Famous errors in Economics


2: Gold backing, a requirement for monetary stability?




1st Introduction

2nd Characteristics of the gold currency

3rd Gold currency in the historical course

4th The quantity equation

5th The quantity theory

6th Criticism and further development of the quantity theory

7th Gold backing is not a sufficient requirement for monetary stability

8th Gold backing is not a necessary requirement for monetary stability





In this chapter, we will critically examine the thesis that the value of money in the context of a gold currency is determined by the value that gold has as a commodity. Here, it is assumed that the value of gold or any other precious metal is not only very high in terms of its weight, i.e. it is valuable, but at the same time it is very stable in terms of value, i.e. it does not undergo any significant changes over time, especially no losses. At the same time, it is assumed that only in this way, i.e. that the money in circulation is covered by a precious metal of stable value, it is possible to keep the value of money stable.


In this chapter, we want to demonstrate that this thesis does not correspond to the truth; the coverage of banknotes in circulation by means of gold or another precious metal is neither a necessary nor a sufficient condition for maintaining monetary value stability. Even within the framework of a gold currency, the value of money may be subject to major fluctuations and may show considerable losses over time; simultaneously, it may very well be possible to keep the value of money stable without any backing of the banknotes by a commodity which is considered to be stable in value.



2nd Characteristics of the gold currency


It is referred to as a gold currency whenever gold either serves as legal tender or when the legal means of payment can be exchanged for gold at a fixed price. A distinction is made between a pure gold specie standard, a gold bullion standard and a gold exchange standard.


If there is a pure gold specie standard, only gold coins are considered legal means of payment.


On the other hand, if we have a gold bullion standard, the demand for money is largely covered by banknotes issued by a central bank of a country, whereby these banknotes are - often only partially - covered by the gold stocks stored at the central bank. In most cases with a gold currency, the central banks were obliged to redeem banknotes for gold on demand. In addition to banknotes, however, gold coins and divisional coins (coins with a small nominal value, which are used for daily small transactions and which metal value is usually lower than the fixed nominal value) are also in circulation here.


On the other hand, if there is a gold exchange standard, the circulating banknotes are covered not only by gold but also by foreign currency convertible into gold, which can be exchanged for gold at any time. In this case, there is not always an obligation of encashment for the banknotes.


As soon as we also take international relations into account, there are two types of monetary stability to distinguish. For domestic economic relations, monetary stability means that a certain amount of money can always buy the same amount of goods. Here it is a matter of the purchasing power of domestic money. Whereas if we look at the external relations of two or more national economies, in the context of monetary stability we are concerned with the exchange ratio of two currencies. For example, how much euro do I get for one dollar?


If the currencies of the individual economies are based on gold, the exchange rate, the ratio of the domestic monetary unit to a foreign monetary unit, can only shift within narrow limits.

An importer can always pay for imported goods either in the currency of the exporting country or else in gold. He always chooses the cheapest and simplest method. The simplest method is, of course, to pay in foreign currency. But if the exchange rate rises, i.e. if the domestic importer has to pay more and more domestic money units in exchange for one foreign money unit, then it becomes cheaper for him to pay in gold from a certain exchange rate onwards. Gold can always be purchased from the central bank at a fixed price, but in addition to this price, there are transport and insurance costs for shipping the gold. This means that the exchange rate cannot rise above the gold price plus the costs of shipping the gold. Similar considerations apply to the foreign importer when buying domestic products, except that his exchange rate is the reciprocal of the exchange rate for nationals, with the consequence that from a domestic perspective the exchange rate can neither fall below the gold price plus shipping costs.


This mechanism now also helps to automatically reduce imbalances in the balance of payments. If a country achieves an export surplus, the gold reserves of the central bank increase, since a part of the imports is paid in gold. The quantity of banknotes also increases to the same extent as the gold reserves of the central bank increase, with the result that the domestic price level rises. As the domestic price level rises, fewer goods are exported, which means that the export surplus declines. Abroad, on the other hand, which has an import surplus, the export of gold leads to a reduction in the money supply and with it the foreign price level, which increases the export opportunities of the foreign country.



