In a market economy, a major service of money is that of the medium of exchange. Producers exchange their products for money, then exchange money for other goods. As the production of goods and services increases, the result is increased demand for the services of the medium of exchange (the service that money provides). Conversely, as economic activity slows, demand for money services follows suit.
The demand for medium of exchange services is also affected by price changes. An increase in the prices of goods and services leads to an increase in demand for the medium of exchange. People are now asking for more money to sell more expensive goods and services. A drop in the prices of goods and services translates into a drop in demand for the medium of exchange.
According to Mises,
The services rendered by money are conditioned by the height of its purchasing power. No one wants to have in his treasury a defined number of coins or a determined weight of money; he wants to keep cash with a determined amount of purchasing power.1
Increase in money supply and liquidity
Take the example of an increase in the money supply for a given state of economic activity. Since we have not had a change in the demand for the services of the medium of exchange, it means that people now have a surplus of money or an increase in monetary liquidity.
Obviously, no individual wants to have more money than they need. An individual can get rid of the excess cash by exchanging money for goods and assets. Individuals as a group cannot, however, get rid of the excess money like this. They can only transfer money from one person to another.
The mechanism that generates the elimination of excess cash is the increase in the prices of goods and assets. Once people start using excess cash to acquire goods and assets, it drives up their prices. As a result, the demand for silver services is increasing. All this in turn contributes to the elimination of the monetary surplus.
Once the money enters a particular market, that means more money is now being paid for a product in that market. Alternatively, we can say that the price of a good in this market has now increased. (Note that a price is the number of dollars per unit of something).
Observe that what has triggered increases in the prices of goods and assets in various markets is the increase in monetary surplus or monetary liquidity in response to the increase in the money supply.
Decrease in money supply and liquidity
While an increase in the money supply for a given level of economic activity results in a monetary surplus, a decrease in the money supply for a given level of economic activity leads to a monetary deficit.
Individuals always demand the same amount of services from the medium of exchange. To adjust to this, they will start selling goods and assets, causing their prices to drop.
At lower prices, demand for the services of the medium of exchange decreases, which in turn contributes to the elimination of the monetary deficit.
Change in liquidity due to changes in economic activity and prices
A change in liquidity, or monetary surplus, can also occur in response to changes in economic activity and changes in prices.
For example, an increase in liquidity may emerge for a given money supply and a decline in economic activity. A decrease in economic activity leads to a decrease in the production of goods. This means that less goods are going to be traded – which implies a drop in demand for the services of money – the services of the medium of exchange.
Once a money surplus emerges, it produces exactly the same result with regard to the prices of goods and services and assets as increasing the money supply, i.e. pushing prices up . An increase in prices in turn contributes to the elimination of surplus money – to the elimination of monetary liquidity.
Conversely, an increase in economic activity while the stock of money remains unchanged leads to a monetary deficit. This in turn triggers the sale of goods and assets, which lowers their prices. The fall in prices in turn contributes to the elimination of the monetary deficit.
In our framework, we define this emerging gap between the interaction of money supply and demand in terms of growth dynamics
% Change in liquidity =% change in money supply minus% change in real economic activity minus% change in price inflation
Again, changes in liquidity over an interval of time are induced by changes in the money supply relative to changes in the demand for money.
Monetary growth and liquidity: are they positively correlated?
Some commentators associate the increase in liquidity with the increase in the money supply. This is not always the case, however.
In fact, an increase in the rate of growth of the money supply could be associated with a decrease in the rate of growth of liquidity. Conversely, it is quite possible that a decline in the rate of growth of the money supply could be associated with an increase in the rate of growth of liquidity.
For example, if the money supply fell by 10% and were accompanied by a decline in economic activity of 10% and a decline in price inflation by 5%, then this would translate into an increase of liquidity of 5%, calculated as follows:
% Change in liquidity = –10% – (–10%) – (–5%) = + 5% In the past, there have been cases where money supply and liquidity have not developed in tandem . Between October 1929 and July 1932, for example, the annual growth rate of the money supply plunged from 8.3% to –14.5% while during the same period liquidity increased from 0.2% to 26, 5%.
Despite the increase in liquidity, the S & P500 fell sharply. The stock index after closing at 16.7 in March 1931 fell to 4.4 in June 1932, a decrease of 73.7% (see graph below).
A dip in the real savings pool was the likely root cause of the stock market decline. Again, this surge took place despite the sharp increase in liquidity.
Changes in money supply and liquidity are not the same thing. Liquidity is the result of the interaction between the supply and demand of money. Contrary to popular belief, it is possible that changes in money supply and liquidity will move in different directions.
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