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Supply vs Demand applied to money

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tcostel posted on Tue, May 29 2012 3:28 AM

I understand the supply side pretty well, but it is the demand side I struggle with. If the supply of money increases, you will get a dollar worth less and thus higher prices, as well as all of the negative effects of inflation (the business cycle, etc).

But why would a decrease in the demand for money not cause the same effect?

For example, say the supply of money is increased. The early receivers of the new money will benefit at the expense of the late receivers/non receivers, for they will be able to purchase goods before they increase in price.

But say people have a decreased demand for cash balances. As a result, they spend more, which will result in more money entering the economy. The early receivers of this money will benefit at the expense of the later receivers, for they will be able to use it before prices rise.

In other words, wouldn't the negative effects of inflation also apply if the demand for money was decreasing?

I can't figure this one out.

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Maybe some context will help. I am currently in an online argument about the broken window fallacy.  My opponent argues that the fallacy does not apply if the business owner (whose glass was broken as goes the traditional parable) would not have spent the money on anything. For example, he argued that if the business owner was merely hoarding money, no new suit would have come into existence. Obviously the hoarder no longer has the savings, but that is not a sufficient response, for the assumption is that whoever gets the money that was hoarded (the glazier, and whatever he then spends money on) will then use that money to purchase products that would not have come into existence had the money not been spent or invested at all and merely hoarded.

I was having trouble articulating a decent response, although intuitively I know that the destruction of the window cannot possibly have a positive effect. I used the demand for money as a response, saying that the net loss is reflected in the loss of purchasing power of the dollar. More money is entering circulation that was not before, equivalent to a reduction in the demand for money, which will lower purchasing power and raise prices. People who did not get this new money would thus suffer a loss.

But then would not any decrease in the demand for money cause harm to someone whose income is fixed, just as an increase in supply would? It would then mean that hoarding money then spending it has a negative economic effect.

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Some random thoughts on the subject:

1.  First, this is a highly theoretical [=unrelated to reality] situation. People don't hoard such vast amounts of money that dishoarding will influence the economy. After all, we are talking about huge amounts of money that is not going to be put into a bank, or invested in any way, but hidden under a mattress. Not happening, and the statistics back this claim up, as Hazlitt wrote in Economics in One Lesson:

Now let us see...what happens to the
$20,000 that he neither spends nor gives away. He does not let it pile
up in his pocketbook, his bureau drawers, or in his safe. He either
deposits it in a bank or he invests it. If he puts it either into a com-
mercial or a savings bank, the bank either lends it to going businesses
on short term for working capital, or uses it to buy securities. In other
words, Benjamin invests his money either directly or indirectly. But
when money is invested it is used to buy capital goods—houses or
office buildings or factories or ships or motor trucks or machines. Any
one of these projects puts as much money into circulation and gives
as much employment as the same amount of money spent directly on

“Saving,” in short, in the modern world, is only another form of spending. The
usual difference is that the money is turned over to someone else to
spend on means to increase production.

The rest of this post assumes, for the sake of argument, that the theoretical happened, that huge amounts of money were stashed under a mattress for a long time, then relased into the economy.

2. There is a huge difference between inflation and dishoarding, mainly in what preceded it. The inflater did not get his money by being productive and getting paid for his productivity, but by printing it. Thus he gets to consume without having produced anything beforehand, and is thus a parasite on the economy.

But a dishoarder got his money by being productive. He increased the wealth in the world way before he goes to the store to decrease it back again by spending. So that any temporary lowering of prices that he caused by not spending right away is like a free loan he gave to the world, which he is now taking back. So yes, he will get things cheaper by buying first, but he earned that right by underconsuming.

As for causing a business cycle, that won't happen. Because the business cycle, meaning the malinvestments, is caused by money being introduced into the economy that does not represent production, as above. Thus entrepeneurs are fooled into thinking there are more resources available than truly exist. But a dishoarder is releasing money that does represent increased production, as above.

Not only that, if we are talking about dishoarding money in such huge quantities, it probably won't be all spent on one giant cocaine binge. It will be potential investors who are dishoarding, getting things they need at a low price. [As opposed to the govt, which never the uses 99% of the money it prints to be productive, but to consume].