3rd Gold currency in the historical course


In the 19th century, almost all major economies had a gold (or silver) currency. However, this global monetary system collapsed during the First World War and could only be restored for a short time after the end of the First World War in the 1920s. After the Second World War, the establishment of the International Monetary Fund (IMF) created a monetary order with the US dollar as the reserve currency and the obligation of the US Federal Reserve to exchange dollar notes for gold at a fixed price at any time.


However, this system was endangered by the fact that the USA, especially in connection with its continuing deficits in the balance of payments, expanded the volume of banknotes in US dollars far beyond the available gold reserves. This practice diminished the confidence of the other member countries in the stability of the reserve currency with the result that more and more central banks, in particular the French central bank, exchanged their reserves in foreign currency (dollars) for gold. As a result, the US Federal Reserve saw itself forced to cancel the obligation to exchange in 1971, as it had too few gold reserves.


If we ask for the stability of a currency system, we must first distinguish between the period in which this currency is introduced and the period in which this system is already established. It is clear that confidence in a newly introduced currency is greater when the money, like the gold coins, has its own commodity value, which can if necessary be drawn on by the person who has sold a commodity against this money.


We have to assume that in early times the individual farms largely produced only for their own needs and had produced almost all the required products themselves. Over time, however, it was realised that the productivity of the own output could be substantially increased if one proceeded based on the division of labour and specialised in a few products. In this case, the needed products that were not produced in the own production must be purchased from other producers and at the same time the self-produced goods that exceed the own needs should be sold to other households (persons).


This division of labour thus presupposes an exchange of the individual goods. Theoretically, both acts of exchange (acquisition of goods not produced by the enterprise itself and sale of goods produced by the enterprise itself in excess of its own consumption) could be carried out in a single exchange of goods for goods. However, such a procedure would be associated with considerable difficulties. In a first step, one would have to make an effort to find an exchange partner who, on the one hand, demands the goods offered by oneself and, on the other hand, offers the goods needed by oneself. Such an exchange partner would probably not be found at all; in any case, very high information costs would have to be incurred in order to find such a partner. Therefore, it would be advisable to first find an exchange partner who demands the goods offered by himself and to acquire the good produced by this partner in exchange, although he himself has no demand for this good. Further acts of exchange would be necessary until the individual could finally acquire the good he himself requires.


In such a situation, the introduction of a general means of payment brought an enormous profit, since in this way only ever two acts of exchange were necessary: first, one sells the self-produced good for money and then buys the needed but not self-produced good for money.


However, this general means of payment, called money, must have certain characteristics so that such an exchange of goods for money can take place. On the one hand, the monetary unit must be neither too bulky nor too heavy; it must also be easy to divide into pieces. On the other hand, the money must be stable in value over time. The seller must be sure that the value of the money he has received as proceeds for the sale of his goods will still be approximately the same if he subsequently wants to buy other goods with this money.


The willingness to accept the money in return for the commodity sold will now certainly be much greater at a time when the monetary unit is newly introduced, when the money also serves as a normal commodity and is thus regarded in its capacity as a commodity on the one hand as valuable, and on the other hand as stable in value. Thus, if it should turn out that this new money is not suitable as a means of exchange, then the seller of his commodity still possesses a valuable commodity.


Other considerations about the necessary properties of a currency are indicated, however, once this currency has been established and generally accepted as a medium of exchange. In this case, a currency unit can very well fulfil its functions as a medium of exchange, irrespective of whether the currency at the same time has an independent value as a commodity.


For money to be able to fulfil its functions as a means of exchange, only two things are required: on the one hand, there must be a general acceptance of this currency as a means of exchange; the individual who receives money when selling his goods or services must generally not be anxious to spend this money again as quickly as possible because he distrusts money as a means of exchange. In normal times, however, it is sufficient for such acceptance that the state legally recognises the money in circulation by stipulating that anyone who pays his debt by handing over this means of payment has actually repaid his debt and that therefore the creditor cannot demand payment of the debt with another means of exchange in court.


