

      You also inadequately address my comment here on a number of levels. First, the point of my comment wasn’t to make an argument in favor of the President’s jobs bill (though I am in favor it); it was only to prove that your self-contradicted assertion that Say’s Law is always true is wrong as long as we operate in a monetary economy. You leave this part of my comment totally unaddressed. Second, your assertions regarding monetary policy and inflation simply don’t apply in our economic environment.

      First, monetary policy: In response to my comment you said, “… if it’s true that people demand to hold more money, then ‘money demand’ can be addressed through monetary policy, which controls the money supply.” At this point, you’re implicitly agreeing that Say’s Law is false. If you’re conceding that excess money demand is possible, then you’re conceding that a shortage of aggregate demand is possible; they are two sides of the same coin. Moreover, you make increasing the money supply sound too easy: if people are demanding to hold more money, then just have the Fed flood the market with dollars. Problem solved, right?

      Normally, that is what we would expect the Fed to do. Monetary policy basically amounts to the Fed expanding or contracting the size of its balance sheet. But currently, short term interest rates are zero. So what does the Fed do now?

      What I hear you saying is, “So what if short term interest rates are zero? The Fed can still increase the money supply right?” Actually, the Fed has tried that. This is the oddly unpopular “quantitative easing” that conservative politicians despise. But quantitative easing has been largely ineffective because the money the Fed “prints” just piles up in commercial banks’ excess reserve accounts. Once short term Treasury debt has close to a zero interest rate, money competes with it as a store of value. Essentially, short term debt and monetary base become perfect substitutes for each other. The Fed can expand its balance sheet all it wants (or, equivalently, “print” as much monetary base as it wants), but it doesn’t do any good: there’s more monetary base in the banking system, and fewer T-Bills, but because these things are perfect substitutes it’s like giving with one hand and taking away with the other. There’s never any market impact.

    2. Tim says:

      Even given this scenario, you seem to think the policy alternative (ie, fiscal stimulus) is doomed to fail because it “would not alter the money supply, since it would be financed by borrowing money from the private economy (and would later be “repaid” by increasing taxes).” But all the Government has to do to increase GDP is mobilize the millions of unemployed workers that the private sector has left idle. It can do this by writing people checks, preferably in order to pay them to do something useful. It baffles me that you would consider this to be “costly.” From an economic standpoint, all it amounts to is reducing the waste associated with unemployment. Nor is it necessary, as you imply, for the Government to issue Treasury debt later in order to “borrow” the money behind the check. The check the Government writes creates money to begin with. To the banking system, these checks simply show up as excess reserves. The only reason the Government issues debt later is because banks like to have an asset that earns more interest than reserves, and the Government likes to accommodate them. You suggested that issuing Treasury debt to pay for deficit expenditures would do no good since it would have to “later be repaid in increasing taxes.” But “borrowing” is only ineffective if you assume that people completely account for higher future tax rates in their current economic plans. Yet this concept, known as Ricardian equivalence, has had virtually no empirical affirmation.

      Your inflation fears are also similarly misplaced. If businesses, consumers, and investors are truly afraid of “unrestrained Government spending” and expect future price levels to be higher, then they would have stopped lending the Treasury money years ago. Inflation expectations are often reflected in people’s willingness to lend the Government money. Yet after trillions of dollars of monetary expansion and Government spending, 10-year Treasury bonds are still selling at near historical lows. As long as the economy remains depressed at the zero lower bound, there’s really no reason to fear inflation. Your logical fallacy here is that of affirming the conclusion: you assume the inflation which causes investors to sell their Treasury debt (and interest rates to rise). But if investors never sell their Treasury debt (and they won’t as long as interest rates are zero), then inflation will generally not occur.

      Furthermore, if you expect a higher price level in the future, then you would expect prices to be higher tomorrow than they are today which means you would choose to spend more money now rather than later. But if more people are choosing to spend more money now rather than later (ie, their demand to hold money is decreasing), then there will be more economic transactions which means more economic output and growth. Rising price levels results in people demanding less cash, not more. So if and when the economy recovers, we should expect to see a rise in the price level. But that’s a good thing!

      In your final paragraphs, you try to prove Say’s Law again by arguing that spending and saving impacts economic output equally. But anyone familiar with fractional reserve banking knows this is false: savings are the product of investment. The economic activity associated with savings has already been created in the current period by the time income is saved. Only when savings are withdrawn and used to draw upon the current flow of economic activity do they contribute to GDP. Yes, total income must equal total expenditures (and saving must equal investment), but you’re misinterpreting how that identity holds.

      In conclusion, you contradict yourself by claiming in your initial post that there are times when supply does not create its own demand, and then arguing in your follow up post that supply always creates its own demand; you neglect to recognize the impotency of monetary policy in a liquidity trap; you fear an inflation problem that neither exists nor is likely to exist; and you try to prove Say’s Law one last time while failing to acknowledge the nature of fractional reserve banking.

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