Money Supply in the Economy

I’ve talked about inflation and I’ve talked about deflation, two problems that arise from an imbalance between the money supply and the economic output (amount of goods and services produced) in a society.

At first blush it seems like it would be simple to keep the money supply and economic output balanced. You just keep a watch on what the economic output is doing and you print that many dollar bills (or stamp that many coins, or whatever). The government can increase the money supply by simply printing more or even more easily by simply making entries in computer records, however, as is often the case with economics, the reality is far, far more complicated.

First, you have to consider what money is. Put simply, money is whatever serves as an accepted medium of exchange in the sale and purchase of goods and services. It’s not a good or service itself. It’s certainly not wealth. After all, a person with a fifty trillion Deutschmark note in the 1923 Weimar Republic could buy less with that than a person with a 1000 Deutschmark note in 1910 (say). Money is not wealth. What you can buy with it is wealth.

One thing about this definition is that you can readily see that a lot of things other than just official currency serves as money from an economic perspective. Letters of credit. Checks. Banknotes. Even old-fashioned “company scrip”. All of those things count as “money” from an economic perspective.

So, just looking at the various things that can act adds complication to the idea of “money supply.” Let’s take a look at a particular example.

Back in the day when money was precious metals, chiefly gold, anyone with a supply of money (gold) would need to provide security to keep it safe from thieves. They would, perhaps, have to have some kind of strongbox, perhaps guards. Those cost. Indeed, the guards can be quite expensive since the temptation for them to take the gold themselves so you have to pay them enough to make the risk-reward for guarding your gold for you look better than the risk-reward for absconding with your gold themselves. You can soon end up spending all your gold just providing protection for the gold. “There has to be a better way,” you think.

What you can do is find someone who also has a lot of gold to guard. Since they already have guards, a strongbox, what have you to protect their own gold. They aren’t going to do that for free (just yet anyway: we’ll get to that in a moment) since your gold will take up space in their strongbox and having more gold means they’re a more attractive target for thieves so maybe they have to add an extra guard. Still, it’s cheaper for them to add capacity to what they already have than it is for you to build a new capacity from scratch so what they charge you to hold your gold for safekeeping is less than you’d have to spend to provide equivalent security yourself. And, once you add in not only your gold but other people’s gold, each individual’s cost to provide the security becomes quite modest. So, you hand over your gold and get a receipt saying how much you have on deposit. It’s a lot easier to provide security for that receipt than it is for the gold that it says you have. Winning all around.

That’s all well and good. Your gold is safe and you have a piece of paper (or parchment, or papyrus, or clay tablet, or carved piece of stone…whatever) that says how much gold you have on deposit. Now here’s the thing. You can use that piece of paper (parchment, papyrus,…) itself as a medium of exchange. After all, somebody can take that and go get the gold it represents from the gold guard company (let’s use a modern term and call it a bank). Even more, you can write a note saying “give this guy this much of my gold” and, so long as you have an appropriate agreement with the bank, they’ll give them that gold. This note now becomes money in the economic sense.

But what about the gold sitting there in the bank? It’s just sitting there but it doesn’t have to. The banker can take part of that gold and loan it to others at interest and use it to get even more gold. This puts the gold back in circulation as money (perhaps to be deposited by others into this, or another, bank). The banker can do this so long as not everyone who has their gold in the bank comes and demands it all as once. Indeed, the banker can end up getting enough money for interest from loans to stop charging people for storing their gold. More, the banker might divide up some of the interest he receives from those loans among folk who keep their gold in his vault to encourage them to encourage people to put and keep their gold there so the banker has more gold to lend, gaining more in interest.

So now you have the same gold being represented twice in the economy, both as the gold itself, loaned out by the bank. That’s an increase in the net money supply. The same principle applies to anything that can be freely traded that stands as a proxy for value for other things.

Note that I said above “so long as not everyone who has their gold in the bank comes and demands it all at once.” Well, when that does happen, then bad things happen. The first people to demand the gold, get it, of course. But soon enough the gold runs out (because much of it has been loaned out) and the folk who come later find the vaults empty. This has several bad effects. One thing that happens is all those “receipts” and notes end up being worthless. The extra money supply caused by counting the same gold twice (once in terms of the receipts/notes and once in being loaned out) vanishes. The money supply contracts drastically, and deflation ensues.

Another factor that can reduce the money supply is foreign trade. When people in the US (since I’m in the US, I’ll use it as the example) buy foreign goods, with US dollars, the result is that folk in the US have goods and services. Folk in the other country have US dollars. Temporarily, at least, those dollars are out of circulation in the US reducing the money supply in the US. Now, normally, those dollars aren’t any good to the foreign individuals themselves. You can’t eat them. They don’t provide transportation. They make horrible clothing. So, those foreigners generally want to either spend or invest them which brings them back into the US economy. However, sometimes a nation will, for reasons of its own, want to accumulate US funds and hold onto it for an extended period (usually banking on the US economy remaining more stable in times of global uncertainty). The result is, again, a reduction in the money supply and deflation.

The same thing I just described can also apply to individuals who hold onto cash with no intent to invest or spend it. And by “hold onto cash” I mean stuff it into a mattress or fill a swimming pool with gold coins (a la Scrooge McDuck). Putting it in the bank or any kind of investment account does not count, as I have just illustrated above.

“They’re hoarding cash” some say.
“How?”
“By putting it in the bank and not spending it.”
“But the bank then turns around and lends it…that’s what banks do and how they make their money.”

Where things get “interesting” is when you have both inflation and deflation at the same time. You have some forces busily increasing the money supply (the Federal Reserve Board and Quantitative Easing as an example) while other forces are busily decreasing it (foreign acquisition of cash). The twin forces can keep an uneasy balance and look like stable economic growth but it’s anything but stable. Sooner or later those folk holding onto cash (and not investing or depositing it) will want to do something with it. If not the individual miser with a mattress full of bills, then said miser’s heirs. And that will mean a sudden influx of cash into the economy. And while an individual miser is unlikely to have accumulated enough uninvested cash to significantly effect the US economy, a foreign government is a different matter entirely. And so the inflation from increasing the money supply faster than the growth of economic output is not eliminated, just deferred.

These are just some of the reasons why “money supply” is a far more complicated problem than many people realize and that attempts to “tune” the economy by manipulating monetary policy can easily backfire. Better, I think, to have a stable monetary policy, say a fixed percentage rate of addition to the money supply annually. (The late Milton Friedman advocated such a policy called a “k-percent rule”).

You’ll still get economic ups and downs, but you won’t add to them by attempts to “fix” them that backfire.