Dmitry Chernikov’s Blog

My first attempt at clarifying the problem of the demand for money was somewhat successful. What’s the difference and connection between this demand (DFM) and the velocity of circulation of money? In the first place, demand for money can be measured at any instant, whereas velocity of circulation can be computed only over a period of time, where it can mean the average amount of money that changes hands.

Let’s entertain two cases. First, suppose that the DFM has increased. This causes surpluses of unsold goods. Hence the velocity of circulation of money will go down. But when prices have adjusted downward and the PPM has consequently risen, velocity will go back to its previous level, all other things, such as the money supply, being equal. Thus, velocity remains the same yet with a higher demand for money.

Second, suppose that the DFM has decreased. Temporary shortages will result. But velocity of money will be unchanged, since, like before, every good is sold, despite the fact that some buyers remained unsatisfied and would have paid the present price, had there been greater quantity supplied. But even when prices increase in response to smaller demand for money, velocity will be unchanged.

Now let’s consider the situation in which the velocity of money at Δt₁ is less than the velocity of money at Δt₂. It seems that people are more willing to get rid of their cash balances during Δt₂, and so the demand for money must decrease, and the PPM, decrease, as well. Similar reasoning applies when the velocity of money decreases.

In the first two cases I examine changes in the DFM which result in opposite price adjustments. In his article The Velocity of Circulation Hazlitt asserts that “In fact (though this happens less often), an increase in the velocity of circulation of money may be accompanied by an increase in the purchasing power of money, i.e., by a fall in prices.” In so doing he seems to be thinking of a peculiar reverse case:

1′) Prices go down yet without a corresponding increase in the DFM, so PPM increases and there is more economic activity and greater V. This is said to be possible “in a speculative collapse, as, say, in late 1929.”

2′) Prices go up yet without a corresponding decrease in the DFM, so PPM decreases and there is less economic activity and lesser V.

My final case, where I assume that V has increased, must be interpreted as caused by the smaller demand for money: “When people value money less and goods more, they will offer more money for goods, and may increase ‘velocity of circulation’.” This corresponds to (2) above. What can happen, I suppose, is that inventories will be cleared out faster, so even though I say that V does not change, in the real world it may increase. (I assume that entrepreneurs will fail to predict a decrease in the DFM and increase supply.)

In addition, Mises is quoted as saying that “In a changing world everybody is under the necessity of keeping an amount of ready cash on hand,” where I assume that by “changing” he means uncertain and un-ERE-like. I make the same point earlier: Cash balances provide “[g]reater security for the hoarder, since one of the functions of money is a ’store of value.’ In other words, it is a shield against the uncertainty of the future and against unforeseen future expenses.”

Thus the DFM can be affected by changes in both (1) the perceived uncertainty of the future and (2) the serviceability of money to protect one against this uncertainty. Changes in the DFM are due to particular monetary-type events. Thus, changes in frequency of payments to workers affect (1); expectations of inflation affect (2). Aside from those, all that change are relative prices of goods and services.

In my first article on DFM I say, following Rothbard, that “a greater number of goods and services on the market due to economic growth” will result in greater demand for money. Seemingly, (1) is unaffected (except insofar as greater security is afforded by more extensive division of labor), and neither is (2); why, then, does the DFM change? I think Rothbard has made a subtle error. For in the two cases mentioned the change in the DFM occasions an opposite change in prices. In the case of economic progress it is the lowering of prices which causes an increase in the DFM. Perhaps an even better way of putting this matter is to say that the relative supply of money has gone down.

This entry was posted on Sunday, April 6th, 2008 at 9:51 pm and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.