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Say’s Law and the Effects of a Growing Money Supply

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The credit cycle drives the business, or trade, cycle. It should be obvious that changes in the quantity of money, mostly in the form of bank credit, have an effect on business conditions. Indeed, that is why central banks implement a monetary policy. By increasing the quantity of money in circulation and by encouraging the banks to lend, a central bank aims to achieve full employment.

Other than quantitative easing, the principal policy tool is management of interest rates on the assumption that they represent the “price” of money. But there is also a cyclical effect of boom and bust, linked to changes in the availability of bank credit, so modern central banks have tried to foster the boom and avoid the slump.

What Happens When There Is No Change in the Money Quantity

But before we can understand what drives a boom and bust business cycle, we first must understand the condition of an economy with no change in the quantity of money.

It matters not what the money is, only that it is accepted by everyone as money—that is to say, a commodity with the sole function of acting as an intermediary between the exchange of labor for goods and services and facilitating the choice between different goods and different services. The root of exchange is not the money, but that it facilitates comparisons of value between goods.

It is therefore the basis behind the division of labor, famously described by French economist Jean-Baptiste Say in his 1803 A Treatise on Political Economy in the following terms:

It is worthwhile to remark that a product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. When the producer has put the finishing hand to his product he is most anxious to sell it immediately, lest its value should diminish in his hands nor is he less anxious to dispose of the money he may get for it; for the value of money is also perishable but the only way of getting rid of money is in the purchase of some product or other. Thus, the mere circumstance of creation of one product immediately opens a vent for other products.


Money performs but a momentary function in this double exchange and when the transaction is finally closed it will always be found that one kind of commodity has been exchanged for another.

Bear in mind that this was written in uncertain times for France, following the collapse of assignats and mandats territoriaux, two forms of state-issued currency during the previous decade—hence the rejoinder about disposing of money immediately. Otherwise, it is a fair description of how producers and consumers, always different but the same people, use money and of money’s true purpose.

The import behind these two statements was subsequently given the title of Say’s law. They were so obviously true that Keynes had a problem getting around them so that an economic role could be created for the state, which was the hidden purpose behind his General Theory. His solution was to minimize any mention of Say’s law and to restrict it to one reference early on (page 26). And that reference was another of his slippery definitions:

Thus Say’s law, that the aggregate demand price output as a whole is equal to its aggregate supply price for all volumes of output is equivalent to the proposition that there is no obstacle to full employment.

This is not Say’s law. What is aggregate demand price output? It is pure nonsense as is aggregate supply price for all volumes of output. These high-sounding phrases deflect attention from the truisms in Say’s law, that we divide our labor to maximize our vendible output so that we can acquire the goods and services we need and desire. No mention is made of full employment. There will always be unemployment among those unable to work, the work-shy, the sick, and the elderly. But they need either their own savings to draw upon or benefactors to support them. Family, charities, and the state perform this function, but in all these cases support must come from those who produce. Say’s law is not and never was equivalent to the proposition that there is no obstacle to full employment.

As to the unemployment question in the wider sense, neo-Keynesian manipulation of money and support for businesses that do not serve the consumer to his satisfaction have coincided with the rise of unemployment.

It will become obvious that the quantity of money in the economy is irrelevant for its efficient functioning, so to have a fixed amount of circulating currency will not impair the workings of the economy in any way. Goods and services are produced solely for the satisfaction of consumers and other businesses, all of which in turn also produce goods and services for others. The economy continually evolves, and through free markets scarce capital is deployed by entrepreneurs to be used as efficiently as possible for profits. The supply of capital comes from consumers’ savings together with money put aside for the purpose by producers themselves.

Consumers are encouraged by producers to defer some of their consumption by compensating them with an amount that exceeds the value they place on possession of current goods over possession at a future date. The mechanism, interest rates, are bid up to achieve the level of deferred consumption required to fund the necessary investment to produce the products demanded in the future. They will reflect three components: the originary rate, which can be equated to a general time preference reflecting the different values of possession and future possession; the risk of loss of capital; and an entrepreneurial value because bondholders and business owners share a common objective even though contractually their interests are separated.

The monetary capital made available to the entrepreneurial class is put together with other factors of production, such as labor, commodities, machinery, part-manufactures, and an establishment to produce goods and services.

