For most economists and commentators the main role of the Fed is to keep the supply and demand for money in equilibrium. Whenever an increase in the demand for money occurs — in order to maintain the state of equilibrium — it is held that the Fed must increase the money supply as a necessary action in order to keep the economy on a path of economic and price stability.
The accommodation of the increase in the demand for money is not considered as money printing and therefore not harmful to the economy. That is, this sort of increase, it is held, does not set in motion the boom-bust cycle as long as the growth rate of money supply does not exceed the growth rate in the demand for money.
Note that by this way of thinking, since the growth rate in the demand for money is offset by the growth rate of the supply of money, then no effective increase in the supply of money occurs. From this perspective, no harm is inflicted on the economy.
Why Accommodating Demand for Money Is Always Harmful
What do we mean by demand for money? In addition, how does this demand differs from the demand for goods and services?
The demand for a good does not reflect the demand for a particular good as such, but the demand for the services that the good offers. For instance, an individual demands food because this provides the necessary elements that sustain his life and wellbeing. Demand here means that people want to consume the food in order to secure the necessary elements that sustain their life and wellbeing.
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 goods and services.
With the help of money, various goods become more marketable — they can secure more goods than in the barter economy. What enables this is the fact that money is the most marketable commodity.
An increase in the general demand for money, let us say, on account of a general increase in the production of goods, doesn’t imply that individuals’ sit on the money and do nothing with it.
The key reason an individual demand’s money is in order to be able to exchange money for other goods and services. So in this sense an increase in the supply of money is not going to be neutralized by a corresponding increase in the demand for money, as will be the case with various goods.
An increase in the supply of apples is neutralized 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%, is absorbed by the increase in the demand for apples by 5%. The same cannot however, be said with regard to the increase in the supply of money, which has taken place in response to the same increase in the demand for money.
Money Isn’t Like Other Goods
We have seen that contrary to other goods, an increase in the demand for money implies an increase in the employment of money to facilitate transactions. This means that an increase in the demand for money by 5% is not going to neutralize an increase in the supply of money by 5%. The increase in the demand by 5% implies that people’s demand for the services of money has increased by 5%.
An increase in the supply of money, in response to an increase in the demand for money, does not imply that its effect on the economy will be neutral. Consequently, any increase in the supply of money out of “thin air” is going to set in motion all the negatives that an increase in money out of “thin air” does.
There Is Always Enough Money
Again, irrespective of whether the total demand for money is rising or falling what matters is that individuals employ money in their transactions.
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. Hence, it is futile to accommodate the increase in the demand for money by the increase in the supply. An increase in the demand for money does not require an increase in the supply as is the case with respect to other goods.
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.1
It is held that if the Fed accommodates an increase in the demand for money this accommodation should not be regarded as an increase in the supply of money as such. But in practice, this accommodation, like any other accommodation by the Fed, results in the increase in money supply out of “thin air.” All other things being equal, this leads to an exchange of nothing for something that sets in motion the menace of the boom-bust cycle.
- 1. Ludwig von Mises, Human Action, 3rd rev. ed. (Chicago: Contemporary Books, 1966), p.421.
This article originally posted here.