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Curiosity 9.1: Does Excess Money Really Affect Spending?
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Excess money can affect spending
directly,
as we have claimed in this chapter, or
indirectly
as will be explained in the next chapter when we examine the role of the interest rate. The following example of how an excess demand for money can directly decrease spending is informative. In the early 1970s in Washington, D.C., a baby-sitting co-op club was formed in which parents baby-sat for club members and in turn could call on club members to baby-sit for them. The club began by giving each member several units of scrip, each worth one hour of baby-sitting time. This scrip served as the medium of exchange for baby-sitting services, thus playing the role of money in this baby-sitting economy.
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The club was successful and grew, but then began to experience a mysterious decline in baby-sitting activity, but not because club members were unwilling to baby-sit. On the contrary, members very much wanted to baby-sit to obtain scrip to use to buy baby-sitting from other club members. The problem was that although everyone claimed to want to buy baby-sitting services, very few were actually buying. All of the available scrip was being held by club members for emergency baby-sitting needs, with no extra scrip left over for members to use to buy normal baby-sitting services. Everyone wanted to baby-sit to earn scrip to buy baby-sitting services, but no one could collect any scrip to spend because everyone else was also trying to accumulate scrip by not buying.
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This baby-sitting economy was in a recession caused by a low demand for baby-sitting services, which was in turn caused by an inadequate supply of scrip. The club's growth had increased the demand for scrip, and without an equal increase in scrip supply, an excess demand for scrip developed. To accumulate scrip, members cut down on baby-sitting demand, creating the problem described. To an economist, the obvious solution is to increase the supply of scrip (money). This action was taken, and the baby-sitting club revived.
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tiplier should not be confused with the money multiplier, described in the preceding chapter (and assumed to be 3 in this example), or with "the" multiplier (the income multiplier with respect to government or other exogenous spending, assumed to be 2 in this example).
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The essence of the story presented in figure 9.1 is that an increase in the money supply causes changes in the economy that increase the demand for money to equal the now higher supply of money. In the new equilibrium, the change in the demand for money must equal the change in the supply of money. In the modern quantity theory the demand for money is given by (1/
v
)
PQ,
so there are three possible sources of change in demand for money—namely, changes in
v, P,
and
Q.
The preceding exposition assumed that
v
and
P
were constant so that a change in
M
elicited an equal percentage change in real income
Q.
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If the economy is at full employment, real income does not change; instead, the extra money supply causes an increase in the price level. To be specific, if the money supply increases by 8
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