A Pricing Model
Summary & Conclusion
This page provides a summary of each of the scenarios that appeared separately on previous pages. I have embedded the model in this summary and conclusion page so you can rerun any of the simulations described, or you can vary the parameters using your own criteria.
Summary

I created this model and its simulations to demonstrate the effect that changes in production have on prices in direct exchange and the effect that changes in production and the quantity of money, in combination, have on prices in indirect exchange (specifically using money).

Prices

The model demonstrates the direct exchange prices that result when traders exchange shoes and wheat directly. At the same time it shows the money prices of these two commodities when the goods for goods exchanges occur indirectly using dollars.

The Model - Scenarios

The table below summarizes the results of the simulations that you have walked through in the four different scenarios.

Production & Sales Scenarios

The left-most three columns define the four scenarios used in these simulations. The second two columns indicate the rates of increase for production and sales for the goods listed at the top of those columns.

Money Supply Simulations

The next six columns give the annualized rates of change (during months 11 through 50) for dollar prices for each of the products in the scenario in that row based on the annual money supply rate of increase—defined as Fixed, Inflation, and Deflation (actual rates shown below titles). For example: In the increasing production scenario shoe production and sales increase at a rate of 8.0%/Yr. When money supply inflates at a rate of 7.0%/Yr, dollar prices will decline at a rate of -1.0%/Yr.

Production & Sales Money Supply
  Increase
(Decrease)
Fixed Inflation Deflation
  0.00 0.07 (0.07)
  Shoes Wheat Shoes Wheat Shoes Wheat Shoes Wheat
Fixed 0.0% 0.0% 0.0% 0.0% 7.0% 7.0% (7.0%) (7.0%)
Increasing 8.0% 4.0% (7.9%) (4.0%) (1.0%) 3.0% (14.9%) (11.0%)
Decreasing (8.0%) (4.0%) 8.1% 4.0% 15.1% 11.0% 1.0% (3.0%)
Mixed 8.0% (4.0%) (7.9%) 4.0% (1.0%) 11.0% (14.9%) (3.0%)
Annual rate of price change during months 11 through 50.

You will notice, in this side by side comparison, that with a fixed supply of money the rate of dollar price change equals almost exactly the inverse of the rate of production and sales growth or decline. (Fractional rates do not exactly equal the fractional rate of production increase because of rounding and the effects of compounding.) When the money supply changes (inflation or deflation) the dollar prices no longer give a clear signal as to the relative changes in the supply of the goods.

On the next four tabs I have provided static diagrams of each of the production scenarios showing the resulting dollar prices from the three types of money growth. They depict graphic representation of the information in the table above.

Fixed Production
Fixed Production

The fixed production scenario gives the best indication of the inflation of changes in the quantity of money. When the quantity of money remains the same throughout, dollar prices remain flat. Dollar prices rise (or decline) at the same fractional rate as the fractional rate of increase (decrease) in the quantity of money.

Increasing Production
Increasing Production

In a generally growing economy (production and sales increasing) dollar prices decline at the inverse of approximately the same fractional rate at which their respective production rates increase, when the quantity of money remains fixed. Inflation tends to push dollar prices higher, while deflation tends to push them down.

Decreasing Production
Decreasing Production

When production declines dollar prices tend to rise when the quantity of dollars remain fixed. As with the other production scenarios changes in the quantity of money tend to push prices in the same direction as the direct of the change in the money supply. In some cases, as with wheat dollar prices during deflation, the dollar price can actually run counter to the direction the production and sales would indicate.

Mixed Production
Mixed Production

In a typical economic system the rates of production for some goods increase as the rates of production for other goods decline. Thus, our scenario of mixed production rates presents a more realistic picture of the effects of inflation/deflation.

In the next tab I will give some preliminary comments about inflation and deflation.

Inflation-Deflation

Much of the information about this pricing model parallels the presentation on Inflation and Deflation in the Money and Banking section of this site—as a matter of fact I have borrowed some of the explanations from that presentation. This presentation uses the same model implemented in different software, which operates online. Eventually I will redesign both of these presentations to make a clearer separation.

Before you can understand the effects of inflation/deflation, you must first understand pricing—that explanation would make up the first presentation. Once you understand pricing, you can more easily comprehend the effects of (money) inflation/deflation—the topic of the second presentation. But, for the time being, I have two presentations that overlap.

