In his recent speech on May 2 2007 to the Society of Business Economists the Governor of the Bank of England has further elaborated on the issue of supply and demand for money.

How should a policymaker respond to developments in money and credit? One approach is to ignore them on the grounds that they contain no incremental information about the outlook for inflation. This approach — which is compatible with many modern models of inflation — may well appear appropriate when money growth is associated with shocks to the demand for money that have few, if any, implications for spending and inflation. Ignoring developments in money and credit would, however, be a mistake when there are shocks to the supply of money. (Speech by Mervyn King, The MPC Ten Years On — May 2007.)

What do we mean by demand for money? And how does this demand differ from demand for goods and services?

Now, demand for a good is not a demand for a particular good as such but a demand for the services that the good offers. For instance, individuals’ demand for food is on account of the fact that food provides the necessary elements that sustain an individual’s life and well being. Demand here means that people want to consume the food in order to secure the necessary elements that sustain life and well being.

Also, the demand for money arises on account of the services that money provides. However, instead of consuming money people demand money in order to exchange it for goods and services. With the help of money various goods become more marketable — they can secure more goods than in the barter economy. What enables this is the fact that money is the most marketable commodity.

Take for instance a baker, John, who produces ten loaves of bread per day and consumes two loaves. The eight loaves he exchanges for various goods such as fruit and vegetables. Observe that John’s ability to secure fruits and vegetables is on account of the fact that he has produced the means to pay for them, which are eight loaves of bread. The baker pays for fruit and vegetables with the bread he has produced. Also note that the aim of his production of bread, apart of having some of it for himself, is to acquire other consumer goods.

Now, an increase in the John’s production of bread, let us say from ten loaves to twenty a day, enables him to acquire a greater quantity and a greater variety of goods than before. As a result of the increase in the production of bread John’s purchasing power has increased. This increase in the purchasing power not always can be translated in securing a greater amount of goods and services in the barter economy.

In the world of barter John may have difficulties to secure by means of bread various goods he wants. It may happen that a vegetable farmer may not want to exchange his vegetables for bread. To overcome this problem John would have to exchange his bread first for some other commodity, which has much wider acceptance than bread. In short, John is now going to exchange his bread for the acceptable commodity and then use that commodity to exchange for goods he really wants.

Note that by exchanging his bread for a more acceptable commodity John in fact raises his demand for this commodity. Also, note that John’s demand for the acceptable commodity is not to hold it as such but to exchange it for the goods he wants. Again the reason why he demands the acceptable commodity is because he knows that with the help of this commodity he can convert his production of bread more easily into the goods he wants.

Now let us say that an increase in the production of the acceptable commodity has taken place. As a result of a greater amount of the acceptable commodity relative to the quantities of other goods the unitary price of the acceptable commodity in terms of goods has fallen. All this, however, has nothing to do with the production of goods.

In short, the increase in the supply of acceptable commodity is not going to disrupt the production of goods and services. Obviously if the purchasing power of the commodity were to continue declining then people are likely to replace it with some other more stable commodity. Through a process of selection people have settled on gold as the most accepted commodity in exchange. In short, gold has become money.

Let us now assume that some individual’s demand for money has risen. One way to accommodate this demand is for banks to find willing lenders of money. With the help of the mediation of banks willing lenders can transfer their gold money to borrowers. Obviously such a transaction is not harmful to anyone.

Another way to accommodate the demand is instead of finding willing lenders the bank can create fictitious money — money unbacked by gold — and lend it out. Note that the increase in the supply of newly created money is given to some individuals. There must always be a first recipient of the newly created money by the banks.

This money, which was created out of “thin air”, is going to be employed in an exchange for goods and services i.e. it will set in motion an exchange of nothing for something. The exchange of nothing for something amounts to the diversion of real wealth from wealth to non-wealth generating activities, which masquerades as economic prosperity. In the process genuine wealth generators are left with fewer resources at their disposal, which in turn weakens the wealth generators’ ability to grow the economy.

Could a corresponding increase in the demand for money prevent the damage that money out of “thin air” inflicts on wealth generators?

Let us say that on account of an increase in the production of goods the demand for money increases to the same extent as the supply of money out of “thin air”. Recall that people demand money in order to exchange it for goods. Hence at some point the holders of money out of “thin air” will exchange their money for goods. Once this happens an exchange of nothing for something emerges, which undermines wealth generators.

We can thus conclude that irrespective of whether the total demand for money is rising or falling what matters is that individuals employ money in their transactions. As we have seen once money out of ‘thin air’ is introduced into the process of exchange this weakens wealth generators and this in turn undermines potential economic growth. Clearly then the expansion of money out of “thin air” is always bad news for the economy. Hence the view that the increase in money out of “thin air” which is fully backed by demand is harmless doesn’t hold water.

In contrast, an increase in the supply of gold money is not going to set an exchange of nothing for something and therefore will not have as such any effect on non-gold producers of goods. We can further infer that it is only the increase in money out of “thin air” that is responsible for the boom-bust cycle menace. This increase sets the boom-bust cycles irrespective of the so-called overall demand for money. We can also conclude from here that regardless of demand an increase in the supply of commodity money doesn’t set boom-bust cycles.

Dr Shostak is a former professor of economics who now works in the private sector

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