According to many commentators, a growing economy requires a growing money stock, because economic growth gives rise to a greater demand for money. Failing to add more money, it is maintained, will lead to a decline in the prices of goods and services, which, in turn, will destabilize the economy and lead to an economic recession or depression. Whenever an increase in the demand for money occurs, the Fed should accommodate this with inflation in order to prevent disruptions and to keep the economy on the path of economic and price stability.
Historically, many different goods have been used as money. Mises observed that, over time,
…there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.
Through the ongoing process of market selection, individuals settled on gold as their preferred general medium of exchange. Most economists, while accepting this historical evolution, cast doubt that gold can fulfill the role of money in the modern world. According to Business Insider from June 15, 2011,
The basic problem is that the supply of gold is not related to the quantity of goods and services being produced…. As a result of this scarcity, prices decline. Individuals have less incentive to produce new goods and services. Economic growth is stifled.
Allowing money to become scarce does the greatest harm to those who have the least. In the past, the relative inflexibility of the monetary system contributed to the chronic lack of growth in many of the world’s less developed countries. Since the 1970s, we have had one of the most flexible monetary systems the world has known, and many of these countries have flourished. With a flexible monetary system, more money can be created to accommodate more growth.
Supposedly, the free market—by failing to provide enough gold—would cause money supply shortages and economic instability.
The Demand for Money
A demand for a good is not a demand for a particular good as such but a demand for the services that the good provides. For instance, an individual demands food because food provides nourishment. In this case, demand means that the individual wants to consume food—the service that the particular food provides. However, this is not the case with respect to money. According to Rothbard,
Money…is solely useful for exchange purposes. Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing.
Money’s main function is simply to fulfill the role of the medium of exchange. By fulfilling this role, money simply facilitates the flow of goods and services between producers and consumers. With the help of money, various goods become more marketable—they can be exchanged for more goods than in a barter economy. What enables this is the fact that money is the most marketable commodity.
Therefore, the reason that an individual has a demand for money is in order to be able to exchange money for other goods and services. Consequently, in this sense, an increase in the supply of money would not be absorbed by a corresponding increase in the demand for money, as would be the case with other goods. For instance, an increase in the supply of apples in response to the increase in the demand for apples is absorbed by the demand (i.e., individuals consume more apples). Thus, the increase in the supply of apples by 5 percent would be absorbed by the increase in the demand for apples by 5 percent.
The same, however, cannot be said with regard to the increase in the supply of money, which increased in response to the increase in the demand for money. Again, contrary to other goods, an increase in the demand for money really implies an increase in the demand to employ money to facilitate transactions for other goods. A simple increase in the supply of money does not solve this. Further, an artificial increase in the supply of money to accommodate a corresponding increase in the demand for money sets in motion several negatives (e.g., price inflation, a boom-bust cycle).
With the existence of a central bank, an artificial increase in the supply of money sets an exchange of nothing for something. When we refer to the demand for money, what we really mean is the demand for money’s purchasing power. After all, individuals do not want a greater amount of money in their pockets, but they want a greater purchasing power. According to Mises,
The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power.
Once the market has chosen a particular commodity as money, the given stock of this commodity is adequate to secure the services that money provides. Within a free market, there cannot be such a thing as “too little” or “too much” money. As long as the market is allowed to clear, no shortage or surplus of money can emerge. According to Mises:
As the operation of the market tends to determine the final state of money’s purchasing power at a height at which the supply of and the demand for money coincide, there can never be an excess or deficiency of money. Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money, no matter whether the total quantity of money is great, or small…. the services which money renders can be neither improved nor repaired by changing the supply of money…. The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do.
Conclusion
If the Fed were to accommodate an increase in the demand for money with fresh inflation of the money supply, this “accommodation” should be regarded as an effective increase in the supply of money as such, not purchasing power. Therefore, there can be no net social benefit to such monetary policy, but it does come with a host of negative consequences.
Courtesy of Mises.org
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