Within that structure I do feel obliged to add the following comments about inflation/deflation:

The Meaning of Inflation/Deflation

Not "General Price Increase/Decrease"

The "general" money price increase/decrease that many refer to as inflation/deflation amounts to a flawed logic. Without the influence of a change in the supply of money, price movements of individual goods tend to offset each other. Thus, no general money price increase/decrease would occur.

My model, because it focuses on only two products, did not reflect this fully, but in real markets, when the dollar price of one product rises (declines), the dollar prices of one or more other products declines (rises). The likelihood that all production will rise or fall simultaneously remains very small.

For a generalized increase or decrease in money prices to occur requires the influence of a change in the one common denominator: money.

Inflation/Deflation = Changes in the Quantity of Money

Inflation or deflation consist only of changes in the quantity of money in circulation.

Inflation
An increase in quantity of money in circulation.
Deflation
A decrease in quantity of money in circulation.

It's that simple. But those changes have significant impact in the economy.

The Impact of Inflation/Deflation

What happens, then, when the quantity of money increases or decreases?

Contradictory or Confusing Signals

First, changing the quantity of money changes its value per unit (More money—dollars lose value. Less money—dollars gain value.) These changes in value inversely affect the dollar prices of other goods. (More money—prices rise. Less money—prices fall.) These changes in dollar prices caused by changes in the quantity of money distort the dollar price information referred to above.

Uneven Impact

The economy does not feel the effect of inflated dollars evenly. Those who receive these digital dollars first benefit; those who receive them later lose. So, in reality the distorting effect of monetary expansion on dollar prices also acts to distort the relative price relationships between different sectors of the economy.

Inflation & Malinvestment

Remember how rising prices should signal shortages and a need for investment. The uneven impact of inflation (increasing money) causes dollar prices in one sector to rise more than other sectors. This influences investors to put money into that sector hoping to reap rewards for curing what they interpret as a real shortage.

Thus, rational decisions, based on faulty information, lead to malinvestment—investments not justified by real production rates. These malinvestments lead to a boom that must eventually bust.

Boom then bust.

Do you see the relationship to the housing market?

Deflation & Retrenchment

We find a different story on the other side of the equation. Deflation (decreasing money) causes an artificial drop in dollar prices. Declining prices signal adequate (possibly excess) production, thus discouraging additional investment. As we have seen from this example a decline in money prices caused by deflation (decreasing money) may disguise real shortages. This may lead to retrenchment just when the market needs investment.

The generalized decline in dollar prices and the resulting retrenchment, all caused by deflation (decreasing quantity of money), lead people to make the flawed correlation between falling dollar prices and economic decline. That flawed correlation encourages re-inflation, and the cycle starts all over again.

Bust.

A word about general price declines ("deflation")

A dangerous idea persists in many economic circles. That idea says that all general price declines lead to economic decline. Yet, all "deflation" does not have the same cause. Therefore, all general price declines do not have the same effect.

General price declines have three basic causes—monetary contraction, market correction, and economic growth:

Monetary Contraction
Money contraction can cause generalized price declines even in a healthy economy. These price declines send false signals to the market causing the retrenchment described above.
Market Correction
Artificial booms caused by money inflation require correction. These corrections will eventually lead back to a healthy economy.
Economic growth
Widespread productivity improvement—a good thing—will cause general price declines.

Price declines caused by monetary contraction represent the only cause for concern. Other types of price declines indicate positive changes in the market. Implementing monetary expansion to fight "deflation" only lead back to the beginning of another boom-bust cycle.

The message to the interventionists: Keep your hands off the money supply!!

Conclusion

In what some have referred to as "the information age," you should have no difficulty understanding that systems distill an incredible amount of information into single units. The words and colors you see on your screen have been packed into small groups of ones and zeros, then unpacked again for you to see.

Free markets pack immense amounts of information into money prices. If we don't interfere with money prices, they can tell us a lot about what people in the market want and what businesses offer.

In this very simple demonstration I have focused on information about production. Although real markets do not operate as cleanly as this imaginary one, they still convey the same basic information:

  1. when the money prices of one product rise in relation to other products, it means that the relative rates of production for that product have declined,
  2. when the money prices of one product fall in relation to other products, it means that the relative rates of production for that product have increased.

In the case of #1, potential demand tends to exceed supply. Entrepreneurs take that as a signal for profit opportunities and work to increase supply.

