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IV. The Supply of Money

To understand chronic inflation and, in general, to learn what determines prices and why they change, we must now focus on the behavior of the two basic causal factors: the supply of and the demand for money.

The supply of money is the total number of currency units in the economy. Originally, when each currency unit was defined strictly as a certain weight of gold or silver, the name and the weight were simply interchangeable. Thus, if there are $100 billion in the economy, and the dollar is defined as 1/20 of a gold ounce, then M can be equally considered to be $100 billion or 5 billion gold ounces. As monetary standards became lightened and debased by governments, however, the money supply increased as the same number of gold ounces were represented by an increased supply of francs, marks, or dollars.

Debasement was a relatively slow process. Kings could not easily have explained continuous changes in their solemnly defined standards. Traditionally, a new king ordered a recoinage with his own likeness stamped on the coins and, in the process, often redefined the unit so as to divert some much needed revenue into his own coffers. But this variety of increased money supply did not usually occur more than once in a generation. Since paper currency did not yet exist, kings had to be content with debasement and its hidden taxation of their subjects.


What should the supply of money be? What is the “optimal” supply of money? Should M increase, decrease, or remain constant, and why?

This may strike you as a curious question, even though economists discuss it all the time. After all, economists would never ask the question: What should the supply of biscuits, or shoes, or titanium, be? On the free market, businessmen invest in and produce supplies in whatever ways they can best satisfy the demands of the consumers. All products and resources are scarce, and no outsider, including economists, can know a priori what products should be worked on by the scarce labor, savings, and energy in society. All this is best left to the profit-and-loss motive of earning money and avoiding losses in the service of consumers. So if economists are willing to leave the “problem” of the “optimal supply of shoes” to the free market, why not do the same for the optimal supply of money?

In a sense, this might answer the question and dispose of the entire argument. But it is true that money is different. For while money, as we have seen, was an indispensable discovery of civilization, it does not in the least follow that the more money the better.

Consider the following: Apart from questions of distribution, an increase of consumer goods, or of productive resources, clearly confers a net social benefit. For consumer goods are consumed, used up, in the process of consumption, while capital and natural resources are used up in the process of production. Overall, then, the more consumer goods or capital goods or natural resources the better.

But money is uniquely different. For money is never used up, in consumption or production, despite the fact that it is indispensable to the production and exchange of goods. Money is simply transferred from one person’s assets to another.1 Unlike consumer or capital goods, we cannot say that the more money in circulation the better. In fact, since money only performs an exchange function, we can assert with the Ricardians and with Ludwig von Mises that any supply of money will be equally optimal with any other.2 In short, it doesn’t matter what the money supply may be; every M will be just as good as any other for performing its cash balance exchange function.

Let us hark back to Figure 3.4. We saw that, with an M equal to $100 billion, the price level adjusted itself to the height 0A. What happens when $50 billion of new money is injected into the economy? After all the adjustments are made, we find that prices have risen (or PPM fallen) to 0B. In short, although more consumer goods or capital goods will increase the general standard of living, all that an increase in M accomplishes is to dilute the purchasing power of each dollar. One hundred fifty billion dollars is no better at performing monetary functions than $100 billion. No overall social benefit has been accomplished by increasing the money supply by $50 billion; all that has happened is the dilution of the purchasing power of each of the $100 billion. The increase of the money supply was socially useless; any M is as good at performing monetary functions as any other.3

To show why an increase in the money supply confers no social benefits, let us picture to ourselves what I call the “Angel Gabriel” model.4 The Angel Gabriel is a benevolent spirit who wishes only the best for mankind, but unfortunately knows nothing about economics. He hears mankind constantly complaining about a lack of money, so he decides to intervene and do something about it. And so overnight, while all of us are sleeping, the Angel Gabriel descends and magically doubles everyone’s stock of money. In the morning, when we all wake up, we find that the amount of money we had in our wallets, purses, safes, and bank accounts has doubled.