The value that the monetary unit acquires in a free market economy, however, does not depend decisively on whether this money also has an additional value as a commodity, but entirely on the quantitative relationship between the quantity of money in circulation and the bundle of commodities that is to be exchanged with the help of the money.



4th The quantity equation


In the course of the history of economic doctrines, this insight asserted itself very early on as the quantity theory. Some mercantilist theorists already recognised the basic features of this theory. The quantity theory was then developed by the classics of economic theory, such as David Ricardo, into a theory that specified the relationship between the value of money and the value of goods.


The starting point is the so-called quantity equation, which shows that at any moment the sum of value of the money in circulation must always correspond to the sum of value of the traded goods. This identity of both sums of value results simply from the fact that both sums refer to one and the same act of exchange. If one starts from the sum of value of the quantity of money in circulation, one asks about the quantity of money offered by the buyers to the sellers, while if one refers to the sum of value of the traded goods, one asks about the quantity of goods offered by the sellers.


Now, one needs to realise here that the traded goods are primarily consumer goods, which in principle are traded only once and then leave the economic cycle, as they are consumed by the households. In contrast, money is a commodity that is basically not consumed by the act of exchange, i.e. it can be exchanged a second, third or umpteen times after the act of exchange has taken place.


Particularly for this reason, within the framework of the quantity theory, it is not primarily the physical quantity of money units that mediates the exchange that is important, but rather the sum of value of the money, which is calculated from the product of the quantity of money multiplied by the velocity of circulation of the money. The velocity of circulation of money indicates how often a banknote changes hands on average within a period due to an act of exchange. For the value of money, it is irrelevant whether this sum of value has doubled, e.g. because the quantity of money in circulation has doubled or because with a constant quantity of money each banknote has conveyed twice the number of exchange acts on average. The decisive factor is always the sum of value of goods that can be bought and this sum of value always corresponds ex definitione (due to the definition of the velocity of circulation of money) to the sum of value of the money that made the acts of purchase possible.


So let us summarise the statement of the quantity equation. The equation applies always:


G * U = P * H


With G as the quantity of money in circulation (mediating an act of exchange), U as the velocity of circulation of money, P as the price level of the goods traded within one period and X as the real quantity of the goods exchanged. The sum of the value of the goods (P * H) is calculated as the following sum:


P * H = p1 * x1 + p2 * x2 + ..... pn * xn



Therefore, although the quantity equation only points to a self-evident identity that does not yet have any informative content, this equation was nevertheless decisive for exploring, based on this equation, the most important determinants of the value of money (which is determined by the price level).



5th The quantity theory


The classic economists now started from the assumption that, firstly, the velocity of circulation of money is derived from the mores of payment and that these mores of payment are predetermined and largely constant, at least in the short term. Secondly, it was also assumed that the real quantity of goods is largely predetermined, since material resources must again be regarded as constant in the short term and since in addition the market works to ensure that all available factors of production are also employed. In this case, it is indeed not possible to increase the real supply of goods in the short run by expanding the money supply in circulation.


If these two assumptions are made, an autonomous increase in the quantity of money in circulation will necessarily lead to an increase in the price level of an equivalent percentage and, at the same time, the price level of goods can only rise when and to the extent that the quantity of money increases. This means that the value of money, which is expressed in the price level of goods, can always be kept constant if the product of the money supply multiplied by the velocity of circulation of money is changed to the same extent as the real quantity of goods. We can also reformulate the quantity equation as follows:


G * U = P * H results in (G * U)/H = P



Note well: in contrast to the quantity equation, which is always valid (ex definitione), this is a real theory, which can only be called true if the assumptions made (constancy of velocity of circulation and real quantity of goods) correspond to reality.



6th Criticism and further development of the quantity theory


Now, the discussion about the quantity theory has shown that these two assumptions by no means correspond to reality at all times. It was above all John Maynard Keynes who criticised the quantity theory in its classical variant. Firstly, it must be expected that the velocity of circulation of money depended on the level of the interest rate, especially in the short term, and secondly, the real volume of trade could very well increase as a result of an increase in the money supply, provided that the existing factors of production were not fully utilised, i.e. that there was predominantly macroeconomic unemployment.


