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Thursday, January 22, 2009

How Rapidly Should the Money Supply Grow?

I would like to make one correction to Howard Baetjer’s article “Inflation 101” (September). The author suggests that inflation results when the money supply expands faster than the rate at which goods and services are produced. The author correctly points out that this expansion of the money supply will lead to rising prices. But inflation exists even when prices are stable. Stable prices can mask underlying inflation if, absent an increase in the money supply, prices would actually have declined. In fact, for most of the nineteenth century, at a time of great industrial and agricultural expansion, prices declined. Price declines were then considered normal—the result of greater efficiencies in production—and a benefit of the industrial revolution.

Today we have come to see price increases as normal and fret when, in rare instances, general price levels actually decline. As Murray Rothbard pointed out, any increase in fiat money over the quantity of gold is inflationary. As a result, even when prices are stable, inflation may be at work robbing us of the benefits of improvements in technology and production.

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Howard Baetjer replies:
Your point that “Stable prices can mask underlying inflation if absent an increase in the money supply prices would actually have declined” is exactly correct. (My excuse: I left it out to keep the article from growing too long.) If, as you rightly point out about the nineteenth century, the output of goods and services grows more rapidly than the money supply properly should grow, then prices should gradually decrease, and that decrease would be perfectly consistent with a healthy economy.

The crucial question is how fast should the money supply properly grow? I agree with Murray Rothbard’s aversion to government-issued fiat money, largely because I believe that governments and their central bankers cannot possibly know how large the money supply should be. I am persuaded by the work of such scholars as Lawrence White, George Selgin, and Steven Horwitz that the supply of money can be rightly determined only by a free-market process in which money is issued by competing private banks, whose customers are free to use what money they see fit.

I disagree, however, with (what I take to be) Murray Rothbard’s claim that “any increase in [paper] money over the quantity of gold is inflationary.” The key factor is not that the quantity of money supplied should grow no larger than the quantity of gold (or whatever other base-money commodity the market process might settle on), but that it should grow no larger than the quantity of money demanded.

That is, monetary equilibrium should be maintained: When people wish to hold more money, banks should create more money. When they wish to hold less, banks should extinguish some. I recommend George Selgin’s The Theory of Free Banking for a fascinating description of how profit-and-loss incentives in free-market banking would naturally keep the money supply at or very near the “right” quantity.