What will be the reaction? Everyone knows it will be instant hoopla and joyous bewilderment. Every person will consider that he is now twice as well off, since his money stock has doubled. In terms of our Figure 3.4, everyone’s cash balance, and therefore total M, has doubled to $200 billion. Everyone rushes out to spend their new surplus cash balances. But, as they rush to spend the money, all that happens is that demand curves for all goods and services rise. Society is no better off than before, since real resources, labor, capital, goods, natural resources, productivity, have not changed at all. And so prices will, overall, approximately double, and people will find that they are not really any better off than they were before. Their cash balances have doubled, but so have prices, and so their purchasing power remains the same. Because he knew no economics, the Angel Gabriel’s gift to mankind has turned to ashes.

But let us note something important for our later analysis of the real world processes of inflation and monetary expansion. It is not true that no one is better off from the Angel Gabriel’s doubling of the supply of money. Those lucky folks who rushed out the next morning, just as the stores were opening, managed to spend their increased cash before prices had a chance to rise; they certainly benefited. Those people, on the other hand, who decided to wait a few days or weeks before they spent their money, lost by the deal, for they found that their buying prices rose before they had the chance to spend the increased amounts of money. In short, society did not gain overall, but the early spenders benefited at the expense of the late spenders. The profligate gained at the expense of the cautious and thrifty: another joke at the expense of the good Angel.5

The fact that every supply of M is equally optimal has some startling implications. First, it means that no one—whether government official or economist—need concern himself with the money supply or worry about its optimal amount. Like shoes, butter, or hi-fi sets, the supply of money can readily be left to the marketplace. There is no need to have the government as an allegedly benevolent uncle, standing ready to pump in more money for allegedly beneficial economic purposes. The market is perfectly able to decide on its own money supply.

But isn’t it necessary, one might ask, to make sure that more money is supplied in order to “keep up” with population growth? Bluntly, the answer is No. There is no need to provide every citizen with some per capita quota of money, at birth or at any other time. If M remains the same, and population increases, then presumably this would increase the demand for cash balances, and the increased D would, as we have seen in Figure 3.6, simply lead to a new equilibrium of lower prices, where the existing M could satisfy the increased demand because real cash balances would be higher. Falling prices would respond to increased demand and thereby keep the monetary functions of the cash balance-exchange at its optimum. There is no need for government to intervene in money and prices because of changing population or for any other reason. The “problem” of the proper supply of money is not a problem at all.


Under a gold standard, where the supply of money is the total weight of available gold coin or bullion, there is only one way to increase the supply of money: digging gold out of the ground. An individual, of course, who is not a gold miner can only acquire more gold by buying it on the market in exchange for a good or service; but that would simply shift existing gold from seller to buyer.

How much gold will be mined at any time will be a market choice determined as in the case of any other product: by estimating the expected profit. That profit will depend on the monetary value of the product compared to its cost. Since gold is money, how much will be mined will depend on its cost of production, which in turn will be partly determined by the general level of prices. If overall prices rise, costs of gold mining will rise as well, and the production of gold will decline or perhaps disappear altogether. If, on the other hand, the price level falls, the consequent drop in costs will make gold mining more profitable and increase supply.

It might be objected that even a small annual increase in gold production is an example of free market failure. For if any M is as good as any other, isn’t it wasteful and even inflationary for the market to produce gold, however small the quantity?

But this charge ignores a crucial point about gold (or any other money-commodity). While any increase in gold is indeed useless from a monetary point of view, it will confer a nonmonetary social benefit. For an increase in the supply of gold or silver will raise its supply, and lower its price, for consumption or industrial uses, and in that sense will confer a net benefit to society.

There is, however, another way to obtain money than by buying or mining it: counterfeiting. The counterfeiter mints or produces an inferior object, say brass or plastic, which he tries to palm off as gold.6 That is a cheap, though fraudulent and illegal way of producing “gold” without having to mine it out of the earth.

Counterfeiting is of course fraud. When the counterfeiter mints brass coins and passes them off as gold, he cheats the seller of whatever goods he purchases with the brass. And every subsequent buyer and holder of the brass is cheated in turn. But it will be instructive to examine the precise process of the fraud, and see how not only the purchasers of the brass but everyone else is defrauded and loses by the counterfeit.

