By Dr Frank Shostak
Through the ongoing process of selection, people have settled on gold as their preferred medium of exchange. Some commentators, cast doubt that gold could 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 growing fast enough.
On this according to Insider from June 15, 2011,
The basic problem is that the supply of gold is not related to the quantity of goods and services being produced………. As a result of this scarcity, prices decline. Individuals have less incentive to produce new goods and services. Economic growth is stifled. Allowing money to become scarce does the greatest harm to those who have the least. In the past, the relative inflexibility of the monetary system contributed to the chronic lack of growth in many of the world’s less developed countries. Since the 1970s, we have had one of the most flexible monetary systems the world has known, and many of these countries have flourished. With a flexible monetary system, more money can be created to accommodate more growth.
On this way of thinking, the free market, by failing to provide enough gold, is going to cause money supply shortages. This, in turn, runs the risk of destabilizing the economy.
Again, following this way of thinking, 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 held, is likely to result in a decline in the prices of goods and services, which in turn is likely to destabilize the economy and lead to an economic recession or, even worse, depression.
Hence, to prevent various economic shocks emanating from imbalances between the demand and the supply of money, it is held that the Fed must keep the supply and 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 by the Fed is considered as a necessary action to keep the economy on the path of economic and price stability.
Note that on this way of thinking a given growth rate in the demand for money absorbs an increase in the supply of money of the same percentage. Thus if the demand for money rises by 5% and the supply of money also rises by 5% the effective increase in money is going to be 0%. On this way of thinking, the increase in the supply of money by 5% is absorbed by the increase in the demand for money by 5%. So, from this perspective, no harm is inflicted on 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, individual’s demand food because food provides the necessary elements that sustain the individual’s life and wellbeing. Demand here means that people want to consume the food in order to secure the necessary elements that sustain people’s life and wellbeing.
Similarly, the demand for money arises because of the services that money provides. However, instead of consuming money, people demand money in order to exchange it for goods and services.
Money’s key role is simply to fulfill the role of the medium of exchange. By fulfilling this role, 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 the barter economy. What enables this is the fact that money is the most marketable commodity.
Thus, whilst in the barter economy a butcher is likely to encounter difficulties to exchange his meat for tomatoes of a vegetarian farmer. In a money economy, the butcher could exchange his meat for money and then exchange money for goods he wants in this case for tomatoes. Note that the vegetarian farmer by exchanging his tomatoes for money can in turn exchange the received money for goods he wants.
An increase in the general demand for money, let us say, on account of a general increase in the production of goods, does not imply that individuals’ are going to sit on money and do nothing with it. The main 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 demand for money is not going to absorb a corresponding increase in the supply of 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 increase in the demand for money.
The increase in the demand by 5% implies that people’s demand for the services of money has increased by 5%. An increase in the supply of money is not going to be taken out of the economy because of the corresponding increase in the demand for money.
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 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.
Once the market has chosen a particular commodity as money, the given stock of this commodity is going to be sufficient to secure the services that money provides.
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.
How can we be sure that the supply of a commodity which is selected by the market to be money will not start rapidly expanding 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 as the medium of exchange.
Individuals who are striving to preserve their lives and well-being will not keep a commodity that is subject to a decline in its purchasing power as money. Note that in an unhampered economy without central bank interference there is no need to be concerned with the optimum money supply growth rate. Any amount of money chosen by the market will do the job that is expected from money i.e. it will fulfill the role of the medium of exchange.
If the market will settle on gold or any other commodity as money the amount of this commodity is going to be in line with people’s requirements.
Given that a commodity that is selected as money is part of the stock of wealth the increase in the supply of such commodity is not going to set in motion the menace of boom-bust cycle. This should be contrasted with the increase in the money supply out of “thin air”.
Conclusion
It is held that if the Fed accommodates an increase in the demand for money this accommodation should not be regarded as an effective increase in the supply of money as such. We suggest that any accommodation by the Fed results in the increase in money supply and leads to boom-bust cycles and economic impoverishment. We also suggest that in an unhampered market without central bank interference, any quantity of a market-selected money will correspond to the correct amount and no one is required to monitor and control this quantity.
