Effects of a Constant Money Supply 

If no additional money is printed, the nominal value of spending in our economy remains constant (assuming no leakage of money to other countries and assuming a constant velocity (see Unit 9) of money). The only long-run variable that then affects the price level is the total (aggregate) real supply of products. Thus, if supply increases, prices decrease.

In the short run, it is possible that cost factors, such as the price of imported oil, or other raw materials, cause prices to increase. However, experience teaches us that these factors fluctuate in the short run only. It is unlikely that the prices of these resources experience sustained increases, especially if the countries in which these resources are produced keep their money supply constant. In fact, it is mathematically impossible for the overall price level in the world to increase if all countries keep their money supply constant. If the demand for one product increases, the price of this product can increase over time. However, given a constant money supply, this means that the demand for other products will have to decrease. Thus, the overall price level must remain constant. Only a decrease in aggregate supply can increase the overall price level in a constant money supply economy. A decrease in real aggregate supply is highly unlikely in free market economies that have experienced average real GDP growth rates of at least 2 – 3% for many decades now.

Given our significant increases in productivity and aggregate supply, if the money supply had remained constant during the past decades, prices would have fallen. Instead, due to increases in the money supply, most industrialized countries have experienced increasing prices.

Concerns about Falling Prices

There is concern about falling prices, because of the association of falling prices with economic depressions. Indeed, falling prices due to a stagnating economy are a bad symptom. However, falling prices are a sign of a strong economy if they fall due to production increases. Even if prices fall when demand decreases it is a necessary thing, because falling prices in a contracting economy will serve as corrections to an eventually improving economy.

Advances in technology and lower costs of production enable businesses to lower prices. This allows everyone to benefit, because real incomes and purchasing power increase. Lower prices do not mean lower profits for businesses. The overall decrease in the price level occurs because businesses innovate, experience advanced technologies, and face lower costs of production.

Some economists are concerned that falling prices and expectations of falling prices in the future slow down current spending. They point at the housing market and notice that in 2008 and 2009 many people postponed their purchase of a house in the anticipation that the price would decrease in the future. This can indeed be a concern, especially if the drop in prices is temporary. However, if prices decrease steadily (as they will do in a constant money supply system), this phenomenon will disappear as people realize that they do not want to wait forever to buy something that they want and need. Computers and other high-tech products, such as smart phones, tablets, and large screen televisions, have fallen in price for a prolonged period of time now. These industries have not suffered in sales.

Video Explanation
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Falling Prices and Increases in the Standard of Living

Andrew Bernstein in The Capitalist Manifesto (Bernstein A., 2005, p.105) describes (with credit to T.S. Ashton, Henry and Rodney Dale, and Paul Johnson) how in the late eighteenth century and beyond many prices declined as a result of innovations and technology advances.

“The results of such innovations were stupendous. In 1765, half a million pounds of cotton had been spun, all by machine. In 1785, the powerful Watt and Boulton steam engines were first applied to spinning by rollers, and in the 1790s steam power was used to drive the mules. Production increased to the point that by 1812 the supply of cotton yarn was so enormous that its price had dropped to a mere 10 percent of what it had been previously.

By the early 1860s the price of cotton cloth … was less than 1 percent of what it had been in 1784, when the industry was already mechanized. There is no previous instance in world history of the price of the product in potentially universal demand coming down so fast. As a result, hundreds of millions of people all over the world, were able to dress comfortably and cleanly at last.”

See: Bernstein, A. (2005). The Capitalist Manifesto. Lanham, Maryland: University Press of America, Inc.

Consistently Falling Prices

Are falling prices in the housing market harmful? Experts warn us about this kind of “deflation” and the harm it would cause to our economy. They refer to the Great Depression and Japan as examples of the harmful effects of deflation. Most experts believe that falling prices are harmful.

Let’s apply basic demand and supply theory to analyze the consequences of falling prices.

Prices fall either as a result of decreasing aggregate demand or increasing aggregate supply. A decrease in aggregate demand is a sign that the economy is not doing well, and it is a symptom of other underlying, structural problems. In this scenario, falling prices are necessary and beneficial to help the economy in its recovery. As prices fall and businesses do some belt-tightening, buyers can afford to purchase more products, and this will increase quantity demanded of goods and services and employment.

Prices can also fall as a result of increasing aggregate supply (because of technology advances, etc.). As aggregate supply increases, ceteris paribus (all else remaining constant, including our money supply), the average price level falls. Here prices fall not because the economy is doing poorly, but because our advancing technology and improving work habits create more products, thus lowering the price level.

In the latter case, prices only fall if a nation’s central banking system doesn’t increase its money supply, or doesn’t increase it very much. If, for example, the money supply increases by 6%, and our aggregate supply increases by 2%, then, ceteris paribus, prices will rise. If the money supply remains constant and aggregate supply increases, then prices fall.

Does the Fed have to increase our money supply in order to stimulate our economy and increase aggregate supply? Some people, including most Federal Reserve Board governors, believe this to be true. And it is true that in the short run, increases in the money supply can increase spending and production, and stimulate the economy. However, in the long run, higher prices of goods and services as well as asset bubbles that burst cause significant economic problems.

Aggregate supply (overall production) increases because businesses are naturally innovative and will look for better ways to produce in order to reduce costs and increase profits, regardless of money supply increases. Let’s study this in more detail.

In a constant money supply economy, by definition and by mathematical necessity, the average nominal (dollar value) amount of business profits remains the same. However, real (the purchasing power of) profits increase (due to falling prices).