Let us compare and contrast the motives and actions of our counterfeiter with those of our good Angel Gabriel. For the Angel was also a counterfeiter, creating money out of thin air, but since his motives were the purest, he showered his misconceived largess equally (or equi-proportionately) on one and all. But our real-world counterfeiter is all too different. His motives are the reverse of altruistic, and he is not worried about overall social benefits.

The counterfeiter produces his new coins, and spends them on various goods and services. A New Yorker cartoon of many years ago highlighted the process very well. A group of counterfeiters are eagerly surrounding a printing press in their basement when the first $10 bill comes off the press. One counterfeiter says to his colleagues: “Boy, retail spending in the neighborhood is sure in for a shot in the arm.” As indeed it was.

Let us assume that the counterfeiting process is so good that it goes undetected, and the cheaper coins pass easily as gold. What happens? The money supply in terms of dollars has gone up, and therefore the price level will rise. The value of each existing dollar has been diluted by the new dollars, thereby diminishing the purchasing power of each old dollar. So we see right away that the inflation process—which is what counterfeiting is— injures all the legitimate, existing dollar-holders by having their purchasing power diluted. In short, counterfeiting defrauds and injures not only the specific holders of the new coins but all holders of old dollars—meaning, everyone else in society.

But this is not all: for the fall in PPM does not take place overall and all at once, as it tends to do in the Angel Gabriel model. The money supply is not benevolently but foolishly showered on all alike. On the contrary, the new money is injected at a specific point in the economy and then ripples through the economy in a step-by-step process.

Let us see how the process works. Roscoe, a counterfeiter, produces $10,000 of fake gold coins, worth only a fraction of that amount, but impossible to detect. He spends the $10,000 on a Chevrolet. The new money was first added to Roscoe’s money stock, and then was transferred to the Chevy dealer. The dealer then takes the money and hires an assistant, the new money stock now being transferred from the dealer to the assistant. The assistant buys household appliances and furniture, thereby transferring the new money to those sellers, and so forth. In this way, new money ripples through the economy, raising demand curves as it goes, and thereby raising individual prices. If there is a vast counterfeiting operation in Brooklyn, then the money supply in Brooklyn will rise first, raising demand curves and prices for the products there. Then, as the money ripples outward, other money stocks, demand curves, and prices will rise.

Thus, in contrast to the Angel Gabriel, there is no single overall expansion of money, and hence no uniform monetary and price inflation. Instead, as we saw in the case of the early spenders, those who get the money early in this ripple process benefit at the expense of those who get it late or not at all. The first producers or holders of the new money will find their stock increasing before very many of their buying prices have risen. But, as we go down the list, and more and more prices rise, the people who get the money at the end of the process find that they lose from the inflation. Their buying prices have all risen before their own incomes have had a chance to benefit from the new money. And some people will never get the new money at all: either because the ripple stopped, or because they have fixed incomes—from salaries or bond yields, or as pensioners or holders of annuities.

Counterfeiting, and the resulting inflation, is therefore a process by which some people—the early holders of the new money—benefit at the expense of (i.e., they expropriate) the late receivers. The first, earliest and largest net gainers are, of course, the counterfeiters themselves.

Thus, we see that when new money comes into the economy as counterfeiting, it is a method of fraudulent gain at the expense of the rest of society and especially of relatively fixed income groups. Inflation is a process of subtle expropriation, where the victims understand that prices have gone up but not why this has happened. And the inflation of counterfeiting does not even confer the benefit of adding to the nonmonetary uses of the money commodity.

Government is supposed to apprehend counterfeiters and duly break up and punish their operations. But what if government itself turns counterfeiter? In that case, there is no hope of combating this activity by inventing superior detection devices. The difficulty is far greater than that.

The governmental counterfeiting process did not really hit its stride until the invention of paper money.