In fact, it can be assumed that to the extent that the current interest rate is lower, the velocity of circulation of money decreases. This relationship can be explained as follows: First of all, there is an inverse relationship between the cash holdings of the economic agents and the velocity of circulation of money. Ex definitione applies that the circulation velocity of money increases (decreases) the less (the more) money the economic agents hold in cash.


The decision on how much money to keep in cash now depends not only on how much money economic agents need to make their current purchases. It can also be worthwhile for a household to temporarily hold part of its financial assets in cash, even though the financial assets actually are normally invested in securities, which bring the owner an interest income.


The fact that under certain conditions individuals nevertheless hold part of their financial assets in cash temporarily, although they do not receive any interest income from this use, is due to the fact that the expected net income from an interest-bearing investment is not only determined by the amount of interest income, but also by whether the price of a security paper changes. The possibility must be considered that the loss of assets due to a decline in the price of a security is greater than the possible interest income, so that on balance the investment of financial assets in securities even leads to a loss in value.


Such a danger is now given, when the current interest rates are at a low level. On the one hand, the interest yield is low here anyway; on the other hand, it can be assumed that the lower the current interest rate level, the greater the probability that interest rates will rise again in the near future.


The expectation of an imminent rise in the general interest rate level is, however, also linked to the expectation of an imminent fall in the price of fixed-interest securities. Fixed-interest securities are characterised, among other things, by the fact that it is not paid the current market interest rate, but an interest rate that is fixed when the security is issued. If the general interest rate now rises, a security owner could profit from selling his fixed-interest securities with the below-average interest rate and exchanging them for securities with a variable interest rate. However, the sale of the fixed-interest securities automatically leads to the feared depreciation.


These considerations show that whenever the interest rate reaches a very low level, it can be advantageous to keep one' s money in cash temporarily and thus forego paying interest. However, this means that the lower the current interest rate, the more the velocity of circulation of money decreases.


Let us now consider somewhat closer the second assumption of the quantity theory in its classical variant. It must be admitted without further ado that the strict connection between the money supply and the price level shown in the quantity theory only exists when all factors of production are at full employment and that in fact in times of economic downturn a part of the production factors lies idle. Thus, we must also reckon with the possibility that an autonomous increase in the money supply can certainly lead to an increase in the real quantity of goods, so that an increase in the money supply needs not automatically and completely fizzle out in price increases.


However, the assumption of Keynesian theory that an increase in the money supply leads to increases in the real quantity of goods at constant goods prices as long as not all factors of production are employed does not correspond to reality either. We have to reckon with the fact that in the case of underemployment only a part of the increase in the money supply leads to an increase in the real quantity of goods and that the remaining more or less large part of the increase in the money supply still fizzles out in price increases.


This assumption is supported by the following circumstances: Firstly, when there is an increase in demand due to an expansion of the money supply, a certain amount of time always elapses before supply matches the increase in demand. Secondly, not all sectors of the economy are affected by underemployment to the same extent. Long before all factors of production are fully employed in the economy as a whole, shortages arise in individual sectors of the economy. These cause prices to rise in these sectors of the economy. And since a part of these goods enters the production of the remaining goods as semi-finished products or as real capital, also there with the costs their prices rise. Thirdly and finally, empirical studies show that Cobb-Douglas production functions are applied in industrial enterprises and that this production technique manifests itself in the fact that unit costs increase when production expands. However, this increase in unit costs usually leads to an increase in prices.


Despite Keynes' justified criticism of the classical variant of the quantity theory, we must therefore assume that autonomous increases in the money supply generally lead to price increases and thus violate monetary stability. Due to the behaviour of the owners of financial assets described above, an autonomous increase in the money supply will not immediately lead to a general price increase; despite the lowering of interest rates, economic agents will wait to buy shares until it has become clear that the general economic upswing is establishing itself. However, as soon as the additional money is no longer held in cash by the majority, demand will also rise and with it the price level.


