Suppose there is a $15 trillion economy made up of five equally sized industries, a through e. The demand for money rises, and those choosing to hold more money reduce their expenditures on the products of industry a. The output of industry a remains unchanged, and the price of the product of industry A falls in proportion to the reduction in money expenditures. Money expenditures on the products of industries b through e are unchanged, as are their prices and output. The price level has fallen, increasing the real quantity of money. The real quantity of money rises to meet the demand to hold money. There appears to be no decrease in real output. There appears to be no disruption at all to industries b through e. Only industry a, where demand fell due to the increase in money demand, suffers a loss of money expenditures. The price of that product did need to fall enough so that the lower money expenditures will purchase the unchanged quantity of real output. Real output is maintained.
Sounds plausible enough. However, add some numbers. The quantity of money is $1.5 trillion. The demand for money rises 20 percent, or $300 billion. So, expenditures on the product of industry a fall by $300 billion, which is 10 percent decrease in expenditures. The price of the product of industry a falls 10%, leaving the real volume the output of industry a unchanged.
The price level is now 2 percent lower. (That is, a 10 percent price decrease in an industry that makes up 20 percent of the economy.) This increases real balances by slightly more than 2 percent. Since the demand for money rose by 20 percent, there remains a shortage of money. Now, those who reduced their expenditures on the product of industry a, particularly those who provide resources to industries b through e have accumulated more money. As is the usual account of monetary disequilibrium, those in industry a, who are receiving 10 percent less money expenditures reduce their purchases of the products of industries b through e. While the decrease in the demand may initially have been solely for industry a, the rot spreads.
Reduced money expenditures for the products of industries b through e, and perhaps further reductions in money expenditures on the product of industry a, result in lower prices until the price level falls the approximately 17 percent needed for real balances to rise 20 percent. If there has truly been a shift in relative demands, so that industry a shrinks and one or more of the others grow, then such a change will occur as the real capital gain generated by the increase in real balances is expended on the products of various industries.
However, it would be possible for the initial reduction in money expenditures for the product of industry a to result in a decrease in the price of the products of industry a sufficient for the price level to fall the necessary amount. Suppose the income velocity of money is 1.25, and people hold money balances equal to 80% of income. In the example above, if the quantity of money was $12 trillion, the 20 percent increase in money demand would result in a $2.4 trillion decrease in expenditures on the products of industry a. With money expenditures in that industry falling in 80 percent, a proportional decrease in the price level would be 80 precent. With industry a making up 20 percent of the economy, the price level falls 16 percent. This raises real balances approximately 2o percent.
While the scenario of a very low velocity is possible, the notion that a reasonable decrease in the prices of a few products facing lower demand because of an increase in the demand for money will avoid monetary disequilibrium is implausible. The more likely consequences is spreading disequilibrium--difficulty in making sales--solved only by a general deflation of prices.