The inventions of paper and printing gave enterprising governments, always looking for new sources of revenue, an “open Sesame” to previously unimagined sources of wealth. The kings had long since granted to themselves the monopoly of minting coins in their kingdoms, calling such a monopoly crucial to their “sovereignty,” and then charging high seigniorage prices for coining gold or silver bullion. But this was piddling, and occasional debasements were not fast enough for the kings’ insatiable need for revenue. But if the kings could obtain a monopoly right to print paper tickets, and call them the equivalent of gold coins, then there was an unlimited potential for acquiring wealth. In short, if the king could become a legalized monopoly counterfeiter, and simply issue “gold coins” by printing paper tickets with the same names on them, the king could inflate the money supply indefinitely and pay for his unlimited needs.

If the money unit had remained as a standard unit of weight, such as “gold ounce” or “gold grain,” then getting away with this act of legerdemain would have been far more difficult. But the public had already gotten used to pure name as the currency unit, an habituation that enabled the kings to get away with debasing the definition of the money name. The next fatal step on the road to chronic inflation was for the government to print paper tickets and, using impressive designs and royal seals, call the cheap paper the gold unit and use it as such. Thus, if the dollar is defined as 1/20 gold ounce, paper money comes into being when the government prints a paper ticket and calls it “a dollar,” treating it as the equivalent of a gold dollar or 1/20 gold ounce.

If the public will accept the paper dollar as equivalent to gold, then the government may become a legalized counterfeiter, and the counterfeiting process comes into play. Suppose, in a certain year, the government takes in $250 billion in taxes, and spends $300 billion. It then has a budget deficit of $50 billion.

How does it finance its deficit? Individuals, or business firms, can finance their own deficits in two ways: (a) borrowing money from people who have savings; and/or (b) drawing down their cash balances to pay for it. The government also can employ these two ways but, if people will accept the paper money, it now has a way of acquiring money not available to anyone else: It can print $50 billion and spend it!

A crucial problem for government as legalized counterfeiter and issuer of paper money is that, at first, no one will be found to take it in exchange. If the kings want to print money in order to build pyramids, for example, there will at first be few or no pyramid contractors willing to accept these curious-looking pieces of paper. They will want the real thing: gold or silver. To this day, “primitive tribes” will not accept paper money, even with their alleged sovereign’s face printed on it with elaborate decoration. Healthily skeptical, they demand “real” money in the form of gold or silver. It takes centuries of propaganda and cultivated trust for these suspicions to fade away.

At first, then, the government must guarantee that these paper tickets will be redeemable, on demand, in their equivalent in gold coin or bullion. In other words, if a government paper ticket says “ten dollars” on it, the government itself must pledge to redeem that sum in a “real” ten-dollar gold coin. But even then, the government must overcome the healthy suspicion: If the government has the coin to back up its paper, why does it have to issue paper in the first place? The government also generally tries to back up its paper with coercive legislation, either compelling the public to accept it at par with gold (the paper dollar equal to the gold dollar), or compelling all creditors to accept paper money as equivalent to gold (“legal tender laws”). At the very least, of course, the government must agree to accept its own paper in taxes. If it is not careful, however, the government might find its issued paper bouncing right back to it in taxes and used for little else. For coercion by itself is not going to do the trick without public trust (misguided, to be sure) to back it up.

Once the paper money becomes generally accepted, however, the government can then inflate the money supply to finance its needs. If it prints $50 billion to spend on pyramids, then it—the government—gets the new money first and spends it. The pyramid contractors are the second to receive the new money. They will then spend the $50 billion on construction equipment and hiring new workers; these in turn will spend the money. In this way, the new $50 billion ripples out into the system, raising demand curves and individual prices, and hence the level of prices, as it goes.

It should be clear that by printing new money to finance its deficits, the government and the early receivers of the new money benefit at the expense of those who receive the new money last or not at all: pensioners, fixed-income groups, or people who live in areas remote from pyramid construction. The expansion of the money supply has caused inflation; but, more than that, the essence of inflation is the process by which a large and hidden tax is imposed on much of society for the benefit of government and the early receivers of the new money. Inflationary increases of the money supply are pernicious forms of tax because they are covert, and few people are able to understand why prices are rising. Direct, overt taxation raises hackles and can cause revolution; inflationary increases of the money supply can fool the public— its victims—for centuries.

