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

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

By Dr Frank Shostak

It is widely held that a growing economy requires a growing money stock, because economic growth gives rise to a greater demand for money. It is also held that failing to accommodate the increase in the demand for money, will lead to a decline in the prices of goods and services. This in turn could destabilize the economy and produce an economic recession, or even worse, depression. 

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 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 are provided by saved final consumer goods. 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. 

Through the ongoing process of selection over thousands of years, individuals have settled on gold as their preferred 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. 

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 government must control the money supply.

What do we mean by demand for money?

By 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 what they want is 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 all other things being equal. 

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. 

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? 

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 individuals’ 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 however, can bypass the free-market discipline. It can issue a decree that makes it legal for the over-issued banks 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. 

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

To prevent such a breakdown, the supply of paper money must be managed. 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 certificate purchasing power is established because various paper certificates 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’s paper certificates, which are declared as legal tender, also serve as reserve assets 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 demand deposits.

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 generate money “out of thin air” to prevent banks from bankrupting each other during the clearance of checks. This leads to persistent declines in the money’s purchasing power, which destabilizes the entire monetary system. 

Even Milton Friedman’s scheme to fix the money growth rate at a given percentage will not 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 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 savings begins to stagnate – or, even worse, shrink – then no amount of monetary pumping will be able to prevent the implosion of the system. 

Conclusion 

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 are not fully covered by gold. In order to sustain such a 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.  

More from Dr Frank Shostak
The Fed and interest rates
Most experts agree that through the manipulation of short-term interest rates, the...
Read More
0 replies on “Why the idea of an optimum growth rate of money supply is questionable”