Demand to hold money

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    Professor Herbener, I was hoping you could shed some light on a hypothetical situation that I haven’t been able to fully grasp. Say we start with an evenly rotating economy in a free market. For some reason there is a relatively sudden unanticipated increase in the societal demand to hold money with no change in societal time preference. During the transition to a new evenly rotating economy (with a higher purchasing power of money and the same interest rate as before, correct?) what will happen to the production structure? It seems to me that the production structure that exists after the shift will be very similar to that which existed before with the same products being produced in the same amounts and the same real gross investment. But during the transition wouldn’t many firms go out of business/declare bankruptcy/liquidate due to the sudden reduction in demand for goods? Would this shake-up affect lower and higher stage producers equally? Would this lead to a drop in GDP and higher than normal unemployment while the production structure adapts? Thanks again.


    Your scenario raises several interesting issues.

    First, the transition from one pattern of demand for things to a different pattern will depend precisely on the extent to which entrepreneurs anticipate the new pattern. In the Austrian approach, we adhere to the realistic view that entrepreneurs have the incentive of earning profit and avoiding loss in making accurate predictions of the future, that entrepreneurs with superior foresight gain command over resources and entrepreneurs with inferior foresight lose command over resources, and that there exists a spectrum of foresight among entrepreneurs from less to more accurate. The transition in the real world from a state of lower demand for money to a state of higher demand for money can neither assume perfectly accurate anticipation nor perfectly inaccurate anticipation on the part of entrepreneurs.

    Second, because the capital structure is an integrated system of production, continuously changing demand for some goods leads to changing demands for other goods across the entire capital structure. The effects of changes in demand for money, in this respect, are not different than the effects of changes in demand for other goods.

    Third, the transition depends on the money production system in the economy. If the economy has a market monetary system, then as the PPM rises from the increased demand for money the production of money would increase, which moderates the rise in the PPM.

    Given these points, let’s suppose that demand for money increases to a new higher level but time preferences stay the same. Entrepreneurs with inferior foresight will see their profits cut and maybe suffer losses. Entrepreneurs with superior foresight will maintain their profits. Those with less profit or losses will not need to immediately reduce production. All entrepreneurs hold equity as a buffer against their inability to forecast accurately every contingency. During the period of drawing down their equity, they revise their expectations. If they perceive, as those with superior foresight have already done, that their demands for inputs must fall in the wake of the reduced demand for their output, then input prices will fall and restore their net income. Even if entrepreneurs are duller in formulating more accurate expectations, the fact that demand for their outputs have fallen reduces their revenues which requires them to reduce their demand for inputs. Their reduced demand for inputs causes input prices to drop which restores the net income of production.

    Only if the price spread between input prices and output prices were systematically and generally altered would the transition affect the length of the capital structure (instead of merely reconfiguring the composition of production within the capital structure. If the increased demand for money caused the spread between output prices and input prices to shrink, then the capital structure might be lengthened out because the interest rate in production would have fallen. Conversely, if the spread between output and input prices increased, then the capital structure might be shortened. In either case, the capital structure would return over time to that dictated by time preferences.

    As to the composition of production within the capital structure, an increase in the demand for money would shift resources out of the production of some goods and into the production of money (given a market monetary system as noted above.) More generally, production would shift away from areas of lower relative demand and toward areas of higher relative demand. This is the same process going on continuously in the market economy as people shift their demands away from some goods and toward other goods.

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