According to popular thinking, not every increase in the supply of money will have an effect on the production of goods. For instance, if an increase in the supply is matched by a corresponding increase in the demand for money, then there will be no 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? In addition, how does this demand differ from the demand for goods and services?
Demand for Money versus Demand for Goods
The demand for a good is not essentially the demand for a particular good as such, but the demand for the services that the good offers. For instance, an individual's 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.
Likewise, the demand for money arises on account of the services that money provides. However, instead of consuming money, people demand it 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.
Take, for instance a baker, John, who produces ten loaves of bread per day and consumes two loaves. The other 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 the 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, in addition to 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. Because of the increase in the production of bread, John’s purchasing power has increased. This increase in the purchasing power cannot always be translated in securing a greater amount of goods and services in the barter economy.
In the world of barter, John may have difficulties securing the various goods he wants by means of bread. It may happen that a vegetable farmer does not want to exchange his vegetables for bread.
To overcome this problem John would have to exchange his bread first for some other commodity that has a much wider acceptance rate than bread. John is now going to exchange his bread for the acceptable commodity and then use that commodity to exchange for the 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 its help he can convert his bread production more easily into the goods he wants.
Through a process of selection, people have settled on gold as the most accepted commodity in exchange. Gold has become money.
What It Means When the Demand for Money Increases
An increase in the general demand for money, let us say on account of a general increase in the production of goods, doesn’t imply that individuals sit on the money and do nothing with it. The key reason an individual has a demand for money is in order to be able to exchange it for other goods and services.
Let us assume that for some reason some individuals' demand for money has risen. One way to accommodate this demand is for banks to find willing lenders of money. With 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 besides finding willing lenders is for banks to create fictitious money, i.e., money out of “thin air”—unbacked by gold—and lend it out.
Creating Money out of "Thin Air" Leads to Exchanging Nothing for Something
Once employed in an exchange for goods and services, money created out of “thin air” sets in motion an exchange of nothing for something. The exchange of nothing for something amounts to the diversion of real wealth from wealth-generating to non-wealth-generating activities masquerading as economic prosperity. In the process, genuine wealth generators are left with fewer resources at their disposal, which in turn weakens their ability to grow the economy.
In contrast, when money is not generated out of “thin air” an individual who has secured proper money has exchanged something useful for it. He then exchanges the money for something else: with the help of proper money, something is exchanged for something.
Once banks curtail their supply of credit out of “thin air,” this slows down the process of exchanging nothing for something. This in turn undermines the existence of various false activities that sprang up on the back of the previous expansion in credit out of “thin” air—an economic bust emerges.
We can thus conclude that what sets in motion the boom-bust cycle is the expansion of credit out of “thin air” regardless of the state of the general demand for money. Could a corresponding increase in the demand for money prevent the damage that the creation of money out of “thin air” inflicts on wealth generators?
Let us say that because 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 it for goods and the exchange of nothing for something will still occur. Once money out of “thin air” is introduced into the process of exchange, it inevitably weakens wealth generators, undermining potential economic growth and also setting up the menace of the boom-bust cycle.
Clearly, then, the expansion of the money supply is always bad news for the economy. Hence, the view that an increase in money out of “thin air” that is fully backed by a corresponding increase in demand for money is harmless is questionable.
