If x amount of money were introduced (discretly, with no one noticing) to the market, how does the market “know” that that amount of money has been introduced (thus adjusting prices)?

Question

If x amount of money were introduced (discretly, with no one noticing) to the market, how does the market “know” that that amount of money has been introduced (thus adjusting prices)?

In: Economics

Answer 1

It only “knows” when the money is spent.

Imagine a really simple economy – Alice, Bob and Chuck. Alice bakes two loaves of bread every day, and Bob and Chuck both earn $1 per day, which they each use to buy a loaf of bread.

Now, one day (as if by magic) Bob and Chuck both get $2 per day instead of one. Bob gets to Alice first, and buys both loaves of bread for $1 a piece, spending his full $2. Now Chuck is upset because he has money, but no bread. Supply and demand are out of sync – at the price of $1 per loaf, there is more demand than there is supply.

Alice has two choices:

– Bake 4 loaves instead of 2, and keep charging $1 to extract all $4 from the economy

– Charge $2 per loaf instead of $1, extracting all $4 from the economy

Alice, being a smart baker, decides just to raise prices.