In theory, the answer is simple enough. Presumably the supply of money affects the rate of spending, and therefore we should have enough money so that we buy, at current prices, all the goods and services the economy is able to produce. If we spend less, we will have idle capacity and idle people; if we spend more, we will wind up with higher prices but no more real output. In other words, we need a money supply large enough to generate a level of spending on new domestically produced goods and services-the economy’s gross domestic product (GDP)-that produces high employment at stable prices. More money than that would mean too much spending and inflation, and less money would mean too little spending and recession or depression.
In practice, unfortunately, the answer is not nearly that simple. In the first place, decisions about the appropriate amount of money are often linked with the notion of counter cyclical monetary policy, that is, a monetary policy that deliberately varies the amount of money in the economy-increasing it (or, more realistically, increasing the rate at which it is growing) during a recession, to stimulate spending, and decreasing it (or increasing it at a less than normal rate) during a boom, to inhibit spending.
The more fundamental issue for us is to understand how changes in the money supply can influence people’s spending in a consistent way.. What a change in the money supply can do is to alter people’s liquidity. Money, after all, is the most liquid of all assets. A liquid asset, as mentioned previously, is something that can be turned into cash, that is, sold or liquidated, quickly, with no loss in dollar value. Money already is cash. You cant get more liquid than that!
Since monetary policy alters the liquidity of, the public’s portfolio of total assets-including, in that balance sheet, holdings of real as well as financial assets-it should thereby lead to portfolio readjustments that involve spending decisions. An increase in the money supply implies that the public is more liquid than formerly; a decrease in the money supply implies that the public is less liquid than before. If the public had formerly been satisfied with its holdings of money relative to the rest of its assets, a change in that money supply will presumably lead to readjustments throughout the rest of its portfolio.
In other words, these changes, in liquidity should lead to more (or less) spending on either real assets or financial assets. Spending on real assets expands; demand for goods and services increases, production goes up, and GDP is directly affected. If spending on financial assets goes up, the increased demand for stocks and bonds drives up securities prices. Higher securities prices mean lower interest rates. The fall in interest rates may induce more spending on housing and plant and equipment, thereby influencing GDP through that route.
Underlying the effectiveness of monetary policy, therefore, is its impact on the liquidity of the public. But whether a change in the supply of liquidity actually does influence spending depends on what is happening to the demand for liquidity. If the supply of money is increased but demand expands even more, the additional money will be held and not spent. “Easy” or “tight” money is not really a matter of increases or decreases in the money supply in an absolute sense, but rather increases or decreases relative to the demand for money. In the past half century we have had hardly any periods in which the money supply actually decreased for any sustained length of time, yet we have had many episodes of tight money because the rate of growth was so small that the demand for money rose faster than the supply.
If people always respond in a consistent manner to an increase in their liquidity (the proportion of money in their portfolio), the Federal Reserve will be able to gauge the impact on GDP of a change in the money supply. But if people’s spending reactions vary unpredictably when there is a change in the money supply, the central bank will never know whether it should alter the money supply a little or a lot (or even at all!) to bring about a specified change in spending.
The relationship between changes in the money supply and induced changes in spending brings us to the speed with which money is spent, its velocity or rate of turnover. When the Federal Reserve increases the money supply by $ 1 billion, how much of an effect will this have on people’s spending, and thereby on GDP? Say we are in a recession, with GDP $100 billion below prosperity levels. Can the Fed induce a $100-billion expansion in spending by increasing the money supply by $ 10 billion? Or will it take a $20-billion-or a $50-billion-increase in the money supply to do the job?