Cash Balance Theory of the Business Cycle

Conventional macroeconomics teaches us that recessions are caused by deficiencies in aggregate demand for goods and services. Austro-monetarist economist Leland Yeager believes that the real focus of the causes of recessions lie in the supply and demand for money. His thesis is simple: recessions are caused when the market of money is at a disequilibrium due to an excess demand for money. Or in simpler terms, “people want to hold more money than exists” (The Fluttering Veil pg.3)

Many misinterpret the supply and demand graph as a static figure where the supply curve meets the demand curve at some fixed point. But the fact of the matter is the real quantity of money that people would like to hold in equilibrium is constantly shifting. As Dwight Lee explains:

The equilibrium price … is typically presented as the most important feature of demand and supply analysis. But seldom do real-world markets ever get to equilibrium. The world is constantly changing, and demand and supply curves constantly shift. Equilibrium is a moving target.

Now add into the fact the nominal rigidity of prices, or more commonly known as the “stickiness” of prices. This means that it takes time for prices to fix themselves.

Take for instance an economy currently at equilibrium with a fixed quantity of money and “sticky” prices. Subsequently, a significant amount of people now want to increase their cash balances i.e., hold onto more money:

When people don’t have enough money that they would like to have then they will attempt to increase it by the two most common ways possible. Either they decrease their expenditures by spending less or they’ll try get higher wages to increase their income. Since there’s only a fixed quantity of money, if one person decides to hold higher more money than previously, everyone must therefore have to have less money than previously as well. Hence”once man’s spending is another man’s income.” Prices are fixed, so this is also true for the real quantity of money.

When someone reduces their spending they’re also decreasing everyone else’s income. The negative consequence of this is that, unless everyone else wants to have less money than before, they now have less money than they would desire. And because of that they too will try to increase their cash balance holdings back to where it was previously. This causes a self inflicting spiral as less people begin to cut back on their spending resulting in a declining aggregate spending and subsequently incomes. The chaos finally ends when people either reach a point where they’ll no longer reduce their spending to get higher cash balances.

For any ordinary commodity, there is some price at which the amounts demanded and supplied would be equal. And so with money: there is some value of the money unit that would equate the amounts demanded and supplied. But -again as is true of any ordinary commodity- the equilibrium value at one particular time might be a disequilibrium value later. Supply and demand schedules are always shifting.

Since the prices of many goods and services are notoriously “sticky,” the value of money does not adjust readily enough to keep the amounts of money supplied and demanded always equal as schedules shift. The value of money is often “wrong.” Depression is such a disequilibrium: given the existing levels of prices, wages, and interest rates, people are on balance more eager to get money by selling goods and labor than to give up money in buying goods and labor. (ibid pg.7)

Two things determine how long this cycle will ensue. For one, the amount of money that people want to hold is positively correlated to how much they expect to spend, so if they are expecting to reducing their spending then they will have to hold onto less money. And secondly, as spending falls, those decreases become more and more agonizing, and so people will become more reluctant to give up consumption for greater cash balances.

This process reduces the real quantity of market transactions below it’s equilibrium level to a disequilibrium. The market is corrected once people have the higher real cash balances they demand by having prices readjusted to the new equilibrium.

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Published by

Manu Belmonte

Senior Editor at The Credible Hulk Magazine and writer at my personal blog learninghayek.wordpress.com

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