Why the Stock of Money Fell
WE TURN NOW to the central issue of this inquiry: Did the stock of money fall because of a fall in the supply or a fall in the demand? This question, of course, is an example of the classic identification problem. For the reasons outlined in Chapter II, the usual econometric methods for dealing with this problem are not appropriate here. While the need for theory to resolve the identification problem is unabated, the theory used here concerns the adjustment mechanism of the economy, not some aspect of comparative statics. Accordingly, we begin our discussion with a brief review of the way in which autonomous changes in the money supply are thought to affect the economy.
Assume that individuals and firms in the economy are content with the stocks of assets, financial and real, that they own. Let the supply of money increase for exogenous reasons--which may or may not be reasons of aggregate economic policy. Then there will be an over- supply of the asset called money; there will be more money in the economy than people want to hold at the prevailing prices. People will attempt to get rid of some of their money holdings. They will "sell" money, that is, they will buy other things with money, and the increase in the demand for these other things will raise their prices. If the other things are assets with a fixed return, this will lower the ratio of their return to their price, also known as their rate of return or their "own rate of interest."
This reaction to a change in the supply of money is known as the