Money and productivity

Traditionally, economists talk about things being produced using some combinations of land, labor, and capital, where capital is taken to mean tools, machines, buildings, and so on. Productivity— productive efficiency—improves when the same output can be obtained with less of at least one of these inputs. Some economists include “money” in the production function as a factor of production that is in addition to land, labor, and capital. As such, the quantity of money appears to be an alternative to (or maybe in addition to) lumber, copper, workers, or other factors. This unfortunate way of thinking about the role of money in the economy tends to be derived from—and maybe to reinforce—notions that there is “not enough money” in circulation. Such a false diagnosis is dangerous because it usually is accompanied by a prescription that the monetary authorities can make people better off by creating money units at a faster rate. That is certainly wrong. It is easy to imagine, and probably common, for the lending officer of a bank to respond to a customer’s request to borrow more funds by saying, “I would like very much to lend you some (more) money but the central bank is making credit very tight and I have no more to lend…how about golf on Sunday?” The would-be borrower is left with the impression that the currently available stock of money is already being “used” by somebody else and that the central bank is preventing him from expanding his business by failing to increase the total availability of money. A popular (but wrong) conclusion is that the output of the economy is being restrained by the inadequacy of money growth. The alternative way to think about the role of money is that improving the quality of money reduces the use of other real productive resources employed in the task of gathering information about relative values and conducting transactions and, therefore, increases the productive potential of the economy. That is, instead of being a supplement to other productive resources, money that is more stable liberates such resources from being employed in activities associated with uncertainties that exist when the purchasing power of money is unstable. When the form of money available in the economy is not reliable—that is, its purchasing power over time is not stable—some of other resources will be employed in dealing with the uncertainties. As monetary policies to stabilize the currency start to become effective and credible, other resources can be redeployed in more productive ways. In the end, the productive potential of the economy is greatest when the fewest of other resources are utilized in performing tasks for which money is intended— gathering information about relative values and conducting transactions. From this analysis it should be clear that a monetary shock—an unanticipated change in the availability of money—would reduce the potential output of the economy. That is because the actions taken by businesses and households to readjust their actual money balances to desired levels will cause unavoidable changes in relative prices and the average level of all prices and, thus, introduce uncertainty into the economy.         Naturally, such increased uncertainty causes resources to be committed to hedging, arbitrage, and speculation. Furthermore, since the quality of price information is diminished, mistakes will be made in interpreting signals about real demands for, and supplies of, goods and services. Overproduction of some things and underproduction of other things will mean that society’s well-being is less than it could be. Resources flow to their highest-valued uses only when the changing prices of things reflect shifts in fundamental real demands for, and supplies of, goods, services, and productive resources. Monetary disturbances introduce price changes that mask these fundamental forces. Consequently, excess production of some things and shortages of other things can occur simultaneously. In a world with stable population and a given set of goods and services where no new products are invented, one would expect the money prices of final goods to gradually decline at the same pace as the improving productive efficiency of the economy’s resources. The gains in wealth to the society from the higher productivity would be distributed to inhabitants in the form of “higher real incomes.” That is, their unchanged money incomes would gradually command a larger basket of goods as increased availability of goods and services pressed down on money prices. This “productivity norm” for the average of money prices can be thought of as a static baseline for the purchasing power of money: It would tend to rise in an expanding economy. It neglects population growth, labor force participation rates, introduction of new products, external trade, and distortions arising from tax structures and regulation. Nevertheless, it describes how people in an economy benefit from a stable currency.[1] It is important to note that a condition of “rising purchasing power of money” is most commonly described by the pejorative “deflation.” This unfortunate custom has caused most observers to believe that a gradually falling “price level” is as bad, or even worse than, a gradually rising “price level.” Our analysis concludes there can be—and historical experience has demonstrated—“virtuous deflations” during periods of rapidly rising productivity.
[1] “An increase in the quantity of goods produced...must bring about an improvement in people’s conditions. Its consequence is a fall in the money prices of the goods...But such a fall in money prices does not in the least impair the benefits derived from the additional wealth produced...But one must not say that a fall in prices caused by an increase in the production of the goods concerned is the proof of some disequilibrium which cannot be eliminated otherwise than by increasing the quantity of money” (Ludwig von Mises, 1949, p. 431).  

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Jerry L. Jordan, PhD

Jerry L. Jordan is a Senior Fellow with the Fraser Institute and an Adjunct Scholar with the Cato Institute. He was President of the Federal Reserve Bank of Cleveland, a member of President Reagan’s Council of Economic Advisors, Dean and Professor of Economics at the University of New Mexico, and Chief Economist for two commercial banks. He has also served as Sr. Vice President and Director of Research at the Federal Reserve Bank of St. Louis and as a consultant to the Deutsche Bundesbank in Frankfurt, W. Germany.

Jordan earned his Ph.D. in Economics at the University of California, Los Angeles and his B.A. in Economics at California State University, Northridge. He holds honorary doctorates from Denison University, Capital University and Universidad Francisco Marroquin.