How Liquidity Affects Changes In Prices — Including Stock Prices

In a market economy, a major service that money provides is that of the medium of exchange. Producers exchange their goods for money and then exchange money for other goods. As production of goods and services increases, this results in a greater demand for the services of the medium of exchange (the service that money provides). Conversely, as economic activity slows down the demand for the services of money follows suit.

The demand for the services of the medium of exchange is also affected by changes in prices. An increase in the prices of goods and services leads to an increase in the demand for the medium of exchange.

People now demand more money to facilitate more expensive goods and services. A fall in the prices of goods and services results in a decline in the demand for the medium of exchange.

Now, take the example where an increase in the supply of money for a given state of economic activity has taken place. Since there was not any change in the demand for the services of the medium of exchange this means that people now have a surplus of money or an increase in monetary liquidity.

Obviously, no individual wants to hold more money than is required. An individual can get rid of surplus cash by exchanging the money for goods. Individuals as a group however cannot get rid of the surplus of money just like that. They can only shift money from one individual to another individual.

The mechanism that generates the elimination of the surplus of cash is the increase in the prices of goods. Once individuals start to employ the surplus cash in acquiring goods this pushes prices higher.

As a result, the demand for the services of money increases. All this in turn works towards the elimination of the monetary surplus.

Once money enters a particular market, this means that more money is now paid for a product in that market. Alternatively, we can say that the price of a good in this market has now gone up. (Note that a price is the number of dollars per unit of something).

1 2 3 4
View single page >> |

Mises Institute is a tax-exempt 501(c)(3) nonprofit organization. Contributions are tax-deductible to the full extent the law allows. Tax ID# 52-1263436

How did you like this article? Let us know so we can better customize your reading experience. Users' ratings are only visible to themselves.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.