Several economic consequences arise from Say’s Law (for example, it is production and not consumption what has to be stimulated in order to boost economic growth) , but we will go straight to the point: Money creation boosts demand , albeit this demand is not a real one.
Products are not paid for with products in this case, so the interaction commodity-money-commodity is now money-commodity. The new money ends in the hands of some (such as the government) and is spent by them on consumption, so that in this case production didn’t precede consumption. The result of an increase in the supply of money is not wealth creation, but wealth redistribution (as we will see in the next article) and a decrease in the price (or purchasing power) of money.
In the case of consumer and producer goods, the more we have, the more wants we will be able to satisfy and, thus, the richer we will be. But this is not true for money. Mises concluded 1 that changes in the quantity of consumer and producer goods as well as changes in the quantity of money lead to a change in their value, but the nature of both types of goods, real goods and media of exchange, is totally different: In the former case there is a variation in the economic position of humanity (for the better if the quantity increases and for the worse if it decreases), but in the latter case there is not such a variation. According to Rothbard “whereas new consumer or capital goods add to standards of living, new money only rises prices –i.e., dilutes its own purchasing power (..). Other goods have various “real” utilities, so that an increase in their supply satisfies more consumer wants. Money has only utility for its prospective exchange; its utility lies in its exchange value, or “purchasing power” 2. The conclusion is that any given supply of money is as good as it can be, or in other words, it doesn’t matter what the supply of money is. Rothbard states that “Any supply will do as well as any other supply. The free market will simply adjust by changing the purchasing power, or effectiveness” 3 of the monetary unit (may it be gold or paper money). Insofar as an increase in the quantity of dollars, e.g., only dilutes its purchasing power, or effectiveness, such an increase does not make us richer. Hence, “the great truth of monetary theory emerges: once a commodity is in sufficient supply to be adopted as money, no further increase in the supply of money is needed. Any quantity of money is “optimal”. Once a money is established, an increase in its supply confers no social benefit” 4.
Did it mean that, under the gold standard, mining more gold was a waste? More gold as money was not needed, but remember that gold and silver had parallel industrial uses (such as ornaments, jewelry or dentistry), so a higher supply of gold meant an increase in its non-monetary use. Actually, the non-monetary uses of gold have been expanding since the beginning of the industrial revolution. Today gold has uses in electronics, computers, the medical sector, aerospace, glassmaking, dentistry … and, although it no longer backs our notes, it is an investment asset highly appreciated due to its role as a refuge value during economic crisis.
A constant stock of money (such as it would be the case under the gold standard with a 100% reserve banking system) doesn’t mean a constant value of money. Recall that the forces of supply and demand interact to determine the price or purchasing power of money, so a fixed supply of money says us nothing about its demand side. We also know from part 3 that every piece of money has to be owned by someone and that, therefore, the sum of all cash balances owned by the people equals the total quantity of money. If society wants e.g. to make better provisions for the uncertain future, they will “save” more, that is, they will be willing to increase their cash balances and in that way the demand for money will go up. Facing a constant quantity of money, this increased demand will confer money a higher purchasing power and prices will fall. However, in order to experience a remarkable change in its purchasing power, such force must not be counteracted by other opposing force. 5
If “all” the economic agents of the society want to increase their cash balances, the value of money will change, but if only “some” of this members increase their demand for money while the rest does the opposite, the latter may compensate the former so that the purchasing power of money goes up very little (or nothing at all or it can even go down). Conversely, a fall in the demand for cash of nearly everyone (expecting a sharp devaluation of the currency) will cause for sure increased spending and higher prices if and only if there is not a counteracting force such a part of the population, acting the opposite way, increasing their demand for cash. In short, the impact of changes in the demand for money of individuals on the purchasing power of money (assuming a constant or slightly increasing stock of money) is negligible.
The supply of gold has always been limited due to the cost of mining it, so any annual output of gold has constituted a small quantity in relation to the total stock available, which has been accumulated during history. The special properties of gold enables this commodity to enjoy a great durability that protects it against wear and tear also. Since the dawn of the industrial revolution till the 1930s, industrialization, the extension of trade all over the world and the population boom experienced in many Western countries pushed the demand for money/gold up. The increase in this demand along with the increasing annual production of goods and services was soon to more than compensate the gradual accumulation of the stock of money/gold. What was the result? A demand for money outpacing its supply led to a gradual increase of the purchasing power of the monetary unit (gold ounce) resulting in a gradual decrease in the prices of all goods and services traded on the market. According to Rothbard “A rising output and falling price level signifies a steady increase in the standard of living for each person in society. Typically, the cost of living falls steadily, while money wage rates remain the same, meaning that “real” wage rates, or the living standards of every worker, increase steadily year by year (…) falling prices did not mean depression, since costs were falling due to increase productivity, so that profits were not sinking” 6. Used as we are to the steady increase of the price level, that is, to inflation, it may sound strange that from the dawn of the industrial revolution till the 1930s prices fell slightly every year as a rule, with the exception of wars, when governments were able to manipulate the supply of money. Note that a pure gold standard system has never existed and that at that time banks were able to create commercial bank money, such as deposits, unbacked by gold, increasing in that way the supply of money and partially compensating the fall in prices.
As we will see in the next article, although the quantity of money as such plays no role in our welfare, changes in its quantity, such as an increase, do have destructive real consequences. In fact, under our current monetary system , the supply of money (and therefore its value) depends on the policies of central banks, which can be more or less independent from the government, but are a fundamental organization of the state apparatus in any case.
Quotations, references and comments
1 Ludwig von Mises, La Teoría del Dinero y del Crédito, page 59. Published by Unión Editorial (1997). Any reference to this book will be based on the Spanish edition. Original title of 1912, Theorie des Geldes und der Umlaufsmittel. English edition of 1934, The theory of Money and Credit.
2 Murray N. Rothbard, What has government done to out money, page 25. Published by Ludwig von Mises Institute, fifth edition.
3 Ibid.
4 Murray N. Rothbard, The Case Against the Fed, pages 19-20. Published by Ludwig von Mises Institue (2007).
5 For instance, it is theoretically possible (although unrealistic in practice) that the effects of an increase in the money supply may be offset if and only if this additional supply is totally compensated with an increase in the demand for money (so that every additional monetary unit is kept unspent as part of cash balances).
6 Murray N. Rothbard, The Case Against the Fed, page 21. Published by Ludwig von Mises Institue (2007).
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