In principle, the central bank could still change tack by means of a restrictive monetary policy and thereby withdraw so much money from the economic cycle that in the end the value of the money in circulation only corresponds to the increase in the real supply of goods. Experience shows, however, that central banks are not willing to take this step for a long time, as they fear that a restrictive monetary policy implemented too quickly would endanger the still young plantlet of economic upswing and thus strangle it too quickly. As a rule, they will only initiate a restrictive monetary policy when prices have already risen so much that an inflationary process can only be avoided by a sharp increase in interest rates.


Even if we accept these corrections to the classical variant of the quantity theory, the insight remains that the value of money depends unambiguously and solely on whether the relationship between the product of the quantity of money in circulation and the velocity of circulation as well as the real quantity of goods can be maintained, i.e. whether the central bank is in other words able to adjust the value of money (not the quantity of banknotes) to the movements in the real quantity of goods. In contrast to the position of the classical economists, the central bank, within the framework of its monetary policy, has not only to pay attention to controlling the quantity of money in circulation, it must also be in a position to react to changes in the velocity of circulation and, moreover, to take into account in its calculations that the real quantity of goods can certainly be stimulated by increases in the quantity of money.


This means, however, that tying money to a commodity value that is as stable in value as possible, such as gold or another precious metal, is neither necessary nor sufficient to ensure the stability of money.


Now, the central banks have drastically increased the money supply in recent years, but without the price level rising as expected - not even after a certain time. Does this not mean that the quantity theory does not correctly describe the determinants of monetary stability? Hardly, the actual reason for the fact that the expected price increases have not occurred so far is due to two developments.


In earlier times, banks exchanged their short-term surplus money holdings with each other. This lending of short-term money stocks was tantamount to an increase in the velocity of circulation, since due to this behaviour of the private banks considerably fewer banknotes were needed to finance the exchange of goods. However, this behaviour of the banks presupposes mutual trust between the banks, because only if they can firmly trust that the other banks are also capable of repaying these short-term borrowed funds, a bank will be willing to engage in this behaviour.


However, this confidence has now been destroyed lastingly by the fact that many banks made highly risky investments in the past, became insolvent as a result and thus triggered the past global financial crisis in the first place. This confidence has not yet returned despite some monetary policy reform measures. However, as long as these short-term transactions remain absent, the velocity of circulation of money remains greatly reduced compared to the times before the last financial crises, so that despite the expansion of the quantity of banknotes, the sum of value of money has increased much less than usual.


However, there is a danger that in the moment when this mutual trust between the banks has returned, the then exceeding money supply will lead to a strong increase in the demand for goods. And if the central bank is then unable or simply unwilling to drastically reduce the quantity of banknotes for the reasons mentioned above, a strong general price increase is still to be expected.


A second reason for the fact that, despite the strong increase in the money supply in the recent past, the predicted inflation failed to appear can be seen in the fact that the surplus money in the hands of private economic entities was not predominantly used for investments in the productive sector as expected, but rather that these funds were invested in gold or in real estate and thus the reasons for a price increase in industrial products failed to appear. The fact that private economic entities, on the other hand, preferred these largely unproductive investments can be explained by the fact that confidence in the success of the enterprises could not yet be established.


Precisely due to the behaviour of the banks, they are not ready to grant investment loans to the same extent as in the past, which would be necessary for the rationalisation of the enterprises. As a consequence, the absence of the feared price increases must also be explained by the lack of confidence of private investors in the profitability of enterprises.



7th Gold backing is not a sufficient requirement for monetary stability


First of all, such a binding (of money to gold) is not sufficient. For no commodity it can be ruled out for all times that its value will not change. It is also true for gold as a commodity that it certainly has a relatively high value compared to other goods and that its fluctuations in value are smaller than those of other goods. Nevertheless, the value of gold will ultimately depend on how the demand and supply of gold changes over time.


Let us begin our considerations initially with the possible changes in the stock of gold. As we have already indicated, gold is one of those goods that are not consumed when used, so we can assume that the amount of gold already present is largely preserved. Consumer goods disappear from the surface when they are consumed, the stock of gold remains largely intact.


