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Friday, February 01, 2013

Supply Is Demand, Just from a Different Viewpoint

Let us imagine a place were oranges are the medium of exchange. Then, when we draw a supply and demand diagram for bananas, the price in oranges goes on the vertical axis and the quantity supplied of bananas on the horizontal one. (If you don't know where this is leading, it is worth drawing this.) The demand curve for bananas slopes downward, and the supply curve upwards, just as though the medium of exchange was dollars.

But imagine that tomorrow, people decide bananas make a better medium of exchange. This will reverse our axes: the price in bananas now goes on the vertical axis, and the quantity supplied of oranges on the horizontal one. (Again, you might want to do this.) And now it ought to be clear: the supply curve for bananas in the first diagram just was the demand curve of banana buyers for oranges. And the demand curve for bananas was the orange producers' supply curve, in so far as they were supplying in order to get oranges.

Making the medium of exchange gold or U.S. dollars does not change this analysis at all: The supply curve for, say, steel, just is the steel producers demand curve for dollars, at least so far as they intend to acquire them by producing steel. (If we imagine their only choices are producing steel or taking leisure, then the steel supply curve is their dollar demand curve simpliciter.)

UPDATE: Nick Rowe in the comments points out the last sentence is wrong: Even if the steelmakers were an untouchable cast allowed to produce only steel, they still have another way to express their demand for money: by buying fewer other goods. And that is surely important, as it introduced the possibility of a general glut.

7 comments:

  1. I think this is right, but isn't this just Say's point? And did you have a problem with it, back then? I can't remember. Anyway, I think Nick Rowe might disagree with you here. He does funny stuff with these kinds of examples, but I am too lazy to read his posts all the way through.

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  2. Gene: let me restate what you should be saying:

    In a 2-good economy, apples and bananas, the supply of apples (as a function of the relative price of apples to bananas) is the very same thing as the demand for bananas. And the supply of bananas is the very same thing as the demand for apples.

    You have rediscovered Walras' Law.

    If apples are the unit/medium of *account*, then we would want to put the price of bananas (in terms of apples) on the vertical axis, and call the two curves "the supply and demand curves for bananas". If instead bananas were the unit/medium of account, then we would instead want to put the price of bananas on the vertical axis, and call the two curves "the supply and demand curves for apples". But it's the same picture in both cases, just drawn upside-down.

    But that has nothing to do with which good is the medium of *exchange*. And it makes no sense to talk about media of exchange in a 2-good economy anyway. You need 3 goods before you can say whether there's a medium of exchange. (If apples are traded for oranges, and bananas are traded for oranges, but apples are not traded for bananas, then oranges are the medium of exchange.)

    And Walras' Law fails to hold in a monetary exchange economy. I've done a number of posts on this, but this is probably my best:
    http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/04/walras-law-vs-monetary-disequilibrium-theory.html

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    Replies
    1. "In a 2-good economy, apples and bananas..."

      Wow, I even made a mistake by choosing oranges? :-)

      "You have rediscovered Walras' Law."

      I knew what I was writing here wasn't original! What I am working on is exposition. And in any case, the way you explain Walras's Law in the link below, this hardly seems to be the same thing! It is an insight that can lead one to state Walras's Law, but it is not Walras's Law.

      "But that has nothing to do with which good is the medium of *exchange*. And it makes no sense to talk about media of exchange in a 2-good economy anyway."

      Hmm, yes, well, the textbook I'm using is going to define money as the medium of exchange, and make its other services subsidiary. If you were teaching freshmen, do you think the "unit of account" / "medium of exchange" issue is important enough to stress it in this context?

      "And Walras' Law fails to hold in a monetary exchange economy."

      OK, but the fact that steel producers demand for money is their supply of steel, IF they are restricted to producing steel for money for some reason, still does hold in a monetary economy. More evidence that what I am saying here is related to, but not identical to, Walras's Law.

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    2. Read your post. What I am getting at above is this: "The value of the excess demand (supply) for the non-money good must equal the excess supply (demand) for money in that market."

      So the above is not Walras's Law. It is a step on the way to Walras's Law, true, but it still holds in a monetary economy.

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    3. O, wait, I get your point: even if the steel producers can only produce steel, they can still try to meet their demand for money by buying fewer other goods. Good point. Update coming.

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    4. Gene: Yep. I think we are now on the same page.

      I find this stuff to be one of the hardest things in economics to keep my head straight about.

      If there are n goods, including money, there are n-1 different demands/supplies of money. Because money is bought/sold in all n-1 markets. Each of the other n-1 goods has only one market, and one demand/supply.

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    5. I used to use apples and oranges. But it always confused my students, because the letter O looks like the number 0. Did Po mean the price of oranges or the price at time 0? So I switched from oranges to bananas.

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