Money supply versus money demand

According to popular thinking not every increase in the supply of money will have an effect on economic activity. For instance, if an increase in supply is matched by a corresponding increase in the demand for money then there won’t be any effect on the economy. The increase in the supply of money is neutralised 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? And how does this demand differ from demand for goods and services?

Now, 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, individuals’ demand for food is on account of the fact that food provides the necessary elements that sustain an individual’s life and well being. Demand here means that people want to consume the food in order to secure the necessary elements that sustain life and well being.

Also, 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.

Demand for money is demand for the medium of exchange

Take for instance a baker, John, who produces ten loaves of bread per day and consumes two loaves. The 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 eight 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, apart of having some of it for himself, is to acquire other consumer goods. Now, an increase in the 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. As a result of the increase in the production of bread John’s purchasing power has increased. This increase in the purchasing power not always can 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 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 can convert the bread he produced more easily into the goods he wants.

Now let us say that an increase in the production of the acceptable commodity has taken place. As a result of a greater amount of the acceptable commodity relative to the quantities of other goods the unitary price of the acceptable commodity in terms of goods has fallen. All this, however, has nothing to do with the production of goods. The increase in the supply of acceptable commodity is not going to disrupt the production of goods and services. Obviously if the purchasing power of the commodity were to continue declining then people are likely to replace it with some other more stable commodity.

Through a process of selection people have settled on gold as the most accepted commodity in exchange. Gold has become money.

Money proper versus money out of “thin air”

Let us now assume that some individual’s 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 – money unbacked by gold – and lend it out.

Note that the increase in the supply of newly created money is given to some individuals. There must always be a first recipient of the newly created money by the banks.

This money, which was created out of “thin air”, is going to be employed in an exchange for goods and services i.e. it will set 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.

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 on account 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 irrespective of whether the total demand for money is rising or falling what matters here is that individuals employ money in their transactions. As we have seen 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. 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 demand is harmless doesn’t hold water.

In contrast, an increase in the supply of gold money is not going to set an exchange of nothing for something. Also an increase in the supply of commodity money doesn’t set boom-bust cycles.

We can further infer that it is only the increase in money out of “thin air” that is responsible for the boom-bust cycle menace. This increase sets the boom-bust cycles irrespective of the so-called overall demand for money.

Gold and boom-bust cycles

According to most economists however on the gold standard, an increase in the supply of gold generates similar distortions that money out of “thin air” does. We will argue below that this is not the case.

Let us start with a barter economy. John the miner produces ten ounces of gold. The reason why he mines gold because he believes there is a market for it. Gold contributes to the well being of individuals. He exchanges his ten ounces of gold for various goods such as potatoes and tomatoes.

Now people have discovered that gold apart from being useful in making jewellery is also useful for some other applications. They now assign a much greater exchange value to gold than before. As a result John the miner could exchange his ten ounces of gold for more potatoes and tomatoes.

Should we condemn this as bad news because John is now diverting more resources to himself. This however, is just what is happening all the time in the market. As time goes by people assign greater importance to some goods and diminish the importance of some other goods. Some goods are now considered as more important than other goods in supporting people’s life and well being. Now people have discovered that gold is useful for another use such as to serve as the medium of the exchange. Consequently they lift further the price of gold in terms of tomatoes and potatoes. Gold is now predominantly demanded as a medium of exchange – the demand for other services of gold such as ornaments is now much lower than before.

Let us see what is going to happen if John were to increase the production of gold. The benefit that gold now supplies people is by providing the services of the medium of the exchange. In this sense it is a part of the pool of real wealth and promotes people’s life and well being.One of the attributes for selecting gold as the medium of exchange is that it is relatively scarce.

This means that a producer of a good who has exchanged this good for gold expects the purchasing power of his effort to be preserved over time by holding gold. If for some reason there is a large increase in the production of gold and this trend were to persist the exchange value of the gold would be subject to a persistent decline versus other goods, all other things being equal. Within such conditions people are likely to abandon gold as the medium of the exchange and look for other commodity to fulfil this role.

As the supply of gold starts to increase its role as the medium of exchange diminishes while the demand for it for some other usages is likely to be retained or increase. So in this sense the increase in the production of gold is not a waste and adds to the pool of real wealth. When John the miner exchanges gold for goods he is engaged in an exchange of something for something. He is exchanging wealth for wealth.

Contrast all this with the printing of gold receipts i.e. receipts that are not backed 100% by gold. This is an act of fraud, which is what inflation is all about, it sets a platform for consumption without making any contribution to the pool of real wealth. Empty certificates set in motion an exchange of nothing for something, which in turn leads to boom-bust cycles. The printing of unbacked by gold certificates divert real savings from wealth generating activities to the holders of unbacked certificates. This leads to the so-called economic boom.

The diversion of real savings is done by means of unbacked certificates i.e. unbacked money. Once the printing of unbacked money slows down or stops all together this stops the flow of real savings to various activities that emerged on the back of unbacked money. As a result these activities fall apart – an economic bust emerges. (Note that these activities do not produce real wealth, they only consume. Obviously then without the unbacked money, which diverts real savings to them, they are in trouble. These activities didn’t produce any wealth hence without money given to them they cannot secure the goods they want).

In the case of the increase in the supply of gold no fraud is committed here. The supplier of gold – the gold mine has increased the production of a useful commodity. So in this sense we don’t have here an exchange of nothing for something. Consequently we also don’t have an emergence of bubble activities. Again the wealth producer on account of the fact that he has produced something useful can exchange it for other goods. He doesn’t require empty money to divert real wealth to him. Note that a major factor for the emergence of a boom is the injections into the economy of money out of “thin air”. The disappearance of money out of “thin air” is the major cause of an economic bust. The injection of money out of “thin air” generates bubble activities while the disappearance of money out of “thin air” destroys these bubble activities.

On the gold standard this cannot take place. On a pure gold standard without the central bank money is gold. Consequently on the gold standard money cannot disappear since gold cannot disappear. We can thus conclude that the gold standard, if not abused, is not conducive of boom-bust cycles.