Sunday, June 22, 2014

Understanding the Price Level

When I teach Austrian economics, I spend a lot of time explaining the three uses of money--holding, spending, and investing--and how only spending and investing affect the overall price level.  This helps my students understand that the total money supply can go up and prices remain stable or actually fall, if all the increase in the money supply goes into the holding portion.  On page 505 of his magnum opus Capitalism, George Reisman explains that the price level is determined by total spending in society divided by total production of goods actually sold in society.  So the spending part of his simple equation is composed of the final two uses of money--spending and investing.  His formula also helps explain the phenomenon of falling prices when total spending goes up, which can occur when there are revolutions in production, such as happened in America in the 1920s.  Furthermore, his formula helps explain an important consequence of malinvestment; i.e., that a society can produce things that no one wants to buy and that this production will not enter into the formula. Yet people were paid and create spending.  So the numerator goes up and the denominator stays the same or may actually fall, causing the overall price level to rise.

Understanding this is very important and not all that hard.  By the way, Reisman's book can be downloaded for free from his website:

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