Only when its paper money has been accepted for a long while is the government ready to take the final inflationary step: making it irredeemable, cutting the link with the gold. After calling its dollar bills equivalent to 1/20 gold ounce for many years, and having built up the customary usage of the paper dollar as money, the government can then boldly and brazenly sever the link with gold, and then simply start referring to the dollar bill as money itself. Gold then becomes a mere commodity, and the only money is paper tickets issued by the government. The gold standard has become an arbitrary fiat standard.7

The government, of course, is now in seventh heaven. So long as paper money was redeemable in gold, the government had to be careful how many dollars it printed. If, for example, the government has a stock of $30 billion in gold, and keeps issuing more paper dollars redeemable in that gold, at a certain point, the public might start getting worried and call upon the government for redemption. If it wants to stay on the gold standard, the embarrassed government might have to contract the number of dollars in circulation: by spending less than it receives, and buying back and burning the paper notes. No government wants to do anything like that.

So the threat of gold redeemability imposes a constant check and limit on inflationary issues of government paper. If the government can remove the threat, it can expand and inflate without cease. And so it begins to emit propaganda, trying to persuade the public not to use gold coins in their daily lives. Gold is “old-fashioned,” outdated, “a barbarous relic” in J.M. Keynes’s famous dictum, and something that only hicks and hillbillies would wish to use as money. Sophisticates use paper. In this way, by 1933, very few Americans were actually using gold coin in their daily lives; gold was virtually confined to Christmas presents for children. For that reason, the public was ready to accept the confiscation of their gold by the Roosevelt administration in 1933 with barely a murmur.


Three times before in American history, since the end of the colonial period, Americans had suffered under an irredeemable fiat money system. Once was during the American Revolution, when, to finance the war effort, the central government issued vast quantities of paper money, or “Continentals.” So rapidly did they depreciate in value, in terms of goods and in terms of gold and silver moneys, that long before the end of the war they had become literally worthless. Hence, the well-known and lasting motto: “Not Worth a Continental.” The second brief period was during the War of 1812, when the U.S. went off the gold standard by the end of the war, and returned over two years later. The third was during the Civil War, when the North, as well as the South, printed greenbacks, irredeemable paper notes, to pay for the war effort. Greenbacks had fallen to half their value by the end of the war, and it took many struggles and 14 years for the U.S. to return to the gold standard.8

During the Revolutionary and Civil War periods, Americans had an important option: they could still use gold and silver coins. As a result, there was not only price inflation in irredeemable paper money; there was also inflation in the price of gold and silver in relation to paper. Thus, a paper dollar might start as equivalent to a gold dollar, but, as mammoth numbers of paper dollars were printed by the government, they depreciated in value, so that one gold dollar would soon be worth two paper dollars, then three, five, and finally 100 or more paper dollars.

Allowing gold and paper dollars to circulate side-by-side meant that people could stop using paper and shift into gold. Also, it became clear to everyone that the cause of inflation was not speculators, workers, consumer greed, “structural” features or other straw men. For how could such forces be at work only with paper, and not with gold, money? In short, if a sack of flour was originally worth $3, and is now worth the same $3 in gold, but $100 in paper, it becomes clear to the least sophisticated that something about paper is at fault, since workers, speculators, businessmen, greed, and so on, are always at work whether gold or paper is being used.

Printing was first invented in ancient China and so it is not surprising that government paper money began there as well. It emerged from the government’s seeking a way to avoid physically transporting gold collected in taxes from the provinces to the capital at Peking. As a result, in the mid-eighth century, provincial governments began to set up offices in the capital selling paper drafts which could be collected in gold in the provincial capitals. In 811-812, the central government outlawed the private firms involved in this business and established its own system of drafts on provincial governments (called “flying money”).9

The first government paper money in the Western world was issued in the British American province of Massachusetts in 1690.10 Massachusetts was accustomed to engaging in periodic plunder expeditions against prosperous French Quebec. The successful plunderers would then return to Boston and sell their loot, paying off the soldiers with the booty thus amassed. This time, however, the expedition was beaten back decisively, and the soldiers returned to Boston in ill humor, grumbling for their pay. Discontented soldiers are liable to become unruly, and so the Massachusetts government looked around for a way to pay them off.