Thus, an economy has all that is needed to supply the evolving demands of consumers: a fixed quantity of money, part of which is retained in savings for investment in production, production, and finally consumption itself. Businesses fail and others emerge. The division of labor ensures everyone is employed, with the exception of those unable to work, who are carried by others who are or are supported by their savings.

Individual prices of goods and services rise and fall, according to changes in demand and the anticipation of producers to meet those changes. It is this environment where Schumpeter’s description of creative destruction applies. Production of goods and services that fail to produce expected returns are quickly abandoned and capital in all its forms redeployed to more productive and profitable uses. The arbiter in this process is always the consuming customer. Any business that fails to satisfy the customer fails itself.

In our example of a fixed money economy, government involvement merely redistributes existing money. Because a government is always bureaucratic and interventionist, it detracts from the economic progress otherwise enjoyed, which is why a high-spending government suppresses economic progress, while a low-spending government permits a greater degree of economic progress. Nonmonetary government intervention only changes the level of economic progress and does not lead to cyclical behavior.

The Effect of Changes in the Quantity of Money

Now let us amend our model to accept fluctuations in the quantity of circulating money. We can now see that there is an additional factor to the conditions of Say’s law: there is money whose economic origin is not that of a selling producer or spending consumer. But being wholly fungible with existing money, it does not have a different identity.

Without the state’s intervention, the source of extra money is bank credit. Banks create loan facilities, which in turn create deposits when loans are drawn down through payments made in the course of business. During a period of bank credit expansion, all banks will see increasing levels of deposits, and when these lead to imbalances for individual banks they are reconciled through wholesale money markets.

The expansion of bank credit favors the banks themselves and their lending customers, who get to benefit and spend it first, before prices can reflect the additional currency in circulation. As the extra money is spent into increasingly wider distribution, it drives prices up behind it in what is known as the Cantillon effect. Eventually, it is fully absorbed into economic activities. But since production resources are relatively inelastic, the purchasing power of currency units declines as the greater quantity of money chases the same goods. This is reflected in an increase in the general level of prices.

But during the process of new money being absorbed into the economy, a cycle of economic activity develops. Initially, the extra money in circulation creates demand for goods and services that did not previously exist. A temporary boom in business activity takes place, but only for those goods and services in the locations where the new money is spent. But unrecorded is the transfer of wealth that benefits early receivers of the new money, from those who only receive it later. The losers are obviously the savers, whose capital buys less, and the workers, whose salaries are devalued.

The spread of rising prices affects businesses as well. As the extra money percolates through the economy, they find that the cost of raw materials and commodities rises, driven by the excess demand for them created by the additional money. Shortages of skilled labor develop, and the cost of labor rises. Waiting times for manufacturing equipment lengthen, and their prices rise as well. Other prices rise, such as establishment costs and the cost of energy. Meanwhile, the availability of monetary capital continues to expand as banks compete for business in the boom times.

At some point, the expansion of the banks’ balance sheets informs the prudent banker that even though times are good, some caution must prevail. The fall in the currency’s purchasing power has led to money being diverted from savings to consumption, because the time preference between possession and nonpossession has increased. Even though higher levels of spending ensure that money continues to circulate through the banks, they need to raise interest rates to maintain the balance between the extension of bank credit and the security of customer deposits. This is because there is an inherent risk for banks in funding term credit through checking accounts, which can be drawn down without notice, instead of term deposits.

The rise in interest rates disrupts producers’ business models and they begin to consider reallocating capital to other applications. As we have seen, when there is a stable quantity of money, this is not a problem, essentially because changing business strategies in a fixed-money economy is a random process. Neither is the extension of production time that tends to accompany artificially suppressed interest rates, illustrated by Hayek’s triangle, ever an issue in a fixed-money economy. But the effect of the expansion of money has been to ensure that all businesses tend to act in the same way at the same time. A significant bias develops, so that the majority of businesses end up at a crossroads at the same time, reassessing businesses that have become unprofitable.

Commercial banks are sensitive to these changed conditions and are only too aware of the risks of extended lending to unprofitable businesses. At the same time, therefore, bankers in the majority of banks arrive at the same conclusion, again all together: they should reduce lending risks for fear of being caught out in a slump.

The expansion of bank credit commences and gathers pace over an extended period of time, and then comes to a sudden halt. It is clear that the origin of the business cycle is found in an increase in the quantity of circulating money in the form of bank credit. Without changes in the quantity of bank credit, a cycle of business activity cannot develop.

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