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Many hold that a growing economy requires a growing money supply in order to provide support to economic growth. This gives the impression that money is the means of sustenance that sustains economic activity. However, money’s main function is to fulfill the role of a medium of exchange. Money itself does not sustain economic activity, rather production, saving, and capital investment.

Historically, many different goods have been used as the medium of exchange. On this, Mises observed that, over time,

…there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money.

Through the ongoing process of selection, individuals settled on gold as their preferred medium of exchange. Many economists—while accepting this historical evolution—cast doubt that gold can fulfill the role of money in the modern world. Many believe, relative to the growing demand for money because of growing economies, the supply of gold is not adequate. Some commentators are of the view that the lack of a flexible mechanism that coordinates the supply versus the demand for money is the major reason why the gold standard leads to instability. In other words, the supply of gold is not growing fast enough. This, in turn, runs the risk of destabilizing the economy. Hence, most economists—even those who express sympathy towards the idea of a free market—endorse the view that the government must control the money supply. According to Larry Elkin,

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.

Demand for Money

By demand for money, what we really mean is the demand for money’s purchasing power. After all, individuals do not want a greater amount of money in their pockets, what they want is a greater purchasing power in their possession. Similar to other goods, the price of money is the array of all the goods and services, or fractions of them, for which a monetary unit will exchange. Therefore, the price of money is determined by supply and demand just like all other goods. If there is a decline in the quantity of money, all other things being equal, its exchange value will increase. Conversely, the exchange value will decline with an increase in the quantity of money, all other things being equal.

Within a free market, there is no such 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. Once the market has chosen a particular commodity as money, the given stock of this commodity will be sufficient to secure the services that money provides. According to Mises:

. . .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.

Furthermore, notwithstanding the increase in the demand for money the increase in the supply will set the foundation for exchanges of nothing for something and economic impoverishment.

From Commodity Money to Paper Money

Originally, paper money was not regarded as money but merely as a representation of gold. Various paper certificates represented claims on the gold stored with the banks. The holders of paper certificates could convert them into gold whenever they believed necessary. Because individuals found it more convenient to use paper certificates to exchange for goods and services, these certificates came to be regarded as money.

That paper certificates are accepted as the medium of exchange, this opened the scope for fraudulent practice. Banks were now tempted to boost their profits by lending certificates that were not covered by gold. A bank that over-issued paper certificates will find out that the exchange value of its certificates, in terms of goods and services, will decline. To protect their purchasing power, holders of the over-issued certificates are likely to attempt to convert them back to gold. If all of them were to demand gold back at the same time, this would bankrupt the bank. The threat of bankruptcy provides a built-in restraint on banks, making it risky to issue paper certificates unbacked by gold, even if it is legal.

Paper money cannot assume a “life of its own” and become independent of commodity money. The government could, however, issue a decree that makes it legal for the over-issued banks not to redeem its certificates into gold. Once banks are not contractually obligated to redeem certificates into gold, opportunities for large profits are generated that set incentives to pursue an unrestrained expansion of artificial money and credit. The uncontrolled expansion leads to uneven price increases of goods and services and economic dislocation through distorting economic calculation, which leads to a boom-bust cycle.

To prevent such a breakdown, the supply of certificates must be managed. This can be achieved by establishing a monopoly bank (i.e., a central bank) that manages the banks within the system and the money supply. To assert its authority, the central bank introduces its own certificate, which replaces the certificates of various banks. (The purchasing power of the central bank’s certificate is established by the fact that various bank certificates are exchanged for the central bank certificate at a fixed rate. The central bank certificate is fully backed by banks’ certificates, which have the historical link to gold). The central bank’s certificate is declared as legal tender, and also serves as reserve assets for banks. This enables the central bank to set a limit on the credit expansion by the banking system via setting regulatory ratios of reserves to demand deposits.

It would then appear that the central bank could manage and stabilize the monetary system. The truth, however, is the exact opposite. The present fiat monetary system emerged because central authorities made it legal for the over-issued banks not to redeem certificates into gold and acted as a “lender of last resort” for these banks. To manage the system, the central bank must constantly generate inflation of money and credit “out of thin air” to prevent banks from bankrupting each other during the interbank clearance of checks. This leads to a persistent decline in money’s purchasing power, which destabilizes the entire monetary system and the structure of production.

Even Milton Friedman’s framework to fix the money growth rate at a given percentage based on rules will not do the trick. After all, a fixed percentage growth is still inflationary money growth, which leads to the exchange of nothing for something (i.e., price inflation, economic impoverishment, and boom-bust cycles).

What about keeping the current stock of paper money unchanged? Would that do the trick? An unchanged money stock would cause a breakdown of the present monetary system. After all, the present system survives because the central bank—by means of monetary injections—prevents the fractional reserve banks from going bankrupt and many businesses, in whole or in part, depend on the low interest rates provided by easy money and credit.

How long the central bank can keep the present system “going” is dependent upon the state of the available private savings, market production, and capital. As long as this still expands, even amid inflationary distortions, the system continues with both genuine, market production and bubble production. However, such policies cannot continue forever because a bust inevitably follows a boom.

Conclusion

In an unhampered market economy, without central bank interference, there is no need to be concerned with the optimum money supply growth rate. Any amount of money will do the job that is expected from money (i.e., it will fulfill the role of the medium of exchange).

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