3. You are describing a situation that is sort of happening right now. The Chinese are sitting on huge piles of dollars [=hoarding]. Some day they will decide to spend it [=dishoard], and take everything out of the US and move it to China, leaving Americans destitute. That won't cause a business cycle, but just poverty for Americans and wealth for the Chinese. However, that's how it should be, in a sense, in that the Chinese merely gave us some time before we suffer the consequences of not producing enough to pay our bills.

4. In a sense, hoarding and dishoarding can cause good times for everyone but the hoarder [who is underconsuming on a grand scale], followed by the reverse. So for the economy as a whole, things haven't changed.


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For example, he argued that if the business owner was merely hoarding money, no new suit would have come into existence.

The glazier will spend the money, and the money will roll around the economy, until it eventually comes into the hands of someone who wants a window. But there is no glass for that new window. It has been used up fixing the broken one.

In other words, any destruction of resources means somebody not getting what they need [that he could have had before]. Just because he got cash to buy the window because the hoarder released his savings, that will not make the resources pop out from nowhere after they have been destroyed.

Imagine a city full of misers who hoard their money. The city is bombed to smithereens in some war,  destroying all the houses. The hoarders, desperate for a place to live, bring out their gold coins. But so what? There still is nowhere to live.

Your opponent is making the same ridiculous assumption all Keynesian make, that if I get cash in my hand that wasn't there before, that will magically bring into the world all the things I want to buy with that cash. They don't have their eye on the ball. They should be thinking about ways to increase production, not ways to increase destruction [and/or consumption, which is ultimately the same thing].


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Clayton replied on Tue, May 29 2012 12:10 PM

The purchasing power of money is, indeed, a function of both supply and demand and the demand-side is the most overlooked part of the theory of money.

Demand for money is better termed "demand for cash balances" or "demand for cash held".

The problem with printing money - as Dave pointed out - is not that it "hurts someone"... after all, starting a new retail store "hurts" all other retailers in your area. The problem is that it is stealing by any other name. This is a difficult point to force a statist to concede because he/she does not believe that taxation is theft, so why should any other form of government-administered redistribution be called theft? In any case, the Austrian theory is value-free so it only makes the weaker claim that increasing the money supply is redistributive.

Changes in demand for money can have massive effects on the purchasing power of money. In fact, hyper-inflation is actually caused by a collapse in the demand for money. The absurd printing of money is just a reflection of the fact that the demand has collapsed.

When a saver's demand for money decreases and he begins to spend, he is acting like a central bank in that he is "flooding the economy" with new cash. Unless lots of people are doing this simultaneously (as in a hyper-inflation scenario), this has no effect on prices because an individual simply doesn't have the power of a central bank to move prices.

But - as Dave pointed out - this "flooding" of the economy had to be preceded by a period of over-production and under-consumption in order for the cash balance to be built in the first place. Hence, there is no theft going on here and, to whatever extent someone could claim to be "harmed" by the rise in prices, this is no different than the kind of "harm" that local retailers suffer when you open a new retail outlet in your area. A claim could be made that such movements of cash - if calculated based on the going purchasing power of cash - are "redistributive" but - if so - they are redistributive only in the sense that any form of speculation is. The social benefits of speculation are well understood in economic theory.

Now, on to hoarding. First of all, no one actually hoards in the sense that they bury cash and forget it ever existed. There are many reasons people save - to buy something that is very expensive (this is just deferred consumption), to self-insure against unforeseen maladies, to build a family legacy through inheritance, to prepare for a very large investment or charitable endowment, etc. etc. But the one thing people never do with money is bury it and forget it which is the only way that the arguments against the broken window fallacy would actually make sense.

What is really at stake is whether the decision-making power regarding the saver's savings should reside with the saver himself or the would-be central-planner. The central-planner doesn't like that the saver is taking too long to spend his savings... he should not be saving for a yacht and should be forced to buy new windows for his shop instead. So let's throw bricks through the windows. And - I would argue - on the grand scale, the real target is inheritance. People don't like the idea of inheritance, they feel that it is somehow unfair. This is why we have the death tax. But, as with all central-planning, the effect is always a discoordination of the economy as the decision-makers have less and less of the relevant information and the calculation of decisions is concentrated into fewer and fewer brains.

So, hidden within the broken window fallacy is the core of the central-planning versus laissez-faire debate. The brick-throwing central-planner simply believes he knows better than all those individual savers whose windows he plans to break. Reality says the central-planner is incorrect.

Clayton -
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