Did you know that there is a supply and demand for money itself – just like any other good or service? Money is an economic good, which means that it is scarce. It even has its own “price.” In the last post on inflation, we discussed how an increase in the quantity of money in circulation in the economy decreases its value – in other words, decreases its price.
Below is a supply and demand graph for money. The current market price (i1) of a given quantity of money (Q1) is determined at the point where the supply and demand curves intersect. An increase in the supply of money is represented by shifting the supply curve to the right from S1 to S2. This rightward shift causes the price of money to then decrease from i1 to i2.
The “i” represents the interest rate. Why is the price of money being represented by the “interest rate” on the graph? Most of the time, when economists refer to the supply and demand for money, they are referring to the supply and demand for short-term loans specifically. The “interest rate” can be thought of as the price for procuring short-term loans.
To understand this further, one can think of the value, or the price, of money as the opportunity cost of holding money. What is opportunity cost? Think about the fact that with every choice you make to spend your money, you’re giving up a million other opportunities to spend your money elsewhere. The opportunity cost of any given choice you make is simply the cost of the next best alternative that you could have taken but have now foregone in making your actual choice. So what is the opportunity cost of holding cash? It is the amount of money you could have earned if you’d used that cash to purchase an interest-earning financial instrument, such as a bond. That amount of money you could have earned is measured by the interest rate. Most often when economists refer to the supply and demand for money, the price of money is the interest rate.
However, a 19th century economist by the name of Ludwig von Mises described the price of money as something altogether broader and more general than the interest rate. Mises described the price of money as its purchasing power. Purchasing power can be thought of as the exchange ratio between money and the actual, consumable goods and services that money buys. Part of Mises’ point is that the shifts in supply and demand of money itself, in whatever medium it exists, are natural. This is a broader concept than the specific phenomenon of inflation created by governments increasing the amount of money in circulation. His fundamental point encourages us to first gain an understanding of the “market” for money, much like you’d endeavor to understand the market for any other good or service. There are many other nuances to the market for money, such as the fact that changes in the price of money do not uniformly or proportionally change prices (‘non-neutrality of money’), or the fact that the term “inflation” itself is a misnomer based on the fallacy of the neutrality of money. But we will stop here.
We’ve established in the last two posts that inflation is an increase in the money supply, which results in a decrease in the price (purchasing power, or more specifically, the interest rate) of money, and an increase in the prices of goods. The price of money goes down, and the actual, observable prices of goods go up – the effects of inflation.
So, why do we often observe interest rates actually increasing when inflation is happening in the real world? As with observing the supply and demand of any good in the real world, there are many other variables at play. The supply and demand graph above is showing the relationship between supply, demand, and price holding all other variables constant. Why? To allow the relationship between individual changes in supply or demand, and the price, to be isolated and understood. But what we actually observe is that the interest rate itself is affected by the inflation. Therefore, it may increase to reflect the fact that the dollar is now worth less. Before including the effects of inflation, the real interest rate declines. The interest rate that we observe as increasing is the nominal interest rate, after taking the inflation rate into account.
We can see this playing out in the real world, not only in the U.S., but in Turkey. A recent WSJ article explains that pandemic-induced inflation has been especially high in Turkey, at more than 21%. To make matters worse, Turkish President Erdogan is forcing the central bank to decrease interest rates:
“The Turkish lira has lost as much as 45% of its value this year, making ordinary Turks poorer. The pandemic-era consumer-price increases that have plagued economies across the world are supersize in Turkey, where inflation stands at more than 21%. People here are rushing to trade their shrinking wages for dollars and gold, are eating out less and are having more trouble finding imported goods, including medicine…Mr. Erdogan has successfully pressured the central bank to slash interest rates despite rapid inflation. Normally, central banks raise rates to encourage saving, discourage borrowing and cool off inflation. But Mr. Erdogan has called for lower interest rates and blamed rising costs on foreign interests.”
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