eli5: How does an economy grow if the money supply doesnt increase in that same year? In gold standard suppose, gold reserves are not increased but economy still manages to grow. How is that possible, how is an economy growing on a stable money supply?
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Money is just a medium to more easily trade wealth. It’s the wealth that grow.
Wealth is anything of value for human, so it’s the food, minerals, manufactured product or services. Everything someone extract, create or offer something of value for other human, it’s creating wealth. The money is not relevant in that.
Money does not define the economy. The economy is all the goods and services that are produced. If the population grows and/or the people increase productivity, then the economy will grow.
“Money creation” is a complicated thing. It isn’t just printed and dropped from helicopters. Central banks try to be careful about how much is to be made available through loans in such a way that it balances maintains employment levels and price levels simultaneously. People argue about whether they are doing it correctly, of course.
The gold standard wasn’t better. People were at the mercy of gold miners. If there wasn’t enough money, you had to wait for it to be “found” in some remote area of the Yukon.
There are two (relatively) simply answers to this.
One is that the value of money – what you can exchange it for – goes up.
Imagine it costs me £100 to produce a computer chip. I discover a way of making the same chip for £50. So I can now produce and sell twice as many chips for the same £100.
There are more goods being produced, so the economy has grown, but there’s no more money required.
The other is that the “velocity” of money goes up. Money moves around the economy faster.
This is easiest to imagine with physical money. I get paid £100, I wait two day then go and spend it. The person I gave it to waits two days and then spends it. So £200 worth of stuff has been bought in four days.
Now imagine that I spend that money the same day I get it. And the person I give it to spends it the next day. And the person they give it to spends it the next day. Now instead of £200 of stuff being bought in four days it’s £400.
So you can see that the amount of stuff that is actually exchanged, and produced, in an economy is not completely fixed by the supply of money.
Think about what the economy is at the base level. The economy is humans taking things from nature and organising to change these resources into useful things that humans can use.
The economy doesn’t grow because the money supply grows, the economy grows because people become more productive and find better ways to do things.
Money is a way to organise this process efficiently, money is a human idea. The money supply does not have to increase to encourage economic activity as humans are naturally productive and innovative. The value of money will adjust to accomodate this growth
Also interestingly the gross domestic product GDP often used in this conversation accounts for all resources of a country that are producible.
So let’s say a huge oil field was developed now the oil production rate doubled of a small country so the GDP grew and the economy ‘grew’. Similarly if the you opened a refinery on the coastline of said country and can now produce gasoline instead of exporting raw oil GDP up. Expand capture of naturals gas from the same field and install a pipeline inland and boom new production.
More esoteric examples of GDP growth is saying well now the banking industry created new derivatives or a fee for using ATMs. That is product as well. Lower the working age or even expand the working age population by having birth incentives 18 years ago and GDP has the potential to grow as well assuming there are jobs for those people.
Off topic but related and again I think interesting. National debt like in the US can be considered investment in future GDP growth. Make college free to the student? Well in the future you might yield a more educated workforce working in banking to take a share of the global banking market, or chip manufacturing, or tech in general, and you’ve realized a gain on that investment. Invest in social security and you get a stronger middle aged workforce now not needed to care for their elderly parents. There is and always will be endless debate about which programs yield more returns but in general this is the concept for why national debt is not bad. It just hasn’t paid off yet.
It the velocity of money. If I pay someone to mow my lawn, and he pays a farmer at the farmers’ market for some food, and the farmer pays a farm hand, and the farm hand then pays me to adjust his back, then we’re all doing work and helping each other and the same stack of money is getting spent many times over. The issue really isn’t the amount of money that exists, it’s how often the money gets spent, because each time it does that represents someone doing some work in return for it. Building something, repairing something, performing a service, doing work.
The flip side, of course, is that the money’s velocity can also become very low. Suppose the farmer doesn’t actually OWN his farm. A rich guy owns it, having inherited it from his father. The farmer is just renting it. And the rich landlord, obviously, says “You’re not allowed to farm that land unless you pay me rent every month.” So the farmer gives the money to the rich landlord.
Well, the landlord was already rich. He’s been rich all along. So getting that particular stack of money doesn’t enable him to go spend money that he wouldn’t have already spent- he doesn’t need that stack of money to afford anything. So instead of spending it, he puts it in the bank or under his mattress or something.
Now, the money’s velocity is “slow.” It’s not getting passed on to another person to get them to do work. It’s just sitting still. The economy is no longer growing.
Imagine the economy as a wheel. The wheel has a certain number of spokes, and you stand nearby and count the amount of times a spoke touches the ground in a given timeframe. You can increase this number by just making the wheel turn faster. The amount of spokes stays the same, but the amount of times any specific point around the wheel meets a spoke is increased. The economy works similarly. When the economy grows, what it really means is that money is moving around much faster. Each actor in the economy holds on to their money for a shorter amount of time, but in return they get more money total (because the wheel is spinning faster).
So what makes this question really interesting is that Adam Smith, father of modern economics, believed that an economy shouldn’t grow over the long term. It might have fluctuations in thr short term, but on average, it would always return to a baseline.
So how did we go from thinking an economy doesn’t grow to continual annual growth seemingly being the norm?
It has to do with how economist measure growth. The word “growth” implies some sort of change over time. So what’s changing over time?
The answer is output, or how much stuff a country produces. You’ve probably heard of Gross Domestic Product, or GDP. This is just the monetary value of all the stuff a country makes.
So let’s say you declared independence and made your house/apartment a micro-nation. In a year, you make 100 chairs valued at $5. Your GDP is $500. If next year, you produce 150 chairs at $5, your GDP is $750 and your annual economic growth is 50%.
So why does an economy grow? Especially when Adam Smith said it wouldn’t. The answer is that Smith was correct – based on all the data he had seen so far. He lived in era when the industrial revolution hadn’t really came into full swing yet.
Technological innovation makes it possible to increase output given the same amount of resources. If your little micro-nation invested on a chair-making machine and you suddenly were able to produce 500 chairs in a year and you continually invest in chair-making machines to increase your chair-making abilities, you’ll see annual economic growth each year.
The economy does not grow or shrink with the amount of money. The economy grows or shrinks with the amount of money that is changing hands.
If everyone with money refused to spend it tomorrow, the economy would shrink down to zero. If everyone started buying twice as much as they normally do and subsequently got paid to produce twice as much as they regularly do, the economy would double. No change in the amount of money supply necessary.
The “economy” is a fancy way of saying “how motivated are people to work”.
The actual money being traded has no real purpose or value. It exists as a means of dividing goods into tradable components.
Someone who makes a portion of a fighter jet can’t sell that fighter jet to someone else, and they wouldn’t want to trade it for a hamburger.
This is where inflation and deflation come in. The “value” of the money changes as the arbitrary assignment of worth changes in people’s heads. If I give my worker 1 shmeckle for every 5 shmeckle donut I sell, I get 4 shmeckles. But minimum donut wages are now 2 so I’ll charge 7, and now that I charge more the land lord needs more money so my employee needs more money and so on.
No one is “getting paid” they are being assigned a value for their work and effort. What is happening is that people are collecting raw materials, people are refining those materials, people design products from those materials, people make those products, and all of this is delivered.
The “economy” issue comes when people want to cheat and hack the system to syphon as much money as possible out of this system for themselves while contributing nothing. That is what capitalistic wealth means.
Now to be fair, there are people who do add to the system, making the system work better. Efficiency, marketing, innovating quality. It’s huge corporate bonuses that cause companies to fall under.
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