What Are the Monetary Systems Leading Most Likely to Business Cycles?

Abstract

It is widely regarded that a monetary system like the predominant present one, with fractional reserve banking and central bank money creation, is very prone to the frequent occurrence of business cycles characterized by a phase of economic expansion followed by a phase of recession. In this paper I assess this and other monetary systems regarding their tendency to avoid business cycles. In particular, besides the present one, it is then analyzed a system that keeps the central bank as monopolist producer of money but with no fractional reserves by commercial banks; a commodity money system with no fractional reserves and, finally, a monetary system with a constant volume of money supply. Some of the features of the system known as “free-banking” are also assessed. The conclusion is that the best monetary systems in the sense of the avoidance of recurrent business cycles are the ones with constant money supply or with a commodity money with no fractional reserves. Regarding the former, some fears are usually advanced because of its supposed “deflationary” character. It is then shown that, in this system, price deflation is only a consequence of economic growth and is a sign of lower unit costs of production due to a rise in productivity. In particular it is shown that in this system of constant monetary supply with increasing output and a corresponding fall in commodity prices the fears associated with “bad deflation” – a decrease in money supply – are unfounded.