Prices and the Money Supply

We saw last week that to complete our model of Dynamicland we need to have a way for the money supply to increase to keep pace with increases in productivity.  But I still want to keep this model as simple as possible – like Orderlyland, to be a world of full employment (only this time with steadily increasing productivity) and still a cash only economy, without banks and financial assets (so that we can see more clearly the difference made when we add these later).

So to start with, we will say that that the Government prints the additional cash required, continually expanding the money supply to match the increased supply of goods from increased productivity.  But to complete the model we need to explain how this cash then enters the economy.

One way would simply be for the Government to spend the new cash on increasing and improving public services.  The new expenditure will end up as salaries for public sector workers, and the rising income will lead to rising demand in the economy.  Businesses can respond to this demand by increasing output if (and only if) they have the productive capacity to do so.  If they can’t increase production, then prices will rise instead.  In the real world, you are likely to see a combination of the two.  Economics textbooks usually present this as a simplistic, “increase in money supply leads to inflation”, not recognising that some businesses may have the capacity to quickly improve output – it’s a huge conceptual gap for someone trying to understand the economy.

If you are in a recession, with businesses closing down, or laying off staff, or cutting wages, then clearly they have unused capacity, and increasing demand through increases in the money supply is likely to stimulate the use of that spare capacity rather than cause inflation.

But in our model of Dynamicland, building on Orderlyland where the economy is healthy and operating near its capacity, if the Government simply spends new money into the economy then businesses are unlikely to be able to respond quickly enough with new production, and inflation will result.  And in any case, we saw last week that without credit to businesses there will be no new investment so there will not be the increases in productivity.  Remember the conclusion from last week:  to understand the economy we have to understand the process by which businesses access credit.

The simplest way to complete the Dynamicland model is to say that the Government prints new money to lend to businesses to spend on investment.  To keep this cash circulating around the economy, as businesses repay the loans the Government spends this cash on increased public services.  However, there’s no reason why the amount of credit needed for new investment would be exactly the increase in the money supply needed to match increases in productivity and avoid deflation, so in fact the Dynamicland Government would have to use its expenditure as a way to adjust the money supply – either destroying money by not spending the loan repayments made by businesses, or creating additional new money to match increases in productivity and spending it into the economy as described above.

As you can imagine, this would be a tricky thing to get right!  Just ignore the unrealistic nature of this model for now, I’ll say a bit more about that in a couple of weeks.  The purpose of Dynamicland is not to model the economy as it is, but rather to isolate specific components so we can focus on their behaviour.  Remember the analogy of a stripped engine – over 4 weeks we’ve shown how productivity, investment, prices and the money supply all fit together.  Now that we have a logically consistent model with these components, next week we can see whether the act of individual saving has the same or different effects to those we saw in Orderlyland.  Then in subsequent weeks we can see what happens when we add in a financial sector (specifically banking and financial assets), and soon we will have a realistic model of the economy.

It’s worth summarising what we’ve been able to demonstrate so far through the Dynamicland model:

  • Increases in productivity require investment…
  • and investment requires credit.
  • At the same time changes in productivity will impact on prices…
  • and changes in the money supply can affect prices too…
  • therefore productivity and the money supply both exert an influence on the price level.
  • Increases in the money supply can be the source of credit that enables investment…
  • … but ultimately increases in the money supply need to track increases in productivity, not the demand for investment spending.

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