Secondly, gold can be mined and thus the supply of gold can be increased. It is true that the gold deposits on this earth are limited and the more gold that has already been extracted from the earth, the higher the extraction costs generally become, since naturally first of all the gold deposits are mined where extraction is possible at relatively low cost. Above all, it is impossible to determine the exact deposits of gold lying in the earth. At the same time, it is completely unknown whether techniques will be developed in the future that will make it possible to extract gold deposits that are too expensive to extract using the techniques known today.


For the maintenance of the value of money, however, the question of whether and how much gold is offered is less important than solely whether the supply of gold can be adjusted to the changing supply of real goods over time. Generally speaking, it is above all technical progress that determines which growth rates can be expected in the supply of goods as a whole and of gold. It would be pure coincidence if the rate of technical progress for gold were the same as for all goods in general. On the contrary, from the supply side it must be assumed that the growth rates of gold and the other goods will be different and that from this side a changing monetary value must be expected over time.


Let us now ask ourselves about the development of the demand for gold. We have to calculate between the following types of demand for gold. Firstly, we need gold to mint gold coins and to cover banknotes. Since monetary stability with a constant velocity of circulation presupposes that the quantity of money stored at the central bank must correspond to the supply of goods, the demand for gold in a gold currency increases for this first reason with the growth in real goods. However, we must also take into account that gold is not needed to cover the banknotes; we have seen that monetary stability depends solely on whether the value of money succeeds in following the development in the real supply of goods. For this reason, the heads of the central banks could also one day abandon the hedging of banknotes by gold storage and sell their existing holdings.


Secondly, gold is needed for the production of jewellery. This demand has been largely constant in the past or has increased with the wealth of a nation. But there is no reason to believe that in the future there will not be a change in demand that will cause it to fall dramatically.


Thirdly, gold is needed as a raw material for the production of goods. The demand here depends decisively on technical progress. Artificial substances can be invented at any time that replace gold as a raw material, or even have better properties. In the past, gold was also needed for artificial teeth. In the meantime, there are materials that give dental prothesis a far more natural appearance, which also promote health and well-being. If other metals besides gold are used for fillings, electrical currents are generated in the mouth, which can cause discomfort.


Fourthly, gold is also a popular means of temporarily holding assets in the form of gold. The more this inclination is met and therefore more gold is demanded, the more the value of gold rises with the consequence that the inclination to invest assets in gold increases further. Here we have a clear sign that a certain behaviour (here the investment of assets in gold) may increase utility in the private sector, but causes great harm in the economy as a whole. The wealth of households is needed for production, the more the wealth is invested in largely unproductive gold, the less the enterprises have the capital that is needed for the production of goods.


If we summarise these considerations, we can conclude that in the long run there is little to suggest that the value of gold will remain unchanged over time. However, this also removes the possibility of guaranteeing monetary stability within the framework of a gold currency. The hedging of the currency by gold is therefore not a sufficient condition for monetary stability.


Now, one could perhaps object that within the framework of a gold currency, the state arbitrarily sets the price that the central bank pays or demands for the purchase and sale of gold, and at first glance this also seems to mean that the state has the possibility of arbitrarily keeping the price of gold constant over time and thus could also indirectly enforce a stability of the value of money.


However, a simple consideration shows that freezing the gold price is not a solution. It is also true for the special good gold that the price of a good ensures that there is a tendency towards equilibrium between supply and demand. If the price is deprived of the possibility to adjust to the respective scarcity conditions, the scarcity will inevitably be perpetuated. Since, in this case, price fluctuations no longer correspond to scarcity conditions, the market can no longer fulfil its primary task of aligning the production of goods with the needs of the end consumers and ensuring an appropriate distribution of goods. Thus, even with a gold backing of money, the value of money can become unstable due to fluctuations in the monetary value of gold.



