Sound Money versus Fiat Money: Effects on the Boom-Bust Cycle
According to the Austrian business cycle theory (ABCT), the boom-bust cycle emerges in response to a deviation in the market interest rate from the natural interest rate, or the equilibrium interest rate. It is held that the major cause for this deviation is increases in the money supply. Based on this it would appear that on a gold standard without the central bank, an increase in the supply of gold will set in motion boom-bust cycle.
An increase in the supply of gold is likely to result in the lowering of market interest rates. This in turn is likely to cause the market interest rates to deviate from the equilibrium interest rate. Consequently, following the ABCT, an increase in the supply of gold is going to set in motion the boom-bust cycle.
According to Robert P. Murphy, Ludwig von Mises held that an increase in the supply of gold could trigger the boom-bust cycle.1
While suggesting that the gold standard could generate business cycles whenever an increase in the supply of gold causes the market interest rate to deviate from the natural interest rate, or the equilibrium rate, Mises, however, viewed this possibility as remote.
Mises regarded the gold standard as the best monetary system as far as keeping the expansion in credit under tight control. Murphy quotes Mises on this:
Even a rapid increase in the production of the precious metals can never have the range which credit expansion can attain. The gold standard was an efficacious check upon credit expansion, as it forced the banks not to exceed certain limits in their expansionist ventures. The gold standard’s own inflationary potentialities were kept within limits by the vicissitudes of gold mining. Moreover, only a part of the additional gold immediately increased the supply offered on the loan market. The greater part acted first upon commodity prices and wage rates and affected the loan market only at a later stage of the inflationary process. (bold added)2
According to Murphy, Mises concluded that
The unsustainable boom occurs when a newly created (or mined) quantity of money enters the loan market and distorts interest rates, before other prices in the economy have had time to adjust. In principle, this process could occur even in the case of commodity money with 100 percent reserve banking.3
Contrary to Mises, Murray Rothbard held that increases in the supply of gold could not set in motion boom-bust cycles. For him the key reason behind boom-bust cycles is the act of embezzlement brought about by central bank monetary policies and fractional reserve bank lending. Both monetary policy and fractional reserve lending set in motion an expansion in the money supply out of “thin air.”
According to Rothbard it is the increases in money out of “thin air” that are the key causes of boom-bust cycles. He held that, the business cycle cannot emerge in a free market economy where money is gold and there is no central bank. According to Rothbard,
Inflation, in this work, is expli
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