Why not a fixed money supply?

I would appreciate thoughts on the matter as this is a bit of early brainstorming on the issue.

I asked this question in a macro-economics class at university once. It seemed simple enough at the time, and seemed to me like a pretty simple and effective way to control a country’s monetary system.

The question was side-stepped quite successfully. So I went to my knowledgeable friend instead.

While there are some interesting conversations happening, I have yet to find a solid overview of the fixed money supply idea and the implications in practice. 

Thinking out loud here, as a general rule technological change and capital investment will enable a given society to produce more goods in future periods. With a fixed money supply, that means that prices will decline over time – deflation.

So the relevant question becomes - how does an economy function with persistent deflation? And my friend has a lot more to say on that. 

Just quietly, imagine you lived in a world with persistent deflation, you would be blogging about a how crazy it would be to propose a world with persistent inflation – how on Earth would it function with the value of money being destroyed each day?

This interesting article outlines a number of tangible problems facing an economy with deflation, including sticky nominal wages and the inability for a central bank to have a negative nominal interest rate. However, past deflationary periods have not curtailed our passage of economic growth, nor do we often read about deflationary periods of prior to the Second World War. The graph below shows the number proportion of inflationary and deflationary years pre and post WW2. The ‘old fashioned’ long-run has almost equal periods of inflation and deflation - a time when money supply was far slower to grow than at present.



One problem is that deflation rarely recovers to mild inflation but springs back to hyperinflation, as suggested here. Because people hoard money during deflation, the government response is typically to increase the money supply, then, when deflation looks under control, these hoarded funds come back into circulation in the real economy leading to rapid inflation. With a fixed money supply, this effect should be dampened.

Maybe then the best thing for governments to do is live with a little deflation, rather than actively responding by increasing the money supply. From the Austrian School we get these insights into the money supply, and why a little inflation might still be a bad thing, and find this conclusion:

... to Mises even a monetary policy that would pursue a pre-determined rate of money supply expansion (as proposed for example by Milton Friedman's k-percent rule) for stabilizing a broadly defined price index would remain a potential source of crisis which, in turn, bears the risk of undermining the value of the currency. This explains why Mises, in an effort to reduce that very risk to the ideal of a free society, argued for stopping the expansion of the money supply, thereby arguing for a concept quite different from today's state-of-the-art monetary policy.

With a fixed quantity of money maybe we could end up with less volatile swings in the value of the currency because behaviour would not be influenced by expectations of monetary policy changes. The expectation of a standing by the fixed money supply would lead less uncertainty, less hoarding, and potentially far more confidence in the currency.

However, we are still left with detailed questions about how debt or could work in this environment, whether people can perceive negative nominal gains as positive real gains (maybe there is a behavioural bias), and whether such a system provides a strong incentive for innovation and capital expansion.