Supply and demand is the heart of economics. It’s essential for understanding nearly everything economists care about. Market prices and quantities, industry revenue, the distribution of income, the effects of tariffs–it all depends on supply and demand.
The usefulness of supply and demand is most obvious in the case of microeconomics, which focuses on households and firms. But it’s just as handy for macroeconomics in studying economy-wide phenomena like growth and business cycles. Let’s use supply and demand to explain inflation, the current hot topic in economics.
As the great Milton Friedman taught us, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” This quote is, unfortunately, the source of much confusion. Usually it’s cherry-picked and truncated to make it seem like inflation is solely caused by easy money. That’s not what Friedman meant. His was a crucial point about using supply and demand to understand money.
Let’s start with the money supply. This one’s pretty easy. First there’s the monetary base, which consists of currency outstanding plus commercial bank deposits held at the Federal Reserve. The Fed can make the monetary base whatever it wants. In addition, there are broader measures of the money supply. Checking accounts, travelers checks, savings accounts, time deposits, and money market mutual funds are all “near monies” included in more expansive money supply categories. Unlike the monetary base, the Fed doesn’t directly control the supply of near monies. Those are determined by profit-seeking firms in the banking system.
Now let’s try to understand money demand. This does not mean “how much money people want.” All of us want more money! Instead, money demand refers to portfolio choice: How much wealth do people choose to keep in liquid form? When money demand increases, the public wants to hold relatively more high-liquidity, low-yield assets.
The price of money depends on supply and demand, the same as other goods. When the supply of apples goes up faster than demand, the price of apples falls. Likewise, when the supply of money goes up faster than the demand for money, its price falls. Money’s price means its purchasing power: the goods and services a given amount of money can buy.
Economists usually proxy the price of money, and hence its purchasing power, by using a price index. Popular examples include the Consumer Price Index and the Personal Consumption Expenditures Price Index. These indexes track the prices of baskets of goods. If the dollar-price of the basket is higher, the number of baskets that can be purchased with a dollar is lower. A higher price level, in other words, corresponds to lower purchasing power.
Inflation refers to an increase in the price level and, correspondingly, a decrease in the purchasing power of money. Does that mean inflation results from the money supply’s growing faster than money demand? All else being equal, yes. But often all else isn’t equal. Remember Friedman’s quote: excess money growth is only one half of the story. We also need to talk about what’s going on in markets for the stuff on which we spend money. As money becomes more abundant relative to goods, money gets cheaper, and hence goods more expensive. Real productivity–how good we are at making cars and laptops and airplanes and Hawaiian vacations and countless other things–affects how far the cash in our wallets goes, as well.
As you can see, it’s supply and demand all the way down. Supply and demand obviously matter for determining the allocation of inputs like capital and labor, and hence productivity. Less obviously, they also matter for macroeconomics. You can’t understand the market for cash balances without using supply and demand. Bringing it all together, the markets for money and goods jointly determine inflation.
You don’t need to have a degree in economics to understand this. Economics, as a discipline, is very accommodating to the proverbial “intelligent layman.” Just make sure you come to the table with a sound understanding of supply and demand.
This article, Supply and Demand Is Not Just for Microeconomics, was originally published by the American Institute for Economic Research and appears here with permission. Please support their efforts.