Should the Fed tamper with the quantity of money?

 

Most economists are of the view that a growing economy requires a growing money stock, because economic growth gives rise to a greater demand for money, which must be accommodated.

 

Failing to do so, 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, even worse, depression.

 

For most economists and commentators the main role of the Fed is to keep the supply and the demand for money in equilibrium. Whenever an increase in the demand for money occurs, to maintain the state of equilibrium the accommodation of the demand for money by the Fed is considered a necessary action to keep the economy on a path of economic and price stability.

 

As long as the growth rate of money supply does not exceed the growth rate of the demand for money, then the accommodation of the increase in the demand for money is not considered as money printing and therefore harmful to the economy.

 

Note that on this way of thinking the growth rate in the demand for money absorbs the growth rate of the supply of money hence no effective increase in the supply of money occurs. So from this perspective, no harm is inflicted on the economy.

 

Historically, many different goods have been used as money. 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[1].

Through the ongoing process of selection, 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 sufficient. On this way of thinking the free market, by failing to provide enough gold will result in money supply shortages. This, in turn, runs the risk of destabilizing the economy.

 

The meaning of demand for money

Now, a demand for a good is not a demand for a particular good as such but a demand for the services that the good offers. For instance, an individual demands food because food provides the necessary elements that sustain his life and wellbeing.

 

Demand here means that people want to consume the food in order to secure the necessary elements that sustain their life and wellbeing. This is however not the case with respect to money. 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[2].

Money’s main job is simply to fulfill the role of the medium of exchange. By fulfilling the role as a medium of exchange, money just 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.

 

An increase in the general demand for money, let us say, on account of a general increase in the production of goods, doesn’t imply that individuals’ want to sit on the money and do nothing with it. The key reason an individual has a demand for money is in order to be able to exchange money for other goods and services.

 

Therefore, in this sense an increase in the supply of money is not going to be absorbed by a corresponding increase in the demand for money, as will be the case with various goods.

 

An increase in the supply of apples is absorbed by the increase in the demand for apples i.e. people want to consume more apples. For instance, the supply of apples, which increased by 5%, is absorbed by the increase in the demand for apples by 5%. The same cannot however, be said with regard to the increase in the supply of money, which has taken place in response to the same increase in the demand for money.

 

Again, contrary to other goods, an increase in the demand for money implies an increase in the demand to employ money to facilitate transactions.

 

Consequently, an increase in the supply of money to accommodate a corresponding increase in the demand for money is going to set in motion all the negatives that an increase in the money supply does.

Furthermore, 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 but they want a greater purchasing power in their possession. 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[3].

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.

 

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.

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].

 

Conclusion

It is held that if the Fed accommodates an increase in the demand for money this accommodation should not be regarded as an increase in the supply of money as such. We suggest that this accommodation as any other accommodation by the Fed results in the increase in money supply and to the exchange of nothing for something that sets in motion the menace of the boom-bust cycle.

 

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

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

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

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