What is the relation between supply and demand for money?


For most economists there is the need to keep the so-called economy along the path of a stable economic growth and a stable price inflation. One of the reasons for the possible deviation of the economy from the stable growth path is a change in the demand for money. If the authorities failing to make sure that an increase in the demand for money is accommodated by the corresponding increase in the supply of money this could result in the economy deviating from the path of stable economic growth and stable inflation. Hence, it is imperative for the central bank to make sure that the growth in the supply of money is in tandem with the growth rate of the demand for money in order to maintain economic stability.

Note that on this way of thinking, a growing economy requires a growing money stock, because economic growth gives rise to a greater demand for money. Failing to accommodate a strengthening in the demand for money could lead to a decline in the prices of goods and services, which in turn will destabilize the economy and lead to an economic recession.

Since growth in money supply is of such importance, it is not surprising that economists are continuously searching for the right, or the optimum, growth rate of the money supply.

Some economists who are the followers of Milton Friedman – also known as monetarists – want the central bank to target the money supply growth rate to a fixed percentage. They hold that if this percentage maintained over a prolonged period it will usher in an era of economic stability.

The idea that money must grow in order to sustain economic growth gives the impression that money somehow sustains economic activity. According to Rothbard,

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[1].

Money’s main job is simply to fulfill the role of the medium of exchange. Money does not sustain or fund real economic activity. The means of sustenance, or funding, provided by saved consumer goods. By fulfilling its role as a medium of exchange, money just facilitates the flow of goods and services between producers and consumers.

Historically, many different goods have been used as the medium of exchange. On this, 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[2].

Through the ongoing process of selection over thousands of years, people settled on gold as their preferred general medium of exchange.

Most mainstream economists, while accepting this historical evolution, cast doubt that gold can fulfill the role of money in the modern world. It is held that, relative to the growing demand for money because of growing economies, the supply of gold is not adequate.

Furthermore, if one takes into the account the fact that a large portion of gold mined is used for jewelry, this leaves the stock of money almost unchanged over long periods.

It is argued that the free market, by failing to provide enough gold, is likely to cause money supply shortages. This, in turn, runs the risk of destabilizing the economy. It is for this reason that most economists, even those who express sympathy toward the idea of a free market, endorse the view that the government must control the money supply.


What do we mean by demand for money?

When we talk about demand for money, what we really mean is the demand for money’s purchasing power. After all, people do not want a greater amount of money in their pockets so much as they want greater purchasing power in their possession. On this Mises wrote,

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[3].

In a free market, in similarity to other goods, the price of money is determined by supply and demand.

Consequently, if there is less money, its exchange value will increase. Conversely, the exchange value will fall when there is more money.

Within the framework of a free market, there cannot be such 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.

Once the market has chosen a particular commodity as money, the given stock of this commodity will always be sufficient to secure the services that money provides.

Hence, in a free market, the whole idea of an optimum growth rate of money is absurd.

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[4].


[1] Murray N. Rothbard, Man, Economy and State (Los Angeles: Nash Publishing, 1970), p.670.

[2] Ludwig von Mises, The Theory of Money and Credit (Irvington-on-Hudson, N.Y: The Foundation of Economic Education, 1971) pp. 32-33.

[3] Ludwig von Mises, Human Action, 3rd rev. ed. (Chicago: Contemporary Books, 1966), p.421.

[4] Ibid.


Tags from the story
More from Dr Frank Shostak
Can expectations neutralise the side effects of loose monetary policy?
According to the Austrian Business Cycle Theory (ABCT), the artificial lowering of...
Read More
0 replies on “What is the relation between supply and demand for money?”