Debate on the Money Supply of a Country

This article provides a debate on the money supply of a country.

Until quite recently both British Economists and the U.K. Monetary Authorities appeared to be paying little attention to changes in the supply of money as a key factor in national expenditure and inflation.

This is because of a persistent influence of the old Keynesian theoretical controversy and also because of the influential Radcliffe Report.

In the Post-War period, the UK has been relying on fiscal policy and the control of bank lending and consumer credit to regulate the level of demand. Now, there is an increasing concern with money supply both as an indicator and a determinant of total expenditure.

Interest in the problem of money supply has been stimulated by the running debate in the USA between the advocates of the ‘New Economics’ (Keynesian) and the ‘Chicago Money Supply School’. Not only Milton Friedman but the leading financial authorities of the world like Central Bankers of Basic and the IMF have also come to attach greater importance to it. In fact, the debate over the money supply was revived with the publication of Radcliffe Committee Report, which was at pains to argue against the notion that the supply of money was the centre-price of the monetary mechanism.

It follows from the arguments contained in the Report that if for other reasons the authorities are inhibited in their manipulation of interest rates, no mere control of supply of money can be expected to do much. This, however, does not mean that the supply of money is unimportant, but that its control is incidental to interest rate policy.

Prof. Milton Friedman, on the other hand, considers the regulation of the quantity of money as a vital factor affecting national income, prices, output and employment. According to him experience in the USA from 1866 onwards shows that there are many socio-economic and political hindrances in the use of tax methods (this is also true in countries like India as is evidenced by the reaction against wealth tax on farm incomes).

Friedman and his associates have collected some empirical data and evidence and made some computerized studies to justify the assertion that there is a strong…though by no means precise and completely regular regulation between changes in the quantity of money and in national income. His studies have shown that his relation is far closer and stronger than the relation between budget changes and national income. According to him it is the rapid rate of monetary growth and not the state of the budget, that raises the spectre of serious inflation. If this rate of monetary growth continues, we experience significant inflation, regardless of what happens to taxes and government spending.

He feels that the recent rate of monetary growth differs very widely from the rate that would avoid inflation. Evidence for the past century suggests that on an average a rate of growth of about 4 to 5 per cent in the quantity of money (defined as currency plus all commercial bank deposits) is consistent with stable prices.

Since January, 1967 the quantity of money has been growing at the rate of 12.5 per cent in the USA. It does not require a very close or precise relation between monetary changes and income changes to predict that continuation of such a, rate of growth will produce severe inflationary pressures. A stable monetary framework would involve a steady increase in the quantity of money at a rate calculated on an average to be consistent with stable prices.

Thus, such a monetary policy would require a sharp decrease in monetary growth from 12.5 per cent a year to about 5 per cent a year—monetary policy that would avoid inflation is also a policy—and the only policy—that would stop the present trend towards higher interest rates. It is now proved beyond doubt through the writings of various financial experts that a country cannot conduct its financial affairs without an expansion in the supply of money (however defined) well in excess of the growth of the domestic product. The rate of growth of money supply in France almost doubled which paved the way for astonishing transformation of the economy.

Thus, there is good reason for the growing pre-occupation with money, not only in its narrow formal definition but in the sense of liquid funds at the disposal of the consumer. Hence any monetary policy must aim at sterilizing excess liquidity in the economy due to excess supply of money.

The work of Milton Friedman, therefore, goes to show conclusively that ‘money matters’; even though one can argue about the extent to which it matters in the sense of affecting, aggregate spending. The work that has been undertaken on the flow of funds analysis, on interesting financial variables into economic forecasting, and on government borrowing and the money supply illustrates a more than passing interest in the subject of money—putting more reliance on monetary control of the volume of money and credit and less on the level of interest rates.

The money multiplier summarizes the relation between money and income: it measures the equilibrium change in income caused by a unit change in the supply of money. If the level of investment can be treated as autonomous and if a static relationship (the consumption function) exists linking consumption with income, the income multiplier measures the total percentage change in income which is induced by a per cent change in investment.

Likewise, if the supply of money can be treated as autonomous and if a stable relationship (the demand for money) exists linking money and income, then the money multiplier measures the change in equilibrium income caused by a unit change in the money supply. However, the extent to which money is autonomous has been called in question stable estimates of money multiplier have not been found, and there is no agreement on the duration of the lag between a change in the money supply and its effect on the level of income.