7. The Money Supply and Inflation

The purchasing power of money (the inverse of the prices of all goods) is determined, like all prices, by supply and demand.  The total demand for money is the sum of all individuals’ demands to hold money in their cash balances.

The total supply of money increases as more of the money commodity is produced, and decreases through wear and tear.  Two important features of a good money are that it is durable and that it is expensive to produce.  These two factors tend to keep the total money supply fixed or at least only changing slightly.  For example, the world’s total supply of gold increases only at a rate of 1-2% per year.

It can easily be seen that the actual amount of money in a society is irrelevant:

• Imagine a small society of 100 individuals, who exchange between them 1000oz of gold for 1000 units of goods per year.  The average unit price of a good will be 1oz.  Now suppose that the gold supply is instantly doubled to 2000oz of gold.  All other things being equal, now the 1000 units of goods being exchanged per year will be exchanged for 2000oz of gold, so the average unit price of good will be 2oz.  Conversely, suppose that the gold supply is instantly halved to 500oz of gold.  Now the average unit price per good would simply be 1/2oz. 

It is clear that there is no “optimum” amount of money.  Any amount of money will do, and prices will be set at the appropriate level.  Growth in productivity for a society does not need the addition of new money:

• Now suppose that a few years later, the society has become more productive, and now 2000 units of goods are exchanged per year.  With a gold supply of 1000oz, the average unit price will be 1/2oz.  Everyone is better off, since the gold they are holding will now purchase twice as many goods.  No increase in the money supply is needed; the prices simply adjust.  As societies become more productive, prices should decrease provided the money supply remains constant.

Thus, there is no reason to tamper with the money supply.  While the actual amount of money is irrelevant, changes in the money supply distort the market, disrupt time-preferences and make calculations more difficult, as we shall see later.

It is worth noting that in a free-market society, banking activities – savings and loans – do not alter the money supply:

• A demand-deposit bank may issue certificates to money in storage, and these may circulate as money substitutes.  So long as the actual money is in storage (i.e. 100% reserve banking), the issuing of certificates for demand-deposits (i.e. certificates redeemable in money-proper on-demand) has no effect on the total money supply, but merely change its composition (between money-proper and money-substitutes).  If banks operate fractional-reserve banking – that is, issue certificates not backed by actual money – then this would increase the money supply.  Fractional-reserve banking is illegal in the free market because it is fraudulent in nature and hence is a violation of property rights.
• A savings-deposit bank may lend money from savers out to borrowers, their income being the difference between the rate charged to the borrower and the rate paid to the saver.  This activity would also not have an effect on the total money-supply, since the loaned money would no longer be part of the saver’s cash balance, only the borrower’s.

New money (i.e. newly mined gold, or newly printed dollar bills) must always enter the economy at some specific point.  Individuals’ cash balances do not all increase at once when new money is introduced; the individual that produced the money owns it first, and spends it first.  It takes time for new money to affect the purchasing power of money (prices of goods).  So the producer of the new money benefits, not only from the increase in his cash balance (which he earned by mining the gold), but because he spends his money while the prices of goods are still set at a level corresponding with the old total supply of money.  The new money is referred to as “high powered” because prices have not yet adjusted to account for its existence.  The second and third receivers of the new money will also be able to use it while it is still high powered.  In particular, all those who use the new money before the prices have adjusted benefit at the expense of those who do not receive the new money until after the prices have adjusted, or not at all.  This is known as the redistributive effect of inflation – the transfer of wealth from late receivers of new money to early receivers.

With gold as money, the harmful effects of inflation are limited by the following factors:

• Gold is expensive and difficult to produce, and cannot suddenly increase in volume significantly.
• Gold has a non-monetary use; an increase in the supply of gold will actually lower the prices in the gold jewelry industry.
• Gold can be produced by competing businesses; there is not just one gold mine in the world.  Gold money cannot be monopolized.

On the other hand, paper dollars, printed by a single source (a government-chartered central bank), are not limited by these factors.  They are very cheap to produce, and without any competing producers of money, the central bank can create money at will and make enormous profits.  They are not providing any useful service, since paper dollars have no non-monetary use.  Let us now illustrate the transfer of wealth that takes place when a paper-money monopoly-supply is increased.

Consider a society of 1000 individuals where one individual, Alan, has the sole authority to create money: he can print new dollar bills.  First let us suppose that the money supply is currently $10,000 and Alan decides to create another $10,000 which he will spend on building a castle.  Before this inflation of the money supply, the 1000 individuals were arranged in the most productive arrangement possible, via the natural division of labor and voluntary exchanges. 

When the supply is increased, the new money first enters Alan’s cash balance.  Then he spends that money: he hires productive factors – land, labor and capital – in order to build his castle.  Now, individuals currently producing useful goods for society and enticed by the new money offered by Alan to transfer their labor services to building his castle.  Let us suppose that 500 of the 1000 individuals stop their productive tasks in order to work for Alan.  The number of goods in the society is thus cut in half; prices will eventually double.  Also, as the new money percolates downward through the economy, the purchasing power of money will be cut in half; prices will eventually double again. 

