To concretely illustrate what happens if the money supply stays constant alongside increases in output capacity, consider the following simple economy consisting of workers (laborers), plantations (capital stock), and plantation owners (capitalists). We’ll assume that this economy contains 1,000 metal coins to use as money in commerce; the supply does not increase or decrease. The workers, who are large in number, go to work each day at the plantations and employ land and equipment to grow and pick fruit. In exchange for their work, the plantations, under the direction of the owners, pay the workers wages. Any excess profit that the plantations earn gets paid to the owners in dividends.
In aggregate, we’ll assume that each year the plantations pay out 900 metal coins in total wages and 100 metal coins in total dividends (from profit). The workers and the owners take all of this money–the full 1,000 coins received–and use it buy and eat the fruit that is being produced. Suppose, for the sake of simplicity, that the plantations are producing 1,000 pounds of fruit each year, and selling each pound for 1 coin. Then the plantations will receive 1,000 coins in revenue each year–exactly what is needed to continue to pay out 900 coins in wages and 100 coins in dividends (from the 100 coins that is profit). The economic sectors will be in balance, and the virtuous cycle of income-and-spending, production-and-consumption, will be able to continue forever–or for as long as the economy produces fruits and wants to consume them.
Now, suppose that through learning, technological innovation, and population growth, the economy’s output capacity increases, such that the plantations eventually develop the ability to produce 2,000 pounds of aggregate fruit each year. Suppose further that the primary consumers in the economy–the workers–want to consume more fruit. Their appetite is large, and their numbers are continually growing.
The problem, of course, is that the workers can’t afford to buy more fruit with their current incomes. They only earn 900 coins per year. The price of fruit is 1 pound per coin. So long as this price holds, the workers will only be able to buy and consume 900 pounds of fruit per year–even though the economy has the ability to produce twice that–2,000 pounds. If the owners wanted to consume the difference–the 1100 pounds of fruit–they could bypass the monetary medium, and have the plantations distribute the fruit to them directly. But they don’t have such a large appetite.
The only way that the system can equilibriate at a higher production level, then, is if the owners start paying the workers the same amount on a faster time scale. The owners would have to pay the 900 coins in wages to the workers every 6 months rather than every year. To take this action would be to effectively double the wages of the workers–pay them what was previously a year’s salary in exchange for only 6 months worth of work. The doubling of the wages would allow the workers to double their spending, thus assuring that the full supply of yearly fruit that gets produced can be purchased and consumed.
But why would the plantations spontaneously double the wages of their workers? They wouldn’t. Wages are a cost to the plantations. Obviously, the plantations aren’t going to voluntarily choose to increase their costs. They would need a catalyst that forces them to increase their costs; a simple increase in output capacity is not such a catalyst.
If wages stay constant, plantations have two options: (1) produce the 2,000 pounds of fruit, where only 1,000 pounds can be bought, or (2) don’t produce the 2,000 pounds of fruit–continue to produce 1,000 pounds, even though 2,000 pounds are achievable and wanted for consumption.
The first option will force a deflation. If the plantations produce more fruit than the workers can afford to buy with present wages, the plantations will have to cut prices. Necessarily, the average price of fruit will get cut in half–only then will all of the fruit be buyable. Notice that on this outcome, incomes and profits will have stayed in constant in nominal terms, but will have doubled in real terms, consistent with the doubling of real economic output. The second option will entail an economic stagnation. The economy will have made progress, grown in its “potential”, but will not be able to realize it. The hard system of money will have prevented the increased capacity to produce and the increased desire to consume from meeting.
The insight here is that there are two ways for non-deflationary economic “growth”–an increase in an economy’s total production and consumption, or alternatively, its total income and spending, at constant prices–to occur. Either the supply of money can increase, or the velocity of money–the speed of its circulation from spending to revenue to wages and dividends back to spending–can increase. If the money supply is locked up in a physical object, such as metal coins, then the only way that growth can occur is through the latter mechanism. Unfortunately, there’s a limit to how fast a physical object can turn over. And so there’s a limit to the amount of non-deflationary economic growth that can occur in a fully hard monetary standard.