Through the ongoing process of exchange, people eventually settled on gold as their preferred medium of exchange. Some commentators cast doubt that gold could fulfill the role of money in the modern world. It is held that, relative to the growing demand for money because of growing economies, the supply of gold is not growing fast enough.
According to Insider from June 15, 2011,
The basic problem is that the supply of gold is not related to the quantity of goods and services being produced. . . . As a result of this scarcity, prices decline. Individuals have less incentive to produce new goods and services. Economic growth is stifled. Allowing money to become scarce does the greatest harm to those who have the least. In the past, the relative inflexibility of the monetary system contributed to the chronic lack of growth in many of the world’s less developed countries. Since the 1970s, we have had one of the most flexible monetary systems the world has known, and many of these countries have flourished. With a flexible monetary system, more money can be created to accommodate more growth.
In this way of thinking, the free market, by failing to provide enough gold, will cause money supply shortages. This, in turn, runs the risk of destabilizing the economy. A growing economy requires a growing money stock, we are told, because economic growth gives rise to a greater demand for money, which must be accommodated. Failing to do so is likely to result in a decline in the prices of goods and services, which, in turn, is likely to destabilize the economy and lead to an economic recession or, even worse, depression.
Hence, to prevent various economic shocks—emanating from imbalances between the demand and the supply of money—the Fed must keep the supply and demand for money in equilibrium. Whenever an increase in the demand for money occurs, to maintain the state of equilibrium the accommodation of the demand by the Fed is considered as a necessary action to keep the economy on the path of economic and price stability.
According to this thinking, a given growth rate in the demand for money absorbs an increase in the supply of money of the same percentage. Thus, if the demand for money rises by 5 percent and the supply of money also rises by 5 percent the effective increase in money will be 0 percent. The increase in the supply of money by 5 percent is absorbed by the increase in the demand for money by 5 percent. From this perspective, no harm is inflicted on the economy.
The Meaning of Demand for Money
Demand for a good is not a demand for a particular good as such but a demand for the services that the good offers. For instance, individuals demand food because food provides the necessary elements that satisfy hunger. Similarly, the demand for money arises because of the services that money provides. However, instead of consuming money, people demand money in order to exchange it for other goods and services.
Money’s key role is simply to fulfill the role of the medium of exchange. Money facilitates the flow of goods and services between producers and consumers that could not obtain under barter. With the help of money, various goods become more marketable. What enables this is the fact that money is the most marketable commodity.
Thus, while in a barter economy, a butcher is likely to encounter difficulties to exchange his meat for tomatoes of a vegetarian farmer. In a money economy, the butcher could exchange his meat for money and then exchange money for goods he wants.
An increase in the general demand for money, let us say, on account of a general increase in the production of goods, does not imply that individuals’ are going to sit on money and do nothing with it. The main reason an individual demands money is in order to exchange money for other goods and services.
In this sense, an increase in the demand for money will not absorb a corresponding increase in the supply of money, as will be the case with various 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 be said, however, with regard to the increase in the supply of money, which has taken place in response to the increase in the demand for money. An increase in the demand by 5 percent implies that people’s demand for the services of money has increased by 5 percent. An increase in the supply of money will not be taken out of the economy because of the corresponding increase in the demand for money. Consequently, an increase in the supply of money to accommodate a corresponding increase in the demand for money will set in motion all the negatives that accompany it.
Furthermore, when we talk about demand for money, what we really mean is the demand for money’s purchasing power. After all, people do not want a greater amount of money in their pockets but they want greater purchasing power in their possession. 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 through a process of exchange, the given stock of this commodity will be sufficient to secure the services that money provides. Within a free market, there cannot be such a thing as “too little” or “too much” money. As long as the market is allowed to clear, no shortage or surplus of money can emerge. In an unhampered economy without central bank interference there is no need to be concerned with the optimum money supply growth rate. Any amount of money chosen by the market will do the job.
With commodity money, an increase in the supply of that commodity will not set in motion the menace of boom-bust cycle. This should be contrasted with inflationary increases of money and credit.
Conclusion
If the Fed accommodates an increase in the demand for money this should not be regarded as an effective increase in the supply of money as such. Any inflation by the Fed results in the increase in money supply and leads to boom-bust cycles and economic impoverishment. In an unhampered market without central bank interference, any quantity of a market-selected money will correspond to the correct amount and no one is required to monitor and control this quantity.
