Why does Money Supply Need to Grow at all?

So I recently did a post on the Quantity Theory of Money (QTM) titled What is the Quantity Theory of Money and When does it Hold?. QTM continues to be a rather controversial subject in economic theory. Asking seemingly naïve, even stupid questions is critical for a deep understanding of QTM. Only unconstrained thinking and unabashed questioning can allow one to fully appreciate the controversy that QTM almost always evokes. 

In this post I will ask and answer a seemingly naïve, yet fundamentally important question - Why does the supply of money need to grow at all? What if the supply of money were to remain constant? 

IMPORTANT: This question is wonderfully answered here on the Philosophical Economics blog - a must read for all Economics aficionados. I’m doing the same explanation here in my own words.... 

Lets use the example of an Economy where Money Supply is Fixed and Output doesn’t Grow 

Let’s assume India is a closed, simple economy. The money supply in India is fixed at Rs 500. 100 units of output are produced; the price of each unit of output is Rs 5; total output or GDP = Rs 500. The entire GDP (Rs 500) gets distributed as income and is spend on buying the output produced. This is your basic circular flow of income where output = income = expenditure. 

Remember from my QTM post: MV=PY. In our fictional economy, M = 500, P = 5, Y = 100, and the velocity of money (V) is =1. We assume that “V’ remains constant. 

If nothing changes (output, demand/tastes, no supply shocks etc.) and everything goes on like this, the Indian economy will remain in this steady state for perpetuity. There will no need for money supply to change. 

But Output needs to grow to keep up with a growing Population

That being said, it’s highly unrealistic to assume that India’s output won’t grow over time. A growing population will demand output growth, and technology advances along with increased resources (labour, capital etc.) will make this growth possible. 

What happens when Output needs to expand, but Money Supply remains fixed? 

So the right question to ask is how will output grow if money supply is fixed? Let’s use the example to answer this. 

Suppose India now has the technology and resources to produce 200 units of output. If unit price were to remain the same, total output would be worth Rs 1,000. But the money supply is fixed at Rs. 500. There is no way output worth Rs 1,000 can be produced if there isn’t enough money in the economy to pay those involved in producing it.

MV ≠ PY

500 x 1 ≠ 5 x 200 

Remember, the velocity of money (V) in our fictional economy is fixed at 1. What can India do in such a situation? 

There are only two Options. 1) Grow Output and accept Deflation or 2) Keep Output constant and accept Economic Stagnation. 

There are really only two options for India:

1)  Grow output and accept deflation 

India can go ahead and produce 200 units of output. However, since money supply is fixed at Rs 500, the price of each unit will have to fall to Rs. 2.5.

MV = PY

500 x 1 = 2.5 x 200 

India will have to accept deflation if it has to grow it’s output without increasing money supply. 

2) Keep output constant and accept economic stagnation

The other option is to continue to produce the same output (100 units), even though the economy has the capacity to produce more. In this case, prices will remain constant (there will be no deflation), but there will be no economic growth either. The economy will stagnate, unable to meet the growing demands of its population. 

MV = PY

500 x 1 = 5 x 100 (no deflation, no output growth)

Both Options are Undesirable. Economic Stagnation is an obvious “bad”, but what’s so bad about Deflation? Read my post Why is Deflation Undesirable? for the answer.