Economics

How Free Market provide Optimal Supply of Money

Posted by chitranjan

I have been thinking about money and read the debates of people from different economic schools of thoughts. After going through their arguments I got few facts about money which are essential for a good money system.

Lets first see what are those facts?

What is money?

First is that money is the medium by which goods and services are exchagned, not for which goods are exchanged.

It may sound confusing but it simply. says that you want money for your goods and service because you know this money will buy you other goods that you want. What if I say you earn this paper money but this won’t buy you anything in return will you still sell me your goods for this paper money?

So therefore you want money only if you can also exchange it for the things you want. Else it is of no use.

Other qualities of Good money?

The money should be easy to carry, transfer, Durable, Divisible, easy to verify, hard to duplicate, stable enough to maintain proper price signals.

Function of money and its utility to society?

The money allow us trade with each other, It is money that has allowed human to move past killing each other for resources.

Lets try to understand it by example and see how money has protected humanity from itself.

Quick story on how money saved the world?

We humans have killed each other to attain resources. You can read history of humans and all we have done is fight. So how come money helped us move past this killing?

The answer is trade, now if I want to have something from you I don’t have to fight you or kill you I just need to get you what you want and inreturn take what I want.

But what you want is difficult for me to get and there is a lot of problem with barter system, so to remove this problem of barter system lets add money into the system.

And lets set it price as well, suppose someone set 1 stone for 1 liter of milk. Now if I get 1 liter of milk and make cheese and butter from it then I should atleast sell the butter and cheese for more than 1 stone because I have spend hardwork and time, so I set the price of 2 stone.

Now from these stones are coming from? These stones are coming from a mine, which is very hard to mine. Thus strong people go there and mine it and in return gets the food and other items.

While previously there was constant battle for power and creation of groups to coup the Leadership.

Now strong men also have the incentive to work rather than stealing, and not so strong men can also work to improve the system to increase production.

Else strong men would have stolen something then a group would decide to kill him and then again that group will do the same which was done to it. and this cycle repeats.

Thus money has played very important role in improving everyones life and automatically allowing people to move to right jobs that suits their skills.

If you want to know how a world without price signals look like here is video.

Now that we know what is money used for? the next question is

how much money should there be?

You will hear so many people in the TV debates and other forums debating that government should reduce money supply to keep inflation down, then someone will come with counter argument that no money creation should be relaxed to allow people to afford money to invest in productions and house buying etc so that we can increase economic output.

So what is going on? should we increase the supply so that it becomes easy for people to setup industries or businesses or keep the supply down to make sure that people can afford goods and services at lower price rate?

The debate of Deflationary and inflationary Economy

Lets understand both types of eocnomies, that way we will understand the problem with both types of eocnomies.

Deflationary Economy

The Delationary economy sets the money supply and it stays fixed and people trade things with it. Because the supply is fixed and everyone wants to have this limited supply thing the price of this thing increase as more and more goods and services come on market to compete for it.

lets say there are only 2100 coins and there are 21 apples? what should the price of each apple?

Price/number of apples 2100/21=100/apple. now that everyone is competing to attain more of it, the person create more apple by increasing the planting of trees. and now there are 42 apples.

So now price/number of apples will be 2100/42 =50/apple.

As you can see with time things get cheaper for people to afford, so what is wrong with this approach?

The problem comes with accouting, when goods are so much that current supply can’t account them.

Let’s look at the 2100 coins now lets increase apple supply to 4200 what should be the price of apples now? price/apple 2100/4200 =0.5 but this is not possible. Why?

Because there are only 2100 coins, there is no decimal place allowed. Thus it is impossible to account apples with this supply. So what should we do now?

We need more units of money to account for apples, so we can either create more coins or we can increase decimal place the result is the same. You have increased the accounting units.

So either you add decimal place to 2100.0 or increase the money supply to 8400 both will result in price/apple to be 0.5/apple.

This is where the problem arise.
Who should be allowed to add this decimal place or increase the supply of money? Well this where I should add my free market system but lets wait and see what system we currently have and how it works and the problems with it.

So to solve this problem with fixed supply we created a centeral authority which has this duty of making sure that there is right amount of money, in many countries it is called centeral banks or Tressuries.

Inflationary Economy

The inflationary economy sets the money supply to be not fixed. Thus scope for increasing money supply as per the demand of the system. But how do we know how much to increase the supply by?

This is where CPI comes, it is called consumer price index. In this index all the items which are basic and essential for day to day life are listed and their prices are also listed.

