According to popular thinking, not every increase in the supply of money will have an effect on the production of goods. For instance, if an increase in the supply is matched by a corresponding increase in the demand for money then there will be no effect on the economy. The increase in the supply of money is neutralized so to speak by an increase in the demand for money or the willingness to hold a greater amount of money than before.
What do we mean by demand for money? In addition, how does this demand differ from the demand for goods and services?
Demand for money versus demand for good
The demand for a good is not essentially the demand for a particular good as such but the demand for the services that the good offers. For instance, an individuals’ demand for food is on account of the fact that food provides the necessary elements that sustain an individual’s life and wellbeing.
Demand here means that people want to consume the food in order to secure the necessary elements that sustain life and wellbeing.
Likewise, the demand for money arises on account of the services that money provides. However, instead of consuming money people demand money in order to exchange it for goods and services.
With the help of money, various goods become more marketable – they can secure more goods than in the barter economy. What enables this is the fact that money is the most marketable commodity.
Take for instance a baker, John, who produces ten loaves of bread per day and consumes two loaves. The other eight loaves he exchanges for various goods such as fruit and vegetables. Observe that John’s ability to secure fruits and vegetables is on account of the fact that he has produced the means to pay for them, which are the loaves of bread. The baker pays for fruit and vegetables with the bread he has produced. Also, note that the aim of his production of bread, in addition of having some of it for himself, is to acquire other consumer goods.
Now, an increase in John’s production of bread, let us say from ten loaves to twenty a day, enables him to acquire a greater quantity and a greater variety of goods than before. Because of the increase in the production of bread, John’s purchasing power has increased. This increase in the purchasing power cannot always be translated in securing a greater amount of goods and services in the barter economy.
In the world of barter, John may have difficulties to secure by means of bread various goods he wants. It may happen that a vegetable farmer may not want to exchange his vegetables for bread.
To overcome this problem John would have to exchange his bread first for some other commodity, which has a much wider acceptance than bread. John is now going to exchange his bread for the acceptable commodity and then use that commodity to exchange for goods he really wants.
Note that by exchanging his bread for a more acceptable commodity John in fact raises his demand for this commodity. Also, note that John’s demand for the acceptable commodity is not to hold it as such but to exchange it for the goods he wants. Again, the reason why he demands the acceptable commodity is because he knows that with the help of this commodity he could convert his production of bread more easily into the goods he wants.
Through a process of selection, people have settled on gold as the most accepted commodity in exchange. Gold has become money.
Increase in demand for money does not imply that individuals do nothing with it
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’ 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.
Now let us assume that for some reason some individuals demand for money has risen. One way to accommodate this demand is for banks to find willing lenders of money. With the help of the mediation of banks, willing lenders can transfer their gold money to borrowers. Obviously, such a transaction is not harmful to anyone.
Another way to accommodate the demand is instead of finding willing lenders the bank can create fictitious money i.e. money out of “thin air” – money unbacked by gold – and lend it out.
Money out of “thin air” sets an exchange of nothing for something
Money, which was created out of “thin air”, once employed in an exchange for goods and services sets in motion an exchange of nothing for something. The exchange of nothing for something amounts to the diversion of real wealth from wealth to non-wealth generating activities, which masquerades as economic prosperity.
In the process, genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators’ ability to grow the economy.
In contrast, when money is not generated out of “thin air”, an individual that has secured proper money has exchanged something useful for it. He then exchanges the money for something else i.e. with the help of proper money something is exchanged for something.
However, when money is generated out of “thin air” nothing was exchanged for it. Once it is employed in the exchange for goods, it leads to an exchange of nothing for something. Once banks curtail their supply of credit out of “thin air”, this slows down the process of an exchange of nothing for something.
This in turn undermines the existence of various false activities that sprang up on the back of the previous expansion in credit out of “thin” air – an economic bust emerges.
We can thus conclude that what sets in motion the boom-bust cycle is the expansion of credit out of “thin air” regardless of the state of the general demand for money.
Increase in the demand for money cannot undo the damage caused by the increase in the supply of money
Could a corresponding increase in the demand for money prevent the damage that money out of “thin air” inflicts on wealth generators?
Let us say that because of an increase in the production of goods the demand for money increases to the same extent as the supply of money out of “thin air”. Recall that people demand money in order to exchange it for goods. Hence, at some point the holders of money out of “thin air” will exchange their money for goods. Once this happens an exchange of nothing for something emerges, which undermines wealth generators.
We can thus conclude that once money out of ‘thin air’ is introduced into the process of exchange, this weakens wealth generators and this in turn undermines potential economic growth and also sets the menace of the boom-bust cycle.
Clearly then the expansion of money out of “thin air” is always bad news for the economy. Hence, the view that the increase in money out of “thin air” which is fully backed by the corresponding increase in the demand for money is harmless is questionable.