The Cantillon effect refers to the idea that changes in the money supply in an economy cause a redistribution of purchasing power between people, disturb the relative prices of goods and services, and lead to the misallocation of scarce resources. . The Cantillon effect is named after the 18th century French economist Richard Cantillon who published his ideas in the 1755 book Essay on the nature of commerce in general.
An unequal distribution
It is generally accepted by economists today that an increase in the overall money supply in an economy leads to a proportional increase in the prices of goods and services over the long term. This is in line with the quantity theory of money, according to which the total quantity of money in an economy plays a crucial role in determining the general price level. Thus, if the money supply in an economy doubles, this should cause the prices in the whole economy to approximately double. In other words, the currency has been widely regarded as “neutral”, in the sense that changes in its supply have no real effect on the economy.
Cantillon, however, noted that when the money supply is increased, new money is not distributed evenly throughout the economy all at once, as most economists assume. Rather, new money is injected first into particular sections of the economy and thus people in those sections of the economy are enriched relative to people in the rest of the economy. In other words, when the money supply is expanded, the purchasing power of the people who first receive the freshly created money is increased at the expense of the rest of society. When the first beneficiaries of the newly created money spend their money on certain goods and services, the prices of these goods and services begin to rise before the prices of other goods and services. Indeed, the newly created currency takes time to infiltrate the whole economy and to proportionally increase the prices of all goods and services. Thus, there is a disturbance in the relative prices of goods as new money is injected into the economy and, contrary to what economists have traditionally assumed, this can lead to real effects on the economy.
The impact of relative prices
It should be noted that relative prices play a crucial role in the allocation of scarce resources in an economy. Prices act as important signals for entrepreneurs in allocating scarce resources to various ends of society and changes in relative prices can therefore affect how scarce resources are allocated. Changes in the money supply can also lead to the misallocation of savings in the credit market, as investors may allocate savings based on relative price signals that are outdated and erroneous.
The Cantillon effect has been widely cited by economists who criticize the central bank’s expansionary policy to deal with economic downturns. Mainstream economists believe that recessions are the result of lower aggregate spending, which can be addressed by expansionary monetary policy that offsets lower aggregate demand. Critics, however, argue that when a central bank increases the money supply, it can have real effects on the economy. Meanwhile, some scholars note that Cantillon was not referring solely to the expansion of the money supply by central banks when writing about the actual effects of changes in the money supply. They point out that changes in the money supply, even under the gold standard, during a gold rush for example when the money supply in the form of gold increases, can have real effects on the economy. Nonetheless, Cantillon’s contributions to monetary theory have encouraged economists to see that changes in the money supply, even by central banks, can have real effects on the economy.