So suppose our economy only runs on apple, then CPI will have its price listed and now we can check it’s price and compare it on a time scale. What we see is this. That prices of apple has decreased by 2X in a year, so if apple cost was 2/apple now it is 1/apple. (2100coin/2100apple=1coin/apple)

This tells the authority which see CPI that to get back to the price level before we should double the money supply. so they increase the supply of coin to 4200coin now (4200coin/2100apple=2coin/apple)

It is this CPI, which tells the centeral banks how much money to increase or decrease to maintain the price stable.

Why keep price stable?

A Price Is a Signal Wrapped Up in an Incentive. So if it is constantly changing then incentive are also changing and we don’t know what the society actually demands. This price stability is very important for economies to function.

Because prices are the meassuring stick to know what is demanded and at what supllies.

Now this is where the problem arise with the inflationary system.

Since now there is an authority which has power on increasing the money supply, it sometimes becomes desperate which leads to ruined price signals.

Suppose an authority enter war with somebody and increase supply and buy the goods needed to complete the war. And the producer of those war goods then go to market to purchase what? you guessed it right. Apples.

But as those people has more money they will bid for apples in the market for apples and since those who provided war goods have more units of money can bid away everyone else thus increasing price of apples.

lets see it the authority increase the supply not because CPI signaled it, but because they entered a war. so supply is 8400coin now apples are still same quantity 2100apple so price per apple = 8400coins/2100apple=4/apple.

This system leads to inequality and those who saved money gets less goods and services for the same money. When this happens at high level it is called hyperinflation and it starts revolution in country and hatered towards the system.

Which leads to civil war or sometimes bad politicians coming to power.

What is the solution then? lets look at one solution.

Free Market Production Of Money

Before we discuss lets see why free market is the most efficient method of distributing goods and services.

You may have heard many people calling free market as the most efficient way of producing something and distributing. Well that is true but It is shocking that when it comes to money production people don’t think that free market can produce the money as well.

Let’s see how free market can produce optimal supply of money and allow the money supply to expand and contract automatically in response to the economy’s demand.

How free market money production will work?

There are two currency of the universe, one is energy and other is time. We should make sure that our normal currency also gets built upon These two universal currency.

Lets see how gold worked

The gold is hard to mine and there for it cost money and resources, so what incentives do gold miners get to mine it?

Lets see it with example of apples again, suppose there are again 2100 gold coins and there are total 2100 goods and services in economy, this is made very simple but economy is more complex than this.

So with this example each good and service will cost 1 gold coin on average. now at this level the cost of mining gold is higher than the value of gold.

What if the products increase further than again we enter that stage where products are more and money is low, what will happen? those products will compete to get that limited supply of gold, and what does demand and supply tells us, when demand is high supply is low then price rises.

Thus in this case everything else start to cost less, and then comes a point when cost of mining gold is less than what you can get in return for that gold.

Which sends signal to the mining industry to mine more gold and when supply increases and demand remain the same what happens price goes down, which means that other things will again start to cost more and as a result the input that goes into mining will also increase in price. Which will signal gold miners to stop the mining.

And we reach optimal supply of money in the system. But then why gold failed and we moved to fiat?

Why Gold failed?

The gold failed because of its hardness to mine, as the economy grew the production of gold was not able to match it. Thus we left a wonderful system.

What next?

Cryptocurrency to the rescue

Just like with gold the hard mining is also there in crypto but it is not limited to actual mining rather it is dependent upon electricity and computer machine.

As more and more people join to mine the difficulty increase to adjust and as miners go away the difficulty also backs off.

Current problem with cryptocurrency?

All the cryptos which are currently on the market either has fixed supply or fixed inflation rate. Both are dangerous as we have learned above.

An money system is ideal when it can response to the underlying Economy and don’t disturb the price signal.

In my view Disturbing Price signals is in the same catergories as theaft, murder, rape. We don’t realize it because the cost is wide spread.

What cryptocurrency needs to impliment?

All these crypto has to make simple change and that is remove the limit of the supply and let the reward of mining be difficulty-current supply.

If difficulty is low and supply is high then no new coins release and slowly price of crypto increase and then comes a point when it becomes profitable to mine the crypto and supply increses and again stops, this will be a constant auto adjust system.

If we impliment this rule to bitcoin then there will be 6.3 trillion bitcoins and their price against usd will be 0.02BTC/USD.

Conlusion

Prosperity of society and life of that prosperity is dependent upon how money is created in the society. Fiat fails because politicians go to war or offer free stuff to get elected. Fixed supply fail because accounting of resources before hard when economy expands and price signals get disturb.

Now we have cryptocurrency which can have any monetary system you program it to be. It is one of the best to test different modles and see what works best for society, I have also shared one system which everyone is free to try and impliment.