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We Don't Need a Central Bank to Deal with Changes in the "Demand for Money"

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Published : September 04th, 2021
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Historically, many different goods have been used as money. On this, Ludwig von 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

Similarly, Murray Rothbard wrote in "What Has Government Done to Our Money,"

Just as in nature, there is a great variety of skills and resources, so there is a variety in the marketability of goods. Some goods are more widely demanded than others, some are more divisible into smaller units without loss of value, some more durable over long periods of time, some more transportable over large distances. All of these advantages make for greater marketability. It is clear that in every society, the most marketable goods will be gradually selected as the media for exchange. As they are more and more selected as media, the demand for them increases because of this use, and so they become even more marketable. The result is a reinforcing spiral: more marketability causes wider use as a medium, which causes more marketability, etc. Eventually, one or two commodities are used as general media-in almost all exchanges-and these are called money.

Through the ongoing process of selection, people settled on gold as their preferred medium of exchange. Some commentators, 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 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.2

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 the 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, an individual’s demand for food emerges 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. 

Also, 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.

According to Rothbard in Man, Economy, and State,

Money, per se, cannot be consumed and cannot be used directly as a producers' good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing.

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. Contrary to other goods, an increase in the demand for money implies an increase in the demand to employ money to facilitate transactions. This means that an increase in the demand for money by 5% is not going to absorb an increase in the supply of money by 5%.

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.3

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.

In a free market, in similarity to other goods, the price of money is determined by supply and demand. Consequently, all other things being equal, if there is a decline in money, its purchasing power will increase. Conversely, its purchasing power will decline when there is an increase in 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.

According to Mises: 

As the operation of the market tends to determine the final state of money's purchasing power at a height at which the supply of and the demand for money coincide, there can never be an excess or deficiency of money. Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money, no matter whether the total quantity of money is great, or small. . . . 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.4

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.

Source : mises.org
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Frank Shostak's consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies.
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Frank, this refutes the most destructive economic fallacy in the world today, which is that the money supply must keep pace with economic growth. As you wrote,

Contrary to other goods, an increase in the demand for money implies an increase in the demand to employ money to facilitate transactions. This means that an increase in the demand for money by 5% is NOT going to absorb an increase in the supply of money by 5%. [my caps]

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.

Great job! A must-read for everyone on this site!
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Frank, this refutes the most destructive economic fallacy in the world today, which is that the money supply must keep pace with economic growth. As you wrote, Contrary to other goods, an increase in the demand for money implies an increase in the dema  Read more
gfs543 - 9/5/2021 at 1:22 AM GMT
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