Purchasing Power

Money that is saved does not vanish into thin air. It is lent out by banks and other financial institutions, being spent by different people for different purposes, but still remaining just as much a part of purchasing power as if it had never been saved. According to Say’s Law— supply creates its own demand. What a group of French economists known as Physiocrats showed in the late eighteenth century was that the production of goods and services automatically generates the purchasing power needed to buy those goods and services. When the economy creates another hundred million dollars worth of output, that is also another hundred million dollars worth of wealth that can be used to buy this or other output. Production is ultimately bought with other production, using money as a convenience to facilitate the transactions. During the Great Depression of the 1930s, for example, there was a massive increase of unemployment, along with business losses for the economy as a whole. The greatly reduced money supply of 1932 was incapable of buying the amount of output that had been produced during the boom years that ended in 1929. More precisely, the 1932 money supply was incapable of buying the 1929 level of output at 1929 prices. Prices began declining as a result of unsold goods, but prices did not fall fast enough or far enough to restore immediately the full production needed to create a full employment. Major malfunctions of the monetary system, including both massive bank failures and counterproductive policies by the Federal Reserve Board, as well as restrictive tariffs that disrupted international trade, and amateurish tinkering with the economy by both the Hoover and Roosevelt administrations, turned a problem catastrophe. John Maynard Keynes argued that government spending could put more money back into circulation and restore the economy to full employment faster than by waiting for prices to fall into balance with the reduced amount of money in circulation. But Keynes never claimed that the economy had just produced too much. President Herbert Hoover and then Franklin D. Roosevelt both tried to keep wage rates from falling, as a means of maintaining the purchasing power of workers, as well as for humanitarian reasons. But there was no way to keep employing the same number of workers as before, at the same wage rates as before, when the money supply was onethird smaller. Prices had to come down in the economy as a whole if everything was to be purchased with a smaller money supply. Some economists, including Nobel Prize winner Milton Friedman, have argued that it was precisely government policies that kept the economy from recovering as quickly as it had before, when left alone.