Does keeping the nominal quantity of money stable in the face of an increase in the demand for money protect against distortions in relative prices? Does an increase in the quantity of money that accomodates an increase in the demand to hold money cause more disruption to the market economy than simply allowing lower prices for those goods whose demand falls?
A simple numerical example shows that the "deflationist" argument ignores the real balance effect and fails to account for the addititional burden placed on the market order needed to generate that real balance effect.
There are five equally sized industries, A through E ,making up a $15 trillion dollar economy. The quantity of money is $1.5 trillion. The demand for money rises 20%, or $300 billion. Those choosing to accumulate money reduce their expenditures on the products of industry A, so that the demand for the products of that industry (the flow of money expenditures) falls from $3 trillion to $2.7 trillion.
Under the first monetary institution, the nominal quantity of money rises by 20%, or $300 billion. The money is all spent on the products of industry E, causing the demand to rise from $3 trillion to $3.3 trillion. Total demands for industries B, C, and D are all unchanged, remaining $3 trillion each, adding up to $9 trillion. The demand for the products of industry A is $2.7 trillion, and the demand for the products of industry E is $3.3 trillion. Total money expenditures on output remains $15 trillion. A market signal is given for industry A to contract and for industry E to expand. The money and real demand for the products of industry A decreased by 10 percent. The money and real demand for the products of industry E have increased by 10 percent.
Under the second monetary institution, the nominal quanity of money remains $1.5 trillion. The price level falls by approximately 17%, so that the real quantity of money rises 20%. The lower price level implies that money expenditures and incomes in the economy need to fall to approximately $12.5 trillion in order for real expenditure to remain the same.
Again, money expenditures in industry A falls $300 billion as before to $2.7 trillion, but because of the lower price level, there is an additional 17 percent decrease to $2.25 trillion. Suppose industries B through E each have a 17 percent decrease in money expenditures, or 500 billion each, so that each are $2.5 trillion. Total money expenditures are then $12.25 trillion. But that is $250 billion less than the $12.5 trillion that reflects the 17 percent decrease in the equilibrium price level. Real expenditures appear to have decreased by $250 billion.
Fortunately, this ignores the real capital gain of those who initially held the $1.5 trillion. The 17 percent decrease in the price level creates a $250 billion real capital gain. It is that real capital gain from holding money that forms the real balance effect. Expenditure of that real capital gain is what causes real expenditure to return to equilibrium.
Suppose those receiving this capital gain increase expenditures on the products of industry D. The result is a decrease in money expenditures in every industry. Money expenditures fall $500 billion in industries B, C, and E. Money expenditures fall $750 billion in industry A. Money expenditures fall $250 billion in industry D. Real demand is unchanged in industry B, C, and E. Real demand in industry A has fallen 10 percent. The real demand in industry D has risen by 10 percent.
The problem with this monetary insitution is that each and every industry is given a market signal to contract. Industry A, B, C, D and E can only sell a smaller volume of goods at current market prices. For industry A, the signal is at least in the right direction. The real demand for its product has fallen and it should contract production. Of course, the 25 percent decrease in money expenditures on its product (from $300 billion to $225 billion) is excessive when the real demand has only dropped 10 percent. More troubling, the real demands for the products of industries B, C, and E are unchanged, yet all of them received the same type of market signal as industry A, less money expenditures and a smaller volume of sales at current prices. Any reduction in output is inappropriate. But most troubling, industry D, which has a 10 percent increase in real demand, also receives a signal that it should contract output. Money demand for its product falls by a bit more than 8 percent, and the amount that can be sold at current prices falls, when the industry should be expanding output.
In the typical market economy the result of all those industries facing lower demand will be reduced production and lower demand for resources, especially labor. The resulting surpluses of those resources results in lower prices for them, including wages. From the point of view of industies A, B, C, D, and E, these are lower costs. As costs fall, Industry D, facing the smallest decrease in demand returns to profitability first and so finally expands production in a way consistent with the increase in real demand. Industries B, C, and E, whose real demand is unchanged, return to profitability next, and output recovers consistent with the intital level. Industry A, with the reduced real demand, may recover to some degree, but its volume of output remains lower, reflecting its reduced real demand. In the end, resources shift from industry A to industry D. Of course, what should have happened is that industry B, C, and E should have had unchanged output, industry D should have expanded from the beginning, and only industry A should have contracted, but only 10 percent, not as much as 25 percent.
This thought experiment was a one time 20 percent increase in the demand to hold money. Once this is accomplished, it is possible, even likely, that the demand for the products of industry A will recover and the demand for industry E (for the first monetary institution) and industry D (for the second monetary institution) will fall back to their previous levels. Since short run elasticities of supply are typically low, the expansion of output in industry E might be limited. Further, if this temporary increase in demand is misperceived as being permanent, firms might make investments in specific capital goods that will be lost. However, this same situation would face industry D with the second monetary institution, which benefits from the real capital gains as the price level falls. Its initial return to profitability as costs fall more than demand may result in malinvestment if the temporary increase in real demand was wrongly perceived as permanent.
In conclusion, the notion that a lower price level necessarily allows for an adjustment of the real quantity of money to an increase in the demand to hold money without any increase in relative demands for particular goods is false. The notion comes from a failure to account for the real balance effect, which is necessary for real expenditures to recover. Further, it is clear that industries with no change in real demands suffer reductions in money expenditures, which are easily misperceived as reductions in real demand. Even industries with increasing real demand can suffer reduced money expenditures demand, resulting in the exact wrong signal.