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Friday, August 19, 2011

Demand for Money

Here's something so good from the Mises forum I'm copying it here. ABCT stands for Austrian Business Cycle theory, which claims that money printing and Fractional Reserve Banking cause booms and busts.

Q: A question about how money can be demanded. Goods are demanded with money, or other goods in a barter economy, if I am not mistaken. For example, I may want to buy a candy bar, but that is want, not demand. I have to supply something to demand with. When people talk about demanding money, I get confused. If one is holding cash, it is said they have a higher demand for money. How? What are they demanding that money with?

SD's Answer: Demand for money has a special meaning, not the same as demand for cars. By definition, it means the desire to keep money under the mattress, and neither spend it nor put in the bank [=invest it].

It is amenable to supply and demand curves, if by supply of money is meant the amount that people are not spending on consumption, and if "price" of money is meant the interest rate. The higher the price, meaning the greater the interest rate offered for money, the less the demand, meaning the less people will hide it under the mattress, because they want the high interest.

In some discussions, the price of money means something totally different, mainly it's value, meaning what you can buy with it, also known as its purchasing power. If at a given moment in a given place a dollar can buy 3 oranges or 4 apples etc etc, then the price of a dollar is defined as three oranges or four apples or etc etc.

Q: ABCT holds that business cycles are caused by an increase in the supply of money. I understand the supply part of ABCT pretty well, but I do not understand how demand factors in.

For example, wouldn't the decrease in the demand for money also cause business cycles? Why would such a decrease not result in economic problems? What about an increase in demand? Both must affect the price of money just as supply does.

This is a deep deep question. Here is my take on it.

How does one make money? By working. In other words, you only have money  if you have first produced something worthwhile, which is what working is . After you have done your share, being productive, then you get money. The money in your wallet allows you to go out there and reap the rewards of your productivity, by consuming what you want.

The point of this obvious little exposition is that before you spent any money, you have contributed to the wealth of the nation by producing something. Otherwise you wouldn't have the money to spend.

In short, having a dollar in your wallet is at once a Certificate of Productivity and a License to Consume. Your consumption will not reduce the wealth of the nation that existed before you were born, because you have already increased the wealth [by working for the money] before you ever took any wealth for yourself [by spending the money].

But what happens if the supply of money is increased? This means, in practice, that the govt prints new money for itself, either paper money or digital money. They are giving themselves a License to Consume with that new money, but it certainly is not a Certificate of Productivity. They did not contribute anything to the economy to get that money; they just printed it up for themselves.

Same with fractional reserve banking, in which a bank is legally allowed to hand out checks for money they do not have. That check is a License to Consume, but not a Certificate of Production.

ABCT explains booms and busts in this way. When the entrepeneur sees so much money floating around, he assumes mistakenly that it represents an increase in valid Certificates of Production. In other words, so much has been produced, apparently, there is a large [and therefore cheap] supply of all the stuff he needs to expand his business. So he starts expanding, using up the resources that are around, thinking there is plenty for everyone. You know the rest.

An increase or decrease in the demand for money, no matter how it is defined, does not create new Licences to Spend. That's why it doesn't create a business cycle.

Now there are some who make the argument that hoarding money will produce changes in what is produced. Which is correct. But they then make the absurd claim that these changes are "distortions", when they are but effects of changing consumer needs. Nobody would call the end of some fad a "distortion". A decision on the part of consumers to spend or not to spend for a while is the heart of the market process, not a distortion of it.

The only true distortion of a market is the granting of a License to Spend to someone who does not have a Certificate of Production. That's why counterfeiting, armed robbery, extortion, fraud, and other crimes are considered distortions of the market [and destructive of it]. Same with money printing.

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