In the short run, a business that develops a cost-saving production technology will experience increased production, lower costs and therefore higher nominal and real profits. In the long run, in a constant money supply economy, the competition copies the cost-saving technology and aggregate production increases significantly. This lowers prices so that nominal profits of all firms decrease and approach the pre-innovation amount. However (and this is the key), because of lower prices, real profits of all firms increase.

The following is a numerical example in a simplified economy that proves this. Assume a money supply of $100 and twenty firms that produce an aggregate supply of a total of 20 products (each firm produces one product). Consequently, the average price level is $5 (natural equilibrium). If five innovative producers double their production, aggregate supply increases to 25, and the average price level falls to $4. The innovative producers’ revenue increases from $5 to $8. Depending on the cost of the innovation, their profits increase as well. It is highly likely that their real profits increase because the average price level in the economy is falling (from $5 to $4). In the long run, if competing firms copy the innovation, the innovate firms still benefit. Aggregate supply increases to 40 (production of all producers doubles), so the average price level falls to $2.50. Each producer’s revenue averages $5 (same as before the innovation), but $5 now buys twice as many products because average prices are cut in half. In a constant money supply economy, everyone’s nominal revenue remains constant, but real revenue doubles.

People forget that wealth depends on real income and not nominal income. If I tell you that I’ll happily accept working for a $1 annual salary, you would declare me insane. But if in this economy a house is priced at a quarter and a car at a nickel, then a salary of one dollar doesn’t look so bad.

Given our natural tendencies and incentives to innovate and increase production (on average at least 2 – 3% each year), prices should be falling. Falling prices will also mean significantly lower prices of real estate, including houses. And, unlike what you read in many newspapers and journals, this is a good thing (as long as they fall consistently and continuously).

Falling prices in a market where prices go up and down all the time are harmful (temporarily). However, falling prices in a housing market are not harmful to the economy as long as prices fall continuously. Look at the computer market. Prices of computers (and tablets, smart phones, etc.) have been falling for decades now, and the market for computers is as strong as ever. The conventional thought is that if buyers or potential buyers expect prices to fall in the future, they will wait to buy the product until the price is lower, say, in 6 months. But why is this not happening in the market for computers and other high tech products? The answer is that if prices fall consistently and continuously, the buyers’ psychology changes. Since consumers know that prices are always falling, they will not wait for a lower price or else they will never buy anything. For the same reason, buyers of houses will not postpone their decision to buy a house if they know that prices of houses fall consistently.

Falling Prices and Mortgage Lending

Aren’t falling prices in the housing market bad for banks? The answer is: no, as long as banks make responsible loans. A bank should ask for a sound down payment (for example, 10% or more) from the borrower, or a payment plan that makes sure that the borrower’s equity (the difference between the value of the house and the outstanding balance of the loan) is always positive. For example, if prices fall 2% each year, and the borrower’s contribution towards the loan principal is 3% each year, then the home owner’s equity rises by 1%; the borrower is never “underwater” (this is when the value of the house is less than the value of the loan) and the bank is always covered. But this is common sense anyway, and these principles should be applied even in our current, mostly inflationary climate. It would have prevented the 2008/2009 housing crisis!

Inflation, even at low levels, is harmful to our macro economy. It increases interest rates, discourages savings, lowers our exports, lowers the value of our dollar relative to other currencies, and creates mal-investments because people invest in gold and other precious metals, antiques, existing real estate, etc. instead of productive endeavors instead of investing in new production. Inflation hurts consumers. An inflation rate of 3% is equivalent to putting an additional sales tax of 3% on all products. Sales taxes are especially harmful to the poor because sales taxes are regressive. Keeping the money supply constant and allowing prices to fall accomplishes the opposite; it helps every consumer and especially poor households. Forget having to raise our minimum wage. The real value of the minimum wage will increase each year due to falling prices.

Falling prices give people instant and continuous increases in their real incomes. Looking at computers again, the beautiful thing about falling prices in this industry is that nearly everyone can afford one now or at least use one (in schools, libraries, etc.). What an opportunity this creates for our society, especially many poor households, if we could make everything affordable like this!

But doesn’t the Fed need to manipulate the economy in case of economic emergencies, as Keynes recommended? The Fed certainly loves this kind of control. But ask yourself what the reason is for the seeming necessity of this manipulation. Nearly all of our past economic emergencies were caused by borrowing bubbles and monetary excesses by central banks. In other words, they contribute to the economic emergency and then print more money to temporarily stimulate the economy and prevent the emergency from getting worse. But by doing so, it sets up the next (and possibly worse) financial crisis.

A constant money supply makes these bubbles impossible, and therefore, greatly diminishes if not eliminates the need for any central bank manipulation.

An increase in the money supply may help the economy in the short run (by increasing liquidity and lowering interest rates temporarily), but it invariably causes more problems in the long run (by increasing inflation and increasing interest rates). A drug addict feels good after artificial stimulation (taking drugs). But in the long run it will ruin the drug addict’s life.

Doesn’t it make sense to stick to the fundamentals in maintaining happiness in our personal lives? Eat well, exercise daily, learn skills, invest wisely, diversify, build sound relationships, be true, honest, etc. Our economy is no different. Instead of artificial and inflationary stimulation, we need fundamental and essential ingredients for a healthy economy: optimal opportunities and incentives for people to work hard, innovate and accumulate wealth (so no excessive taxes and regulations that discourage work), protection of private property, a sound, non-discriminating economy and an honest legal system, a sound school system (with school choice for everyone), and a constant money supply which promotes increases in, not nominal, but real incomes.