Hello, all. So I am trying to gain a thorough understanding of why the Fed, or any other Central Bank, needs to keep pumping money into the economy as it grows. My question is not asking why inflation happens, but rather focuses on the money supply. I grasp how increasing the money supply tends to increase inflation, and how, on the other hand, the Real GDP increasing tends to decrease inflation (all this is bundled up in the MV = PY equation) and other higher-level economic concepts, but why does the money supply need to increase at all in the first place?

I am essentially asking what would be wrong with keeping it the same as the economy grows or contracts. The colorful analogy found here helped me understand it a bit more, but I am still thoroughly confused.

  • $\begingroup$ Perhaps the answers here answer your question as well? $\endgroup$ – Giskard Aug 1 '17 at 7:39
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    $\begingroup$ @EnergyNumbers I don't think this is a duplicate, since zero inflation is not the same as a fixed money supply(at least with conventional definitions). This question is positing a scenario in which there would be deflation $\endgroup$ – Salmoncrusher Aug 1 '17 at 16:16
  • $\begingroup$ Thank you for your comments. I have edited my post to make it clearer what exactly I am asking. $\endgroup$ – Coolio2654 Aug 1 '17 at 19:30
  • $\begingroup$ After reading your edit I also think the question is a duplicate. Note that the other question is not about why inflation happens either. It is why it is desirable, why the central bank wants it to happen. $\endgroup$ – Giskard Aug 2 '17 at 8:22
  • $\begingroup$ You should ask a new question instead of modified the whole question. $\endgroup$ – mootmoot Aug 4 '17 at 14:15

I would highlight this article on money creation in the modern economy (by researchers at the Bank of England) - (link to article). A key observation is that modern central banks do not directly determine the money supply, they set the rate of interest. (The policy of Quantitative Easing complicates matters, but what is happening there is that the monetary base is larger tha usual, but the central bank cannot set it below an effective minimum.)

This means that the central bank is not really determining "the money supply", but rather reacting to the private sector's demand for money at the target interest rate. In other words, the central bank has no ability to keep "the money supply" at a constant level. (The fact that the "money supply" is a vague term does not help. Is it M0?) It would have to move around the interest rate in a fairly erratic fashion in order to attempt to keep the money supply constant. (This was experienced during the money growth targeting experiments in the 1970s and 1980s.)

The money supply does not have stable short-term relationship to other economic variables. Even if it were possible to keep it constant, what objective would that achieve? Other variables would be moving around, in probably unwelcome directions. Instead, developed country central banks attempt to keep an economic variable that people care about - inflation - near a target level. (Other targets include fixing the price of the currency versus a foreign currency, or even gold.)

From a theoretical point of view, if money velocity were stable, nominal GDP would be stable if the money supply did not grow. Since we expect real GDP to grow as a result of productivity growth and population growth (in most countries), the implication is that there would be a steady deflation in the price level. This would imply that workers would need to get annual wage decreases, which is a situation that is psychologically unwelcome. As a result, there is a bias towards a positive rate of inflation. This implies growth in the money supply (assuming constant velocity).

A psychological bias against deflation is not just an arbitrary preference; in real-world data, wage decreases are avoided. (Sorry, I do not have a reference; I discuss references later.) Therefore, if policy attempts to force wage decreases, the result is that workers are laid of instead. Output would fall, that is, there would be a recession. This is a suboptimal outcome from almost any standpoint. An additional real-world issue is that debt contracts are entered into with the implicit assumption of positive earnings growth. Deflation leads to mass defaults, and recession.

There is a large literature on the optimal level of inflation, which was a hot topic when central banks entered into the inflation targeting. The reader should be able to find dozens of articles in this vein either with web searches or at the websites of inflation targeting central banks. I found this survey paper from the Bank of Canada published in 2015, which I assume would be authoritative (I have not read it). (Link to survey paper.)

  • $\begingroup$ So, if I am understanding you correctly, "increasing" the money supply, through the Fed influencing banks, keeps pace with Real GDP growth and thus prevents deflation, which makes sense. But is there any objective preference to valuing inflation over deflation over purely psychological ones? $\endgroup$ – Coolio2654 Aug 3 '17 at 21:22
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    $\begingroup$ We need to set policy for the people that exist, not hypothetical beings without psychology. I added a small addition to respond. $\endgroup$ – Brian Romanchuk Aug 3 '17 at 21:52

Actually, the expression more money supply is not clarifying at all (i) which effect is desired and (ii) what really occurs, whence your (really natural) question.

What is implicit behind this expression is that commercial banks will have an easier access to (re-)financing. If commercial banks play their role of Money multiplier -- which is not that obvious since they may prefer to clean their balance sheets --, they will basically be more prompt to grant credits. Put differently and using an abusive but pedagogical term: they will be psychologically more prompt to waste money, and thus to stimulate demands here and there.

Since growth is very often conceived as being demand led, more demands (of goods or whatever) at a constant level of supply (of those goods or whatever) in turn means inflation, until levels of supply, here and there, adjust and create jobs, generate dividends, etc...

To conclude and summarize

Basic Reason of Why the Money Supply Needs to Increase?

Because one needs commercial banks to be more relax and play their role.

what would be wrong with keeping it the same as the economy grows [...]

The economy cannot really grows without leverage.

[...] or contracts

Bubbles may form and explode sooner or later in this case, which is nothing desirable.

Adjusting the money supply is a difficult balancing exercise for central banks.


Just to complement @Kanak answer.

The major roles of finance industries are providing financing facilities, instead of involving in the creation of various speculative derivatives and masquerade them as "investment" product and call it "diversify from the financing business". When shit hits the fans, e.g. a shift of paradigm due to policy changes, technology change, mentality change, such none-core "diversify profile" will crash.

Take Germany financial industries as an example, there is a huge number of Genossenschaftbank that provide credit to the local industry, rather than involving in various "diversification", they survive most of the crisis, few need to call out for "more money supply". All funds managers view the credit unions like Genossenschaftbank as "conservative", because they have little investor pressure to make huge returns. As long as a financial institution not fooling around with "huge returns", you will not see high underwriting risk(nonperforming loans) coming from such institutions.

  • $\begingroup$ Hmm, that's pretty interesting. Seeing as I am going into a Financial Engineering MA, would you have any reading recommendations on understanding what types of financial instruments are "unnecessarily speculative," to use that description, on a higher level, versus instruments that are fundamentally sound? $\endgroup$ – Coolio2654 Aug 3 '17 at 21:17
  • $\begingroup$ @Coolio2654 : Please revert your edit to what you originally asked. I cannot suggest any specific reading, but I am a fan of freakonomics. $\endgroup$ – mootmoot Aug 4 '17 at 14:19
  • $\begingroup$ Freakonomics does sound like a good source, thx. As to your other point, all of the answers made here were in reply to my edited question, so wouldn't it be confusing to revert back to the original version which, apparently, no one understood? $\endgroup$ – Coolio2654 Aug 4 '17 at 23:42

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