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

Chapter Twelve: Money Mischief 282 The PPM is also affected by the money supply and it is capable of shifting as well, as seen in Figure 12.6 . If the Fed increases the money supply to stimulate economic growth, the purchasing power of money must fall, ceteris paribus . With the same number of goods and services in the real economy, printing additional dollars causes individuals to bid up prices of real goods and services as they try to spend the new money. As prices rise, each individual dollar bill will purchase less real resources. Similarly, if the Fed fails to stop a banking crisis and refuses to lend to stop a liquidity-driven panic (as it did during the Great Depression), the money supply will fall as with MS 2 , and the purchasing power of money will increase to PPM 2 . When the purchasing power of money increases, this is typically referred to as deflation (since real goods and services prices are going down in terms of dollars). Similarly, when the purchasing power of money decreases we call it inflation , since the prices of real goods and services are increasing in terms of dollars (discussed more in the next section). Liquidity refers to a firm’s or individual’s access to cash to meet any payment requirements. If someone (individual, firm, or bank) is illiquid, they do not have enough of their assets in the form of cash (or readily convertible to cash). Being illiquid does not mean they are bankrupt; they could sell some of their other assets for cash to meet their unexpected needs, although it could be costly to do so. This is contrasted with insolvency, where not only does a bank (or individual or firm) not have ready cash, their assets (what they own) are less than their liabilities (what they owe); therefore they are insolvent, and should declare bankruptcy. ILLIQUID OR INSOLVENT? SHORT ON CASH OR FLAT BROKE? In a fractional reserve banking system, banks can suffer a liquidity crisis if too many withdrawals occur at once—they are not “liquid” enough with cash. In this scenario, they are not bankrupt (they have a good loan portfolio), just illiquid . Alternatively, a bank may be insolvent even if it is liquid. The question of solvency is determined by comparing assets to liabilities, whereas liquidity focuses on the amount of cash reserves a bank has. FEDERAL RESERVE POLICY As was said earlier, in a first best world, we might not have a central bank; but since that’s not the world we live in, let’s take a more focused look at how we can get the best “2nd best” world. P ($) Q (#) Q 1 Q 3 Q 2 PPM 1 PPM 3 PPM 2 M S1 M S2 M S3 M D1 Figure 12.6, Changes in M S on the Purchasing Power of Money (PPM). When supply of money drops, with a given money demand, the purchasing power of money will rise from PPM 1 to PPM 2 . Likewise, an increase in M S will lower the PPM to PPM 3 . Deflation: a fall in the general level of prices over time. Inflation: a rise in the general level of prices over time.