No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 281 some as a store of wealth. How much they choose for each category in part depends on the certainty of the future. If you think your job may be ending soon, for example, you may want to increase your holdings of money and reduce current consumption. But we do know that the demand curve for money slopes downward to the right—just as any other good or service—and for the same reasons; we apply our uses of money to our most urgent needs, and any increase in money supply we apply to progressively less important needs. Therefore, the marginal utility of money falls as its quantity increases. For money supply, we assume the Federal Reserve controls the stock of money at a desired level, per Figure 12.4 . The equilibrium price of money is a bit more problematic than other commodities. For every other good, we determine an equilibrium price in terms of dollars. But for an equilibrium price of dollars, we need to think in reverse: what is the purchasing power of a given unit of money? In other words, how much will my dollar buy? Whatever the value of money is in terms of purchasing power, it is of course subject to change in the usual way: whenever either M S or M D changes, the purchasing power of money changes. Let’s consider a M D change. In Figure 12.5 we can see the result of both an increase and a decrease in money demand. Let’s say that everyone expected a massive increase in inflation as a result of the continued deficit spending of the current government. In this scenario, expectations of future lost purchasing power will result in a lower money demand—people will want to get rid of their existing stock while goods/services prices are still relatively low. In this case, the demand for money falls to M D2 , and the purchasing power of money will fall with it (to PPM 2 ). Conversely, imagine that the economy goes into a nice growth spurt such that people don’t worry about losing their jobs. In that case, they will want more money to spend for exchanges. Their money demand may increase to M D3 , and that would raise the purchasing power of money to PPM 3 . P ($) Q (#) Q 1 PPM 1 M S M D Figure 12.4, Monetary Equilibrium. The overall market demand for money slopes downward since the marginal utility of money falls as the quantity of money increases. The money supply is fixed by the monetary authority (Fed). The price of money can be thought of simply as its purchasing power. How much of all other commodities can a given amount of money purchase? P ($) Q (#) Q 1 PPM 1 PPM 2 PPM 3 M S M D1 M D2 M D3 Figure 12.5, Changes in M D on the Purchasing Power of Money (PPM). When demand for money drops, with a given money stock, the purchasing power of money will fall from PPM 1 to PPM 2 . Likewise, an increase in M D will raise the PPM to PPM 3 .