On Monetary Policy in a Specie-Based Economy
by Terence Wynne

The basic function of monetary policy is to match the supply of money to the sum total goods and services in an economy. The effective supply of money in an economy is equal to the value of the money in circulation multiplied by the number of times the money changes hands in a given period of time (the velocity of the money). In a modern economy, the velocity of money is tied to the reserve ratio, the fraction of deposits a bank is required to keep on hand in non-interest-generating accounts. Let us suppose the reserve ratio is 20%, or one-fifth. If there is $100 in circulation, eventually that money will be deposited in a bank somewhere. The banks can, collectively, loan back out 80%, or $80, of that money. That $80 will be re-deposited at some point, and 80% of that, or $64, can again be loaned out. The sum of the resulting sequence, a + ar + ar² + ar³. . . is a/r. In our example, that is $100/(.2) = $100/(1/5) = $100*5 = $500. Thus, the velocity of money is the inverse of the reserve ratio.

The reserve ratio can be quickly and efficiently altered to meet the demands of monetary policy. In an inflationary period (too much money chasing too few goods and services), the reserve ratio can be increased, reducing the effective supply of money. In a deflationary period, the reverse is true.

When specie is money and there is no modern banking system, the velocity of money cannot easily be manipulated. Thus, to effect changes in the money supply, the amount of money in circulation has to be directly manipulated. The reverse is also true; when the amount of money (gold, silver) in the economy is changed, there will be inflationary/deflationary pressures placed on the economy.

Consider a wise king who runs a budget surplus and socks away money for a rainy day. By storing specie in a vault, he is decreasing the money supply and forcing deflation on his economy. Woe unto the peasant who suddenly doesn’t have a coin small enough to meet his daily needs. Under these circumstances, economic transactions will tend towards barter and further hoarding of money (coins) can be expected throughout the economy, exacerbating the problem.

So, the king perseveres and manages to create a rainy-day fund. One day, barbarian hordes cross the frontier and the king needs to raise an army in a hurry. Out come the rainy day funds. There are no more soldiers in the kingdom (or food to feed them or horseshoes for their mounts) than there were the day before, but the king throws money at them so they sign with him and not his Dukes. Along with the calamities of war, famine, and pestilence rides another horseman – inflation. More money is chasing the same sum total of goods and services.

If the king attempts to debase his currency to make it stretch further, again inflation strikes. There may be more coins in circulation, but each contains less specie, less money. The coins may be called the same thing as they were in the good, old (pre-debasing) days, but you will need more of them to buy a loaf of bread (or a castle) precisely because each one contains less actual money.