8th Gold backing is not a necessary requirement for monetary stability


What about the second question, whether hedging the currency with gold is at least a necessary condition for monetary stability? Do we therefore have to assume that monetary value stabilisation cannot succeed without hedging the currency with gold holdings at the central bank? According to what has been said so far, we can clearly answer this question in the negative. We have shown that the value of money remains stable if it is possible to adjust the value of money to the changes in the real quantity of goods. Does a central bank have the possibility to achieve this goal?


Of course, we must not imagine this task to be as simple as the central bank simply having to adjust the quantity of banknotes to the development of the real quantity of goods. We have seen that in order to stabilise the value of money, it is not so much the quantity of banknotes that is important, but the sum of value that can be exchanged with the banknotes in circulation. However, the value of money depends on both the quantity of money and the velocity of circulation. If we assume that the central bank can primarily only control the quantity of banknotes issued by itself, the stabilisation of the value of money depends on the money supply (in the sense of banknotes and coins) being adjusted to the ratio of the value of the quantity of traded goods divided by the velocity of circulation. The following applies:


G * U = P * H è G = (P * H)/U



The central bank must therefore not only monitor changes in the real quantity of goods, but also in the velocity of circulation of money and adjust the quantity of banknotes to these changes.


Now we have to assume that a very large part of the turnover of goods is not paid with banknotes or coins, but by transfers from the bank account of the buyer to the bank account of the seller. We are talking here about the fact that the money in circulation consists not only of banknotes, but also of book money. However, it is not the central bank, but the private banks that have access to the amount of book money in circulation. Therefore, there is always the danger that the monetary policy of the central bank will be thwarted by the creation of book money on the part of the private banks. For example, the central bank would like to reduce the money supply in circulation because goods production is declining due to the economic cycle, but the private banks thwart this objective of the central bank by expanding the amount of book money in circulation.


However, this practice of the private banks basically corresponds to the fact that the circulation rate of the banknote money is changed. Instead of stating that the money supply is made up of banknotes and book money and that the private banks have autonomy over the amount of book money, we could also have said that the change in the amount of book money increases the velocity of circulation of the banknote money. The fact that a buyer can pay for his purchases by transferring money means that more purchases can be made with the same quantity of banknotes.


Precisely because of these correlations, efforts have been made since the Great Depression, but especially since the end of the Second World War, to provide central banks with additional instruments that allow them to influence the behaviour of private banks. Thus, the central banks have been given the right to act as buyers or sellers of securities on the money and capital markets in order to give private banks incentives to adapt their policies to the objectives of the central banks and thus to influence the overall money supply. At the same time, central banks also have the right to request private banks to deposit a certain, but variable, percentage of bank liabilities with the central bank as a minimum reserve. While the German Central Bank made extensive use of both instruments, the European Central Bank has largely refrained from the possibility of a minimum reserve policy so far.


With both instruments, the central bank can now also influence the amount of book money of the private banks. Let us assume, for example, that the private banks have sufficient money at their disposal and that they intend to expand their credit supply to businesses and households in this way and thus to create book money. The central bank can attempt to offer the banks highly interest-bearing securities, and in this manner induce them to invest their money holdings in these securities. Or it can raise the minimum reserve rate, and in this way force the banks to tie up a major part of their liquid funds by means of the minimum reserve deposit with the central bank.


Now, the central bank may be overstrained to realistically assess future short-term changes in the real quantity of goods as well as in the velocity of circulation of money. Precisely for these and other reasons, it was recommended by e.g. Milton Friedman that the central bank should generally refrain from influencing economic behaviour in the sense of a stop-and-go policy. Frequent changes in interest rates increase the uncertainty of long-term investments. The goal of monetary stability would be much more likely to be met if the central bank aligned its money supply with long-term expectations of changes in the domestic product and the velocity of circulation.


In this way, the price level would also be subject to short-term fluctuations due to economic fluctuations. Nevertheless, the value of money would be kept stable in the long run, provided that the central bank would realistically estimate the long-term growth rates of the domestic product. In this case, changes in the interest rate of the central bank would only occur if the central bank had to correct its forecasts about the long-term growth rate of the domestic product.


These considerations show that hedging the currency by storing gold at the central banks is not a necessary condition for the value of money to remain stable over time.