Many Libertarian economist (mostly from Austrian School of thought) believe that government/central bank interference in market is coercive and detrimental. According to them the booms and busts are created by the Central banks which artificially controls money supply by manipulating interest rate and "quantitative easing". Many advocate a gold standard or a "fixed money supply" would bring harmony in markets and protect it from going to extremes (booms and panics). In this post, I want to discuss the consequences of fixed money supply and its impact on market equilibrium.
The consensus among economists is that increase in money supply leads to inflation. In deflationary period, money supply is increased as a remedy to protect economy from going into recessions. Similarly, decrease in money supply leads to deflation and is often used as a tool to control inflation and slow-down the growth of economy. The effective relationship between money supply and commodity prices can be derived by a supply-demand curve. However there is another dimension to it and that is the population growth. This was already discussed in the post (Inflation: A Necessary Evil? ).
The necessary condition for a healthy economy is to have growth for the simple fact that human population grows over time and need to have increase in production to keep up with the demand. In a fixed money supply scenario, increase in production to fulfill growing population-needs causes deflation. There were actually times in late 19th century when deflation was a norm because of constrained money-supply. A fixed money supply would cause prices to fall over time given a positive population growth-rate. The consequence of this deflation will be that people would be more interested in holding cash instead of investing it because the value of currency grows over time (and prices of commodities go down). The result of this decreased investment is high unemployment, falling production in near term. This in turn results in shortage of goods and lead to rising commodity prices. The rising commodity prices will then cause the currency to lose value causing inflation. This inflation in turn will lead to increased investment. This increased investment leads to increase in production and in due course of time causes drop in commodity prices. Thus the economy swings between inflation and deflation cycles (i.e. booms and busts). The duration of these booms and busts is not a week or month but it stretches over a longer duration during which things get over done. The whole cycle gets erratic with prices sharply shooting up and going down as the perception of market participant changes. There will be much more wastage because of abandonment of production-resources during deflationary period. The unemployment rate will fluctuate wildly and will cause a lot of economic instability. That is a fixed money supply would cause more frequent and more extreme economic cycles. This is in complete contradiction to what Libertarian economist portray.
Lastly, if we look back at history, booms and panics in stock market were much more frequent and of much bigger magnitude than in modern times (Pre-Federal Reserve Act period). This is something which all libertarian economists hide in their literature. The fact of the matter is in capitalism where people allocate resources depending on prevailing perception the occurrence of booms and busts is inevitable. Those who blame central banks for this should ponder more over fixed money supply system.
The consensus among economists is that increase in money supply leads to inflation. In deflationary period, money supply is increased as a remedy to protect economy from going into recessions. Similarly, decrease in money supply leads to deflation and is often used as a tool to control inflation and slow-down the growth of economy. The effective relationship between money supply and commodity prices can be derived by a supply-demand curve. However there is another dimension to it and that is the population growth. This was already discussed in the post (Inflation: A Necessary Evil? ).
The necessary condition for a healthy economy is to have growth for the simple fact that human population grows over time and need to have increase in production to keep up with the demand. In a fixed money supply scenario, increase in production to fulfill growing population-needs causes deflation. There were actually times in late 19th century when deflation was a norm because of constrained money-supply. A fixed money supply would cause prices to fall over time given a positive population growth-rate. The consequence of this deflation will be that people would be more interested in holding cash instead of investing it because the value of currency grows over time (and prices of commodities go down). The result of this decreased investment is high unemployment, falling production in near term. This in turn results in shortage of goods and lead to rising commodity prices. The rising commodity prices will then cause the currency to lose value causing inflation. This inflation in turn will lead to increased investment. This increased investment leads to increase in production and in due course of time causes drop in commodity prices. Thus the economy swings between inflation and deflation cycles (i.e. booms and busts). The duration of these booms and busts is not a week or month but it stretches over a longer duration during which things get over done. The whole cycle gets erratic with prices sharply shooting up and going down as the perception of market participant changes. There will be much more wastage because of abandonment of production-resources during deflationary period. The unemployment rate will fluctuate wildly and will cause a lot of economic instability. That is a fixed money supply would cause more frequent and more extreme economic cycles. This is in complete contradiction to what Libertarian economist portray.
Lastly, if we look back at history, booms and panics in stock market were much more frequent and of much bigger magnitude than in modern times (Pre-Federal Reserve Act period). This is something which all libertarian economists hide in their literature. The fact of the matter is in capitalism where people allocate resources depending on prevailing perception the occurrence of booms and busts is inevitable. Those who blame central banks for this should ponder more over fixed money supply system.
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