Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed.
PART 10 Money and Prices in the Long Run
Chapter 30 of 36 Money Growth and Inflation
Section 6 of 31
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Figure 1 - How the Supply and Demand for Money Determine the Equilibrium Price Level
The horizontal axis shows the quantity of money.
The left vertical axis shows the value of money.
The right vertical axis shows the price level.
High money value = low price level.
Low money value = high price level.
The supply curve for money is vertical because the quantity of money supplied
is fixed by the Fed.
The demand curve for money is downward sloping because people want to hold a larger quantity of money when each dollar buys less.
At the equilibrium, point A
· the value of money, left vertical axis
· and the price level, right vertical axis
· have adjusted to bring into balance
· the quantity of money supplied and the quantity of money demanded
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What ensures the quantity of money the Fed supplies and the quantity of money people demand are in balance?
This depends on the time span being considered.
In the short-run, interest rates play a key role, to be discussed soon.
In the long-run, the overall level of prices adjusts to the level at which the demand for money equals the money supply.
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If the price level becomes higher than the equilibrium level
· people will want to hold more money than the Fed has created
· the price level must fall to balance supply and demand
If the price level becomes lower than the equilibrium level
· people will want to hold less money than the Fed has created
· and the price level must rise to balance supply and demand
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At the equilibrium price level the quantity of money people want to hold exactly balances the quantity Qm of money supplied by the Fed.
If the money supply was smaller, left of Qm, the value of money would be higher and the price level would be lower.
If the money supply was larger, right of Qm, the value of money would be lower and the price level would be higher.
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Figure 1 shows these ideas.
The horizontal axis shows the quantity of money.
The left vertical axis shows the value of money 1/P.
The right vertical axis shows the price level P.
Notice the price level axis on the right is inverted.
A low price level is shown near the top of this axis.
A high price level is shown near the bottom.
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This inverted axis illustrates
· when the value of money is high, as shown at the top of the left axis
· the price level is low, as shown at the top of the right axis
The two curves in Figure 1 are the money supply and money demand curves.
The supply curve is vertical because the Fed has fixed the available quantity of money at Qm.
The demand curve for money is downward sloping.
This indicates when the value of money is low and the price level is high people demand a larger quantity of money to buy goods and services.
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At the equilibrium point A the quantity of money demanded balances the quantity of money supplied.
This equilibrium of money supply and money demand determines the value of money and the price level.
In sum
· when the Fed supplies more money the value of money goes down which increases prices
· when the Fed supplies less money the value of money goes up which decreases prices
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equilibrium of supply and demand
juyōtokyōkyū no heikou
需要と供給の平衡
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