In the case of #2, potential supply tends to exceed demand. Entrepreneurs take that as a signal for reduced profit opportunities and look to invest their resources elsewhere.

These simple price signals lead to highly efficient resource allocation.

What to Remember

Money only has value as a medium of indirect exchange. Increasing its quantity adds nothing to economic welfare. So, even moderate inflation, advocated by some, has no economic benefit. And, decreasing the quantity of money subtracts nothing from the economy. The quantity of money, however, does influence dollar prices, which have a vital role conveying economic information.

Dollar prices provide vital signals for effective, efficient, and adaptable decisions by market actors. Any disruption of those signals by artificial changes in the quantity of money (inflation or deflation) causes rational decisions to produce flawed results.

Formulas

For the technicians

I have included the actual formulas included in the model used for this presentation:

Calculated

dollar price of shoes
Value: [dollar shoe transactions]/[shoe sales]
Units: dollars/pair
Note: The dollar price of shoes based on shoe sales and transaction parameters.
dollar price of wheat
Value: [dollar wheat transactions]/[wheat sales]
Units: dollars/bushel
Note: The dollar price of wheat based on shoe sales and transaction parameters.
monthly fractional money increase rate
Value: Pulse([increase start], ([annual fractional money increase rate]/12), [increase duration])
Units: 1/Month
Note: The calculated monthly fractional money increase rate used to calculated the money increase rate.
shoe to wheat price
Value: [shoe sales]/[wheat sales]
Units: pair/bushel
Note: The direct exchange price of a bushel of wheat in terms of pairs of shoes.
shoes to wheat dollars
Value: [dollar price of wheat]/[dollar price of shoes]
Units: pair/bushel
Note: Converts the dollar price of shoes to a wheat price for shoes. Done for the curious to assure the calculations reconcile.
wheat to shoe price
Value: [wheat sales]/[shoe sales]
Units: bushel/pair
Note: ​The direct exchange price of a pair of shoes in terms of bushels of wheat.
wheat to shoes dollars
Value: [dollar price of shoes]/[dollar price of wheat]
Units: bushel/pair
Note: ​Converts the dollar price of wheat to a shoe price for wheat. Done for the curious to assure the calculations reconcile.

Model Stocks

Money
Initial Value: 10000
Units: Dollars
Note: The current quantity of money after cumulative increases or (decreases).
Shoes
Initial Value: 200
Units: pair
Note: The current inventory of shoes, based on production less sales with a beginning inventory of 200 pairs.
Wheat
Initial Value: 1000
Units: bushel
Note: ​The current inventory of wheat, based on production less sales with a beginning inventory of 1,000 bushels.

Model Flows

money increase rate
Rate: [Money]*[monthly fractional money increase rate]
Units: Dollars/Month
Note: The rate at which the quantity of money increases monthly.
shoe production
Rate: [base shoe production]*((1+([annual fractional shoe increase]/12))^Months)
Units: pair/Month
Note: The monthly rate at which the system produces shoes. Calculated from a base rate and annualized fractional rate.
shoe sales
Rate: [shoe production]*[fractional shoe sales rate]
Units: pair/Month
Note: The monthly rate of shoe sales. Based on a fraction of production.
wheat production
Rate: [base wheat production]*((1+([annual fractional wheat increase]/12))^Months)
Units: bushel/Month
Note: The monthly rate at which the system produces wheat. Calculated from a base rate and annualized fractional rate.
wheat sales
Rate: [wheat production]*[fractional wheat sales rate]
Units: bushel/Month
Note: The monthly rate of wheat sales. Based on a fraction of production.

Money Transaction Parameters

shoe to wheat ratio
Value: .5
Units: Unitless
Note: The ratio of the distribution of Money between shoes and wheat. i.e. $ for shoes / $ for wheat.
transaction time
Value: 1
Units: Month
Note: The time period, in months, for each set of transactions. For simplicity, it takes 1 month for each transaction.
dollar shoe transactions
Value: ([Money]*[shoe to wheat ratio])/[transaction time]
Units: Dollars/Month
Note: The total number of dollars per month devoted to shoe purchases.
dollar wheat transactions
Value: ([Money]*(1-[shoe to wheat ratio]))/[transaction time]
Units: Dollars/Month
Note: ​The total number of dollars per month devoted to wheat purchases.
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