Simply put, prices increase when there is excess demand, and decrease when there is scarcity. When there is excess demand, prices tend to jump around. This happens because a buyer is more willing to pay more than the seller is willing to give up a good, at the expense of making money on a good. It is called the “saturation point.” When a buyer is willing to pay more than the seller is willing to give up, the price rise is less pronounced. A seller has to offer more for a good even if he does not intend to sell. To demonstrate how this works, let’s look at two hypothetical situations.
Hypothetical price spike:
$5,000 in cash
$1,000 in gold
$1,000 in silver
Now let’s say that the buyer wants $3,000 in gold and $1,000 in silver.
A seller can offer the buyer a deal with a price of $4,000, but if he wants the buyer to pay more, he must also offer $1,000 in gold (or $3,000 if he wants silver) and $1,000 in silver. The market price of the silver will rise (since it will be outbid by the money from the $1,000 in gold) and the cash price will drop. The market price of the gold will increase (the buyer will be better off with the $3,000 in gold) and the cash price will decrease.
Here is the kicker. When there is just enough gold to satisfy all the buyer’s cash needs, he is willing to pay the full price. This is a huge difference from the situation where there is too much gold. When enough gold is available, the market price is lower, and the cash price rises (the seller is less of a saver).
There are two different prices in this scenario. If prices were the same in all cases, but the seller were making a profit with too much silver, how would this market behavior affect the price?
As the price increases, the seller’s profit will decrease, and if the cash price falls, it will still be very high. When the price decreases, the cash price will increase at the same time that it approaches the equilibrium price. The money supply expands slightly, but it is still high since there is a strong buyer.
As in the case illustrated in the previous section, the price of gold is not always at equilibrium. The
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