Thursday, December 23, 2004

Macroeconomics I - Money Supply

This is a small story to illustrate what happens if money supply in a country increase without anything else changing. (An excerpt from The Mystery of Banking By Murray N. Rothbard)

To show why an increase in the money supply confers no social benefits, let us picture to ourselves what I call the “Angel Gabriel” model. The Angel Gabriel is a benevolent spirit who wishes only the best for mankind, but unfortunately knows nothing about economics. He hears mankind constantly complaining about a lack of money, so he decides to intervene and do something about it. And so overnight, while all of us are sleeping, the Angel Gabriel descends and magically doubles everyone’s stock of money. In the morning, when we all wake up, we find that the amount of money we had in our wallets, purses, safes, and bank accounts has doubled.

What will be the reaction? Everyone knows it will be instant hoopla and joyous bewilderment. Every person will consider that he is now twice as well off, since his money stock has doubled. But, as they rush to spend the money, all that happens is that demand curves for all goods and services rise.(What this means is people want more of the same goods at the cureent prices). Society is no better off than before, since real resources, labor, capital,goods, natural resources, productivity, have not changed at all. And so prices will, overall, approximately
double, and people will find that they are not really any better off than they were before. Their cash balanceshave doubled, but so have prices, and so their purchasing power remains the same.
Because he knew no economics, the Angel Gabriel’s gift to mankind has turned to ashes. But let us note something important for our later analysis of the real world processes of inflation and monetary expansion. It is not true that no one is better off from the Angel Gabriel’s doubling of the supply of money. Those lucky folks who rushed out the next morning, just as the stores were opening, managed to spend their increased cash before prices had a chance to rise; they certainly benefited. Those people, on the other hand, who decided to wait a few days or weeks before they spent their money, lost by the deal, for they found that their buying prices rose before they had the chance to spend the increased amounts of money. In short, society did not gain overall, but the early spenders benefited at the expense of the late spenders. The profligate gained at the expense of the cautious and thrifty: another joke at the expense of the good Angel.

The moral of the story is :

  1. Plain increase in money supply does not change how society produces goods. This is called the Classical Dichotomy. Modern Macroeconomics refutes this theory. I will try to cover it later.
  2. Another important point if you had not noticed is that the immediate sufferers of such an inflations are people who earn fixed incomes, i.e. whose cash balances does not increase in such a situation.
So, what should the government be doing with the money supply ?
The fact that every supply of M is equally optimal has some startling implications. First, it means that no one—whether government official or economist—need concern himself with the money supply or worry about its optimal amount. Like shoes, butter, or hi-fi sets, the supply of money can readily be left to the marketplace. There is no need to have the government as an allegedly benevolent Uncle, standing ready to pump in more money for allegedly beneficial economic purposes. The market is perfectly able to decide on its own money supply.

But isn’t it necessary, one might ask, to make sure that more money is supplied in order to “keep up” with population growth? Bluntly, the answer is No. There is no need to provide every citizen with some per capita quota of money, at birth or at any other time. If M remains the same, and population increases, then presumably this would increase the demand for cash balances, and the increased D would, as we have seen in Figure 3.6, simply lead to a new equilibrium of lower prices, where the existing M could satisfy the increased demand because real cash balances would be higher. Falling prices would respond to increased demand and thereby keep the monetary functions of the cash balance—exchange at its optimum. There is no need for government to intervene in money and prices because of changing population or for any other reason. The “problem” of the proper supply of money is not a problem at all.

What the above piece means is that if the government does not intervene an increase money supply, but the population is rising, the prices will keep falling. Eventhough this is true, Modern Macroeconomics does not view such a scenario as favourable to the economy. Can you guess why ? Just give it a thought. Just post your questions if you have any.

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