So even though Alan’s employees may be earning more dollars, the vast majority of them will actually be losing out through having to pay higher prices when the economy has adjusted.  Furthermore, some goods previously produced would have become unavailable while the workers were diverted.  As with labor, capital and land resources would have been diverted away from their most productive uses and into the building of the castle.  Additionally, any improvements in useful production techniques (technological improvements, or new knowledge) that might have occurred during the six months, did not, because energy was instead spent on castle-building. 

It can be seen that this scenario is a vast transfer of wealth from the people to Alan, and a huge waste of labor energy which could have been spent producing for the market instead of producing purely for Alan.  While there may be other short-term beneficiaries (for example, highly-paid employees of Alan), it can be seen that the average person is far worse off because of this increase in the money supply.  In fact, due to the disruption and lack of productivity, even Alan will be worse-off in the long-term, since there will be less consumer goods being produced than there would otherwise have been.

Another effect of inflation of the money supply is a disproportionate benefit to borrowers and a disproportionate loss to savers.  If Scott had $100 in his cash balance (his savings) before the inflation, this represented $100-worth of goods at the old prices.  After the prices have doubled twice from Alan’s inflation, the same $100 will buy only $25-worth of goods at the old prices.  Though the nominal amount has not changed, Scott has lost three quarters of his savings.  Conversely, someone who borrowed $100 bought $100-worth of goods with it, and yet he only had to give up $25-worth of goods when he came to pay the loan back after Alan’s inflation.

Individuals recognize this gain to borrowers and loss to savers in an inflationary scenario implicitly in their time-preferences.  If people expect price increases, they will tend to purchase goods sooner rather than later – in other words, they will increase their time-preferences.  They will consume more than they save and invest.  This lack of investment will tend to affect higher-order producers first, and will slow down growth.  The very act of increasing time-preferences means that people want less money in their cash-balances: this decrease in demand for money further decreases the purchasing power of money, so prices increase still further.  There is the prospect of “runaway” inflation, or hyperinflation.  This is all caused by one individual having the sole power to easily create money.

Let us now analyze more carefully the redistributive effect of inflation in this scenario.  Let us suppose that Town A is the society of 1000 inhabitants including Alan, and that Town B is an almost identical town 10 miles away, and that Town C is a third almost identical town 10 miles further away.  Towns B and C use dollars, although Alan is the only person who can create new money.  Let us suppose that before Alan’s manipulations all three towns were equally productive.

Soon after Alan’s inflation of the money supply, the purchasing power of money is decreased, and productivity in Town A is decreased because the resources have been diverted to castle-building.  Prices in Town A begin to rise.  Now, the inhabitants of Town A start traveling to Town B to purchase goods.  There is a transfer of wealth from Town B to Town A.  After a while, prices in Town B are bid up, so the inhabitants of Town B start buying goods from Town C.  There is a transfer of wealth from Town C to Town B.  Unfortunately for Town C, there is nowhere left with low prices, so they are the biggest losers in this scenario.  They gave up useful goods in exchange for less-useful money.

Even the productivity of Towns B and C will be affected by Alan’s injection of money.  Suppose that inhabitants of Town A, benefiting from low prices in Town B, particularly increase their demand for a particular good like wine.  Prices in the wine industry in Town B are bid up relatively more than all the other industries.  The people in Town A have not earned this extra wine, because they have not become more productive for consumers’ needs.  Responding to high-profit opportunities in the wine industry, entrepreneurs in Town B divert resources from wheat-producing into wine-producing.  The two markets have been distorted, so that now they are not best-arranged for satisfying consumers’ desire.  People suffer from less wheat being produced, all because of Alan’s manipulations.

It is clear then that inflation transfers wealth and diverts resources from late receivers of the new money to early receivers of the money.  The early receivers of the new money will be in certain geographical areas and certain industries, and which ones depend on where the money is originally spent by the creator of the new money.  We shall examine the full effects of government inflation and government spending in the next chapter, but to further illustrate the distorting effect of new money on the economy, consider this example.

New money is first spent by the central bank that created it.  The central bank lends it to the government at interest.  The government then spends the money.  Suppose the government decides to spend it in the arms industry – say, 10 new helicopters.  Resources will be diverted away from their productive uses (for satisfying consumers’ desires) into the building of helicopters.  Weapons contractors benefit, and so do all the producers who make the higher-order goods that go into the construction of the helicopters.  Electronic equipment, aluminum, steel, ammunition, etc – which could have been used productively (if non-specific) or resources not spent creating them (if specific).  Labor and land used to produce the helicopters has also been diverted from more productive uses.  The new receivers of the money – the weapons contractors, their suppliers, their employees, businesses where the employees spend their money – all benefit from this spending. 

But, just as in the case of Alan and the three towns, what the early receivers gain, the late receivers.  There is a transfer of wealth and a distortion of production.  There will always be more people who lose out than who benefit, and in the long-term, everyone will lose out due to less consumer goods being produced.  Where Alan made the biggest gain before, the biggest gain here is again made by the producer of the money – the central bank, which lent the money to the government, and keeps the interest from the loan as profit.  The next biggest gain is the second spender of the new money – the politician who was able to indulge in consumption that would not otherwise have been possible.

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