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, we are
told, then there won’t be any effect on the economy. The increase in the
supply of money is neutralized, 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.
Why People Demand Money
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 fruits 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 fruits and
vegetables with the bread he has produced. Also note that the aim of his
production of bread, apart from having some of it for himself, is to acquire
other consumer goods.
Now, an increase in 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 does not necessarily translate into securing a greater
amount of goods and services in the barter economy, however.
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 an
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.
Historically, in many societies, through a process of selection, people
have settled on gold as the most accepted commodity in exchange. Gold has
become money.
Real Money 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.
Will More “Demand for Money” Save Us?
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 it is harmless to have an increase in money out of “thin
air” — if fully “backed by demand”— 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 cycle irrespective of the so-called overall demand for money.
Does Gold Cause Boom-Bust Cycles?
According to most economists however, in an economy with a gold standard,
an increase in the supply of gold generates similar distortions that money
out of “thin air” does.
This is not the case.
Let us start with a barter economy. John the miner produces ten ounces of
gold. The reason he mines gold is he believes there is a market for it. Since
people demand it, we know that gold contributes to the well-being of
individuals. John 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
jewelry, 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?
No, because this is just what happens 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 commodities to fulfill 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 percent 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.
In the case of the increase in the supply of gold no fraud is committed
here. The supplier of gold has simply increased the production of a useful
commodity. So in this sense we don’t have 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 himself. 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 — a true gold standard without central bank
manipulation — this cannot take place. 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.