It tried to borrow 3 to 4 thousand pounds sterling from Boston merchants, but the Massachusetts credit rating was evidently not the best. Consequently, Massachusetts decided in December 1690 to print £7,000 in paper notes, and use them to pay the soldiers. The government was shrewd enough to realize that it could not simply print irredeemable paper, for no one would have accepted the money, and its value would have dropped in relation to sterling. It therefore made a twofold pledge when it issued the notes: It would redeem the notes in gold or silver out of tax revenues in a few years, and that absolutely no further paper notes would be issued. Characteristically, however, both parts of the pledge quickly went by the board: the issue limit disappeared in a few months, and the bills continued unredeemed for nearly 40 years. As early as February 1691, the Massachusetts government proclaimed that its issue had fallen “far short,” and so it proceeded to emit £40,000 more to repay all of its outstanding debt, again pledging falsely that this would be the absolutely final note issue.

The typical cycle of broken pledges, inflationary paper issues, price increases, depreciation, and compulsory par and legal tender laws had begun—in colonial America and in the Western world.11

So far, we have seen that M, the supply of money, consists of two elements: (a) the stock of gold bullion and coin, a supply produced on the market; and (b) government paper tickets issued in the same denominations—a supply issued and clearly determined by the government. While the production and supply of gold is therefore “endogenous to” (produced from within) the market, the supply of paper dollars—being determined by the government—is “exogenous to” (comes from outside) the market. It is an artificial intervention into the market imposed by government.

It should be noted that, because of its great durability, it is almost impossible for the stock of gold and silver actually to decline. Government paper money, on the other hand, can decline either (a) if government retires money out of a budget surplus or (b) if inflation or loss of confidence causes it to depreciate or disappear from circulation.

We have not yet come to banking, and how that affects the supply of money. But before we do so, let us examine the demand for money, and see how it is determined, and what affects its height and intensity.

  • 1. A minor exception for small transactions is the eroding of coins after lengthy use, although this can be guarded against by mixing small parts of an alloy with gold.
  • 2. See Ludwig von Mises, The Theory of Money and Credit (Indianapolis: Liberty Classics, 1981), p. 165 and passim.
  • 3. Similarly, the fall in M depicted in Figure 3.4 also confers no overall social benefit. All that happens is that each dollar now increases in purchasing power to compensate for the smaller number of dollars. There is no need to stress this point, however, since there are no social pressures agitating for declines in the supply of money.
  • 4. With apologies to David Hume and Ludwig von Mises, who employed similar models, though without using this name.
  • 5. Mises, Money and Credit, pp. 163 ff.
  • 6. One reason for gold’s universal acceptance as money on the free market is that gold is very difficult to counterfeit: Its look, its sound as a coin, are easily recognizable, and its purity can be readily tested.
  • 7. Often, even irredeemable paper is only accepted at first because the government promises, or the public expects, that the paper after a few years, and whenever the current “emergency” is over, will become redeemable in gold once more. More years of habituation are generally necessary before the public will accept a frankly permanent fiat standard.
  • 8. During World War I, the U.S. Government, in effect, suspended redeemability of the dollar in gold.
  • 9. Gordon Tullock, “Paper Money—A Cycle in Cathay,” Economic History Review 9, no. 3 (1957): 396.
  • 10. Strictly speaking, the first paper money was issued five years earlier in the French province of Quebec, to be known as Card Money. In 1685, the governing intendant of Quebec, Monsieur Meules, had the idea of dividing some playing cards into quarters, marking them with various monetary denominations, and then issuing them to pay for wages and materials. He ordered the public to accept the cards as legal tender and they were later redeemed in specie sent from France. See Murray N. Rothbard, Conceived in Liberty (New Rochelle, N.Y.: Arlington House, 1975), vol. II, p. 130n.
  • 11. See ibid., pp. 123-40.