What is the point of monetary policy? Why does the money supply ever have to change? After all, money is just a tool to make business easier. If there is enough money to make a transaction, it is not clear why we need it more. The resources of an economy depend on natural resources, labor, capital, technology and legal institutions, not a piece of green paper in our wallets.
While this view is correct in the long run, having too little or too much money in the economy leads to all sorts of mischief in the short run. While money may have little to do with economic growth, the business cycle has a lot to offer.
The most important insight into price theory is that market price reveals information about the relative wealth deficit. The market is a vast communication network, where signals in the form of prices are supplied and transmitted by demand. Prices help customers budget wisely and make businesses profitable. Since their activities are coordinated by the pricing process, producers’ plans are mixed with consumer plans.
But a few things are needed to work in the market price system. One of them is money, which is a common denominator for comparing usage and production lines. Indeed, money has a “market” of its own – in addition to money supply, it makes sense to talk about the demand for money. Be careful, though. The demand for money really means how much money we want to hold on to our income, or close money options like checking accounts or debitable mutual funds. Not how much money we want to get. Think portfolio allocation, not cost flow.
If money supply and demand for money match then everything is fine. Prices use them to communicate the cost of use and production opportunities. But what if the supply of money and the demand for money do not match? Now we have a problem. The “value” of money, which is really only its purchasing power, must be adjusted to “clear” the money market, to bring supply and demand back to parity. Since money is about half of all exchanges, money market integration spreads in the market for goods and services.
Think of an economy like a wheel. Spokespersons of different markets. The money market is the hub. A wheel can work with a few, even many, broken spokes. But if the hub is the chest, the wheel is useless. Similarly, if the money market is turbulent, market prices will not accurately reflect actual supply and demand conditions. Consumers and producers will get false signals about how valuable some resources are compared to others. And when market prices generate bad information, people make bad decisions.
We call this discrepancy between supply and demand in the money market a financial balance. Excessive money causes inflation, as individuals try to spend their extra cash balance. Although the end result is a permanently weak dollar, along the path of conversion, the misallocation of resources may be due to an increase in the price differential rate. Suppose, for example, wages rose 10 percent but steak prices rose only 2 percent. If these changes are driven by money supply problems rather than actual supply and demand changes, people will probably buy more stakes than them in a well-functioning economy. And, given the reasons, wrong pricing can happen in other markets as well. The new pattern of economic activity as a result of financial imbalances is a flaw. We will eventually have to pay for it in the form of costly restructuring of wages, prices and supply chains.
Similarly, too little money creates an unnecessary recession. As families seek to rebuild their cash balance, businesses are experiencing declining sales. Misinterpreting this as declining demand, they lay off workers and reduce production. The dollar eventually strengthens, the adjustment process ends and the economy returns to “full employment.” But in between we had an expensive and unnecessary recession.
The whole point of financial institutions is that the rules and procedures we use to control the financing are to maintain financial balance. It would be better if those institutions increased the supply of money when the demand for money increased and reduced the supply when the demand for money decreased. In this way we can stay as close to the financial balance as possible, avoiding the bad consequences of both excess supply and excess demand in the money market.
Of course, how well our financial institutions work is an empirical question. Historically, the US Federal Reserve has been pretty bad at its job. However, the Fed’s poor performance does not dampen the aspirations of some organizations that can do the job well.
In the long run, financing is not important. But on short to medium runs, it’s pretty important. There are good reasons to change the money supply. Don’t let the Fed’s incompetence distract us from the fundamental economic tensions caused by money.