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Should the Fed Increase the Money Supply in Response to a Growing Economy?

Summary:
Most commentators believe a growing economy requires a growing money stock because economic growth gives rise to a greater demand for money, which then must be accommodated. Failing to do so will lead to a decline in prices of goods and services which, in turn, destabilizes the economy and leads to a recession or, even worse, depression. The main role of the Fed, then, is to keep the supply and the demand for money in equilibrium. An increase in the demand for money should be accommodated by the Fed. This is necessary to keep the economy on a path of economic and price stability. If the growth rate of money supply does not exceed the growth rate of the demand for money, the accommodation is not considered as harmful to the economy, according to the theory. The

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Should the Fed Increase the Money Supply in Response to a Growing Economy?Most commentators believe a growing economy requires a growing money stock because economic growth gives rise to a greater demand for money, which then must be accommodated. Failing to do so will lead to a decline in prices of goods and services which, in turn, destabilizes the economy and leads to a recession or, even worse, depression.

The main role of the Fed, then, is to keep the supply and the demand for money in equilibrium. An increase in the demand for money should be accommodated by the Fed. This is necessary to keep the economy on a path of economic and price stability.

If the growth rate of money supply does not exceed the growth rate of the demand for money, the accommodation is not considered as harmful to the economy, according to the theory. The growth rate in the demand for money absorbs the growth rate the money supply, so there is no effective increase in money growth. This perspective holds that there is no economic harm.

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.

Through the process of selection, individuals settled on gold as their preferred general medium of exchange. Most economists, while accepting this historical evolution, cast doubt that gold can fulfill the role of money in the modern world.

Most economists believe that economic growth increases demand for money, the supply of gold is insufficient. This belief states that the free market, by failing to provide enough gold, will generate money supply shortages which then destabilize the economy.

The Meaning of Demand for Money

Demand for a good is not demand for a particular good as such, but rather demand for services the good offers. For example, an individual demands food because food sustains his life and well-being. Demand here means that people want to consume the food to secure the necessary elements that sustaining life. This is not, however, the case with demand for money. According to Murray Rothbard:

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 fulfills the role of medium of exchange by facilitating the flow of goods and services between producers and consumers. With the help of money, various goods become more marketable and can be exchanged for more goods than would occur in a barter economy. Money as a marketable commodity enables this exchange.

An increase in the general demand for money on account of a general increase in the production of goods doesn’t imply that individuals wish to hoard money and do nothing with it. People demand money to exchange it for other goods and services. Therefore, an increase in the supply of money is not absorbed by a corresponding increase in the demand for money, as is the case with other 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 percent, is absorbed by the increase in the demand for apples by 5 percent.

The same cannot, however, be said about increasing the supply of money, which takes place in response to the same increase in the demand for money. Again, contrary to other goods, an increase in the demand for money implies an increase in the demand to employ money to facilitate transactions.

Consequently, an increase in the supply of money to accommodate increases in demand for money sets in motion all the negatives effects that occur with an increase in the money supply, creating an exchange of nothing for something. Furthermore, when we refer to demand for money, we really mean the demand for money’s purchasing power. After all, people do not want a greater amount of money in their pockets, but rather greater purchasing power.

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 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. All other things being equal, if there is less money, its exchange value will increase. Conversely, the exchange value will fall when there is more money. In a free market, there cannot be “too little” or “too much” money. As long as the market is permitted 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.

Conclusion

Many economists believe that if the Fed accommodates an increase in the demand for money, this accommodation should not be regarded as an increase in money supply. We believe that this accommodation by the Fed results in the increase in the money supply, creating a situation of exchange of nothing for something, setting the menace of the boom-bust cycle in motion.


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Frank Shostak
Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. He received his bachelor's degree from Hebrew University, master's degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University.

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