The Demand for Money

August 7, 2009 – In Economics 101 college professors teach that prices are determined by supply and demand. Not usually taught, however, is that the ‘price’ – i.e., the purchasing power – of money is also established by these same two economic determinants.

Economists focus quite extensively on the supply of money, which in the US is the total quantity of dollars in circulation. The demand for money, however, is largely ignored.

Most economic theory is built upon the supposition that the demand for money grows consistently by about 1.5% per annum. This growth rate is purposefully chosen because it approximately equals world population growth, so it is assumed that if population grows by that rate, the demand for money in commerce will also approximate that same growth rate. It is an imprecise assumption, but the underlying problem is that the demand for money cannot be quantified, in contrast to the supply of money.

The quantity of dollars in circulation is reported by the Federal Reserve. These are the mix of so-called Ms, with M1 being a compilation of cash currency and dollars in checking accounts at banks. M2 adds to that definition all of the dollars in savings accounts and certain money-market accounts.

The Federal Reserve measures the total quantity of dollars in circulation, and regularly reports their estimate. The following table presents M1 and M2 as of July 22nd.

An even broader measure of the total quantity of dollars in circulation is M3, which includes, among other things, time deposits at banks. M3 is no longer reported by the Federal Reserve, but is estimated by private economists. For example, John Williams of http://www.shadowstats.com estimates that M3 presently totals about $14.8 trillion dollars. Given the US population of 304 million, there is approximately $49,000 in circulation for every American man, woman and child.

In 1913, the year the Federal Reserve was established, the American population was 97 million. M3 that year was approximately $20 billion, so on average there was $210 in circulation for every American man, woman and child, or just 0.4% of the current average. Are there more dollars in circulation per person because Americans are so much wealthier today than they were in 1913 or is something else at work here?

First, a point of clarification is necessary. Money is not wealth, at least as far as I define these two terms. Wealth is real things that satisfy one’s needs and wants. Money is the means to buying those needs and wants, but is not wealth itself. And there is no doubt that the US has become wealthier in terms of the vast array of goods and services that have raised living standards considerably since 1913. But is more money needed today to avail oneself of those goods and services?

While the American population has grown by 1.2% per annum on average since 1913, the growth in M3 has been much greater at 7.1% per annum. Logically we need less money today than 1913 because the efficiency of currency has improved. Methods of payment not even available in 1913, like electronic fund transfers and plastic cards, now move dollars in an instant. So less currency today should satisfy one’s needs.

There is of course another factor to consider. The dollar was not the world’s major currency in 1913, so the demand to hold dollars for this reason is greater today than it was back then. Nevertheless, it would be hard to argue that so many extra dollars per American exist today for that reason.

In fact, there is a pernicious factor at work here. Namely, the Federal Reserve and US banking system are creating too many dollars. Because the quantity of dollars is growing more rapidly than demand, the dollar’s purchasing power is being eroded in a process we call inflation. Going back to Economics 101, if supply grows more rapidly than demand, price falls, and purchasing power is the ‘price’ of a dollar.

The following table from the Federal Reserve presents the current annual growth rates in M1 and M2. Both are far above the population growth rate in the US and even the whole world.

These growth rates have increased the quantity of new currency over the past year far beyond the demand for new currency needed in commerce, and are therefore inflationary. The dollar is being debased. The Federal Reserve is allowing the dollar’s purchasing power to be inflated away. Own gold and/or silver to protect yourself and your family from this ongoing erosion of what a dollar buys.