Why the idea of an optimum growth rate of money supply is questionable

By Dr Frank Shostak

Most economists hold that a growing economy requires a growing money stock, on the grounds that 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.

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 is maintained over a prolonged period of time it will usher in an era of economic stability.

The idea that money must grow in order to support economic growth gives the impression that money somehow sustains economic activity. However, money’s main job is simply to fulfill the role of the medium of exchange. Money does not sustain or fund economic activity. The means of sustenance, or funding, is provided by saved final consumer goods. By fulfilling its role as the 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[1].

Through the ongoing process of selection over thousands of years, people 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. 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 account the fact that a large portion of gold mined is used for jewelry and various industrial use, this leaves the stock of money almost unchanged.

On this way of thinking, 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. Hence most economists, even those who express sympathy towards the idea of a free market, endorse the view that the money supply must be controlled by the government.

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 what they want is a greater purchasing power in their possession.

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

. . . 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[2].

How can we be sure that the supply of a selected commodity as money will not start rapidly expand because of unforeseen events? Would it not undermine people’s well-being?

If this were to happen, then people would probably abandon this commodity and settle on some other commodity. Individuals who are striving to preserve their lives and well-being will not choose a commodity that is subject to a decline in its purchasing power as money.

Yet, even if we were to agree that the world under the gold standard would have been a much better place to live than under the present monetary system, surely we must be practical and come up with solutions that are in tune with current reality. Namely, that in the world in which we presently live, we do have central banks, and we are not on the gold standard. Given these facts, what then should be the correct money supply growth rate?

We suggest that in the framework of the present paper money system it is not possible to devise a scheme for a “correct” money supply growth rate. Here is why.

From commodity money to paper money

Originally, paper money was not regarded as money but merely as a representation of gold. Various paper certificates represented claims on the gold stored with the banks. The holders of paper certificates could convert them into gold whenever they deemed necessary. Because people found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money.

Paper certificates that are accepted as the medium of exchange open the scope for fraudulent practice. Banks could now be tempted to boost their profits by lending certificates that were not covered by gold. In a free-market economy, a bank that over-issues paper certificates will quickly find out that the exchange value of its certificates in terms of goods and services will decline. To protect their purchasing power, holders of the over-issued certificates are likely to attempt to convert them back to gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. In a free, competitive market then, the threat of bankruptcy would restrain banks from issuing paper certificates unbacked by gold.

This means that in a free-market economy, paper money cannot assume a “life of its own” and become independent of commodity money.

The government can, however, bypass the free-market discipline. It can issue a decree that makes it legal for the over-issued bank not to redeem paper certificates into gold. Once banks are not obliged to redeem paper certificates into gold, opportunities for large profits are generated that set incentives to pursue an unrestrained expansion of the supply of paper certificates[3].

This uncontrolled expansion of paper certificates raises the likelihood of setting off a galloping rise in the prices of goods and services that can lead to the breakdown of the market economy.

To prevent such a breakdown, the supply of the paper money must be managed. The main purpose of managing the supply is to prevent various competing banks from over-issuing paper certificates and from bankrupting each other. This can be achieved by establishing a monopoly bank-i.e., a central bank that manages the supply of paper money.

To assert its authority, the central bank introduces its paper certificates, which replace the certificates of various banks. (The central bank’s money purchasing power is established on account of the fact that various paper certificates, which carry purchasing power, are exchanged for the central bank money at a fixed rate. The central bank paper certificates are fully backed by banks’ certificates, which have the historical link to gold.)

The central bank paper money, which is declared as legal tender, also serves as a reserve asset for banks. This enables the central bank to set a limit on the credit expansion by the banking system via setting regulatory ratios of reserves to loans.

It would then appear that the central bank could manage and stabilize the monetary system. The truth, however, is the exact opposite. Note again that the present paper monetary system emerged because central authorities made it legal for the over-issued banks not to redeem paper certificates into gold.  To manage the system, the central bank must constantly create money “out of thin air” to prevent banks from bankrupting each other during the clearance of checks.

This leads to persistent declines in money’s purchasing power, which destabilizes the entire monetary system.

Since the present monetary system is fundamentally unstable, the central bank is compelled to print money out of thin air to prevent the collapse of the system. (Again, the present monetary system emerged because the government allowed banks the issuance of unbacked by gold certificates).  It does not really matter what scheme the central bank adopts as far as monetary injections are concerned – it can print money directly or it can act in the money markets to target interest rates. Regardless of the mode of monetary injections, the boom-bust cycles are likely to become more ferocious as time goes by. Even Milton Friedman’s scheme to fix the money growth rate at a given percentage won’t do the trick. After all a fixed percentage growth is still money growth, which leads to the exchange of nothing for something – i.e., economic impoverishment and the boom-bust cycles.

What about keeping the current stock of paper money unchanged? Would that not do the trick? An unchanged money stock will cause an almost immediate breakdown of the present monetary system. After all, the present system survives because the central bank, by means of monetary injections, prevents the fractional reserve banks from going bankrupt.

It is therefore not surprising that the central bank must always resort to large monetary injections when there is a threat from various political or economic shocks. How long the central bank can keep the present system going is dependent upon the state of the pool of real savings. As long as this pool is still growing, the central bank is likely to succeed in keeping the system alive.

Once the pool of real savings begins to stagnate – or, even worse, shrink – then no amount of monetary pumping will be able to prevent the implosion of the system.


Since the present monetary system is fundamentally unstable, there cannot be a “correct” money supply growth rate. The present monetary system emerged because central authorities allowed the practice of issuing banknotes that were not fully covered by gold. In order to sustain such system the central bank was introduced. By means of ongoing monetary management, the central bank’s job is to prevent banks from bankrupting each other during the clearance of checks. Whether the central bank injects money in accordance with economic activity or fixes the money supply growth rate, it continuously destabilizes the system.  To make the system truly stable is to permit the free market to take over. In a truly free market, there is no need to be concerned with the issue of the “correct” money supply growth rate and no institution is required to regulate the supply of money.  

[1] Ludwig von Mises, The Theory of Money and Credit (Irvington-on-Hudson, N.Y: The Foundation of Economic Education, 1971) pp. 45.

[2] Ludwig von Mises Human Action fourth revised edition p 421.

[3] Hans-Hermann Hoppe, “How is Fiat Money Possible?-or, The Devoluton of Money and Credit,” The Review of Austrian Economics 7, no.2 (1994), pp.49-74.

Tags from the story
More from Dr Frank Shostak
Raising interest rates is not the right tool to counter inflation
By Dr Frank Shostak There is almost complete unanimity among economists and...
Read More
One reply on “Why the idea of an optimum growth rate of money supply is questionable”
  1. “Money does not sustain or fund economic activity.” Yes it does, and for the simple reason that the more money people have, the more they spend…!!!!!

Comments are closed.