Sunday, January 19, 2014

Supply Constrained versus Demand Constrained Products, versus Money Supply

A change-in-money-supply is a tool used in economic theory to accomplish the goals of economist. A criticism of this tool is that the effects of money supply change are not as predictable as theory would suggest.  In this post we will look at the interaction between products and money supply to gain a better understanding of possible interactions.

We will begin by considering the limits of product availability and then consider money supply variation.

Supply Limited Products
Suppose that we have a potato shortage.  The price of potatoes increases. Suppose next that pity is shown on one person who can not afford to buy potatoes at the increased price and this person receives a money gift.  The lucky person now purchases potatoes BUT now another person is discovered who can not buy potatoes!  The gift of money has only shifted the identity of the persons unable to buy potatoes!  More money does not create more potatoes!

The potato shortage story is a description of a supply limited product.

Demand Limited Products
Products are limited by demand when supply is unlimited.  Cordless power drills in modern America are available in at least 10 different brands. They are differentiated by color, strength, durability, etc, and PRICE.  It is hard to imagine that everyone would rush to buy a cordless power drill if the price fell to zero but clearly, price is a differentiation criteria.

We next suppose that we observe a person unable to buy even the lowest price cordless power drill, decide to take pity on him, and give him a gift of money.  He now can buy a cordless power drill and would take the next step of selection which would be to choose between the lowest priced drill and second lowest priced drill.  Presumably the second lowest priced drill would not be a single choice but a choice between color, strength, durability, etc, in a multivariate supply.  One person buying a drill certainly would NOT set up conditions that would prevent another from buying a cordless power drill. It is logical to assume that the purchase of one drill would create the need (opportunity) to build a replacement drill.

The cordless-power-drill story is a description of a demand limited product.

These two examples of products at opposite-ends-of-the-supply-curve can be used to predict what might happen in a generous economy that decides to give money to people.

Money Supply Generosity
A generous economy may look to see that many people are unable to purchase as much as most and then attempt to correct the imbalance with government action. An easily prescribed method is to give money to the people in need.  This action would increase the buying power of the needy but would also raise the question of where the money came from.  We will first examine how more money in the hands of the needy would affect the product mix of the economy.

Assume that more money from some source is placed in the hands of needy persons. For products in limited supply, the inability to purchase would shift from the needy to the new-needy.  The formerly needy persons would now have enough money to buy but that shift would force formerly not-needy persons into the needy category.

For demand limited products,  additional money in the hands of the needy should increase demand and create the opportunity of producing replacement product. The additional demand should increase employment.

Where Could Money-for-generosity Come From?
Additional money for government generosity could come from three sources:
1. Taxes
2. Borrowing from private money holders.
3. Never-to-be-repaid government borrowing from government agencies

Taxes would be a forced, permanent shift of buying power from people-who-have-money to those-who-do-not-have-money.

Borrowing from private money holders requires that the private money holders first have money.  Borrowing from them would would delay their spending on personal consumption and would not diminish their wealth.  A case can be made that borrowing from private money holders could perpetuate the system that enabled initial accumulation of wealth, and could result in an increase in lender's wealth.

Never-to-be-repaid government borrowing from government agencies would be an increase in the permanent money supply of the economy.  The persons first receiving the newly created money would have increased buying power, allowing them to purchase on terms identically available to those people already holding money. The final holders of the newly created money would be capital accumulators expected to hold the funds for investment for long periods of time.

The Long Term Effect of Generosity
The reader should notice that government generosity to one person has an effect on others in every description.  Need may be shifted, the opportunity for employment increased, wealth transferred, or wealth increased. Government generosity is never neutral; some people will gain much more than others.

Government generosity is not limited to needy people.  Government generosity can be extended to paradigms where government pays employees generous wages, undertakes generous projects, extends generous foreign aid, and generously contributes to cultural interest such as art and science.

When some people or supply chains gain more than others from government action, political divisions arise.  The politics of taxes are much easier to predict and understand than are the politics of money supply change.  Money supply change by private-sourced-borrowing is easier to understand than money supply change by borrowing-from-government-agencies.  This post will not attempt to analyze either source of money supply expansion.

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