Does Increasing the Money Supply also Increase Economic Growth?

by
Frank Shostak
My articles My booksMy videos
Follow on:

Many economic commentators believe increasing the quantity of money can revive an economy. This is based on the view that with more money in their pockets, people will spend more and others follow suit, as they hold that money is a mere means of payments.

Money, however, is not the means of payments but rather a medium of exchange. It only enables one producer to exchange his product for the product of another producer. 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.” The means of payments are always goods and services, which pay for other goods and services. Money simply facilitates these payments as a medium of exchange.

For example, a baker exchanges his bread for money and then uses the money to buy shoes. He actually pays for the shoes not with money but with the bread he produced. The baker’s production of bread gives rise to his demand for money, which emerges because money is the most marketable commodity. The holder of money believes that he can exchange it for goods and services that he requires, in contrast to the barter system where the payment of goods for goods is not always possible. (For instance, a butcher might not be able to pay with his meat for shoes if the shoemaker is a vegetarian.)

People Demand Purchasing Power Not Money as Such

Demand for money is the demand for money’s purchasing power.  According to Ludwig von 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.” Now, a decline in the supply of money, all other things being equal, will result in the strengthening of the money’s purchasing power. Conversely, the purchasing power of money will decline if the quantity of money increases. There cannot be such a thing as “too little” or “too much” money. As long as the market is allowed to clear, no shortage of money can emerge.

Once the market has chosen a particular commodity as money, the given stock of this commodity will be sufficient to secure the services that money provides. Hence, in a free market, the idea of an optimum growth rate of money is absurd. 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.

We Produce to Consume

The ultimate purpose of production is consumption. People produce and exchange goods and services to improve their situation in life. Production for its own sake and not for consumption is a meaningless undertaking. In a free-market economy, both consumption and production are in harmony with each other as consumption is likely to be fully backed by production.

What permits the baker to consume bread and shoes is his production of bread. A portion of his bread production is allocated for his consumption of bread while the other portion is used to pay for shoes. Note that his consumption is fully backed, paid by his production. Any attempt to increase consumption without the increase in production leads to an unbacked consumption, which must come at somebody else’s expense.

This is precisely what monetary pumping does. It generates demand not supported by production. This type of demand undermines the real savings and in turn destabilizes the formation of capital and weakens rather than strengthens economic growth.

It is real savings and not money that funds and makes possible the production of better tools and machinery. With better tools and machinery, it is then possible to lift the production of consumer goods and services.

Again, contrary to what economists like Paul Krugman claim, setting in motion consumption unbacked by production via monetary pumping will only stifle economic growth. Unbacked consumption diminishes the flow of real savings that makes economic growth possible. If it had been otherwise then poverty in the world would have been eliminated a long time ago, given the huge amount of money creation by governments throughout history.

Once, however, the growth rate of unbacked consumption reaches a stage where the flow of real savings becomes negative, the economy falls into an economic slump. Any attempt by the central bank to pull the economy out of the recession via monetary pumping makes things worse as it increases unbacked consumption, further depleting real savings.

The collapse in the source of economic growth exposes banks’ fractional reserve lending and raises the risk of runs on banks. To protect themselves, banks curtail the generation of credit coming from “thin air.”

Under these conditions, further monetary pumping by the central bank is unlikely to increase bank lending. On the contrary, more pumping destroys real savings and undermines more businesses, making banks even more reluctant to expand lending.

Within these conditions, banks would likely agree to lend only to creditworthy businesses. However, as an economic slump deepens, it becomes much harder to find many creditworthy businesses. Hence, the central bank may find that despite its attempt to inflate the economy, the money supply will start falling. Obviously, the central bank could offset this decline by an aggressive monetary pumping.

The central bank can monetize the government budget deficit. (During the covid restrictions, it underwrote billions of dollars of checks sent to individuals.) All this, however, only further undermines real savings and ultimately devastates the economy.

Does an Increase in Demand Set in Motion Economic Growth?

Most mainstream economists believe that an increase in the money supply will increase demand for consumer goods and services. Thus, they hold that more induced demand will lead to more production to meet demand, expanding the economy.

However, to accommodate more production of consumer goods and services, there is the need for a suitable infrastructure. If, however, the infrastructure creation was not undertaken due to an insufficient provision of real savings, it will not be possible to have more economic growth.

No amount of increase in the money supply will make economic expansion possible. On the contrary, an increase in the money supply will undermine the formation of real savings and delay, not promote, economic recovery.

Conclusion

Contrary to popular thinking, money is not the means of payment but serves as a medium of exchange. Hence, increasing the money supply cannot strengthen economic growth. On the contrary, it will weaken the generation of real savings and undermine prospects for sustained economic growth.