By Mark Thornton
Cantillon effects are named for their discoverer, Richard Cantillon, who is widely credited as the first economic theorist, and in particular, was the first to show that changes in the money supply and credit have important impacts on the economy by changing relative prices. Cantillon showed that an increase in the supply of money would cause economic expansion, but that ultimately the process would be self-reversing as prices would rise and imports would increase, sending money back out of the economy. Cantillon further showed that monetary inflation does not affect all prices equally or at the same time, but in sequences that depend on the spending behavior of money holders all along the channels of monetary flows. These ideas have been adopted and extended by Knut Wicksell, Ludwig von Mises, and F.A. Hayek and more recently by McCulloch (1981) and Garrison (2001).
Cantillon effects are the real fundamental changes in resource allocation that result from changing relative prices between the time of the creation of new money and the full adjustment to the increase in supply. For Cantillon, an increase in commodity money, such as silver, would increase employment and prices. It would impose "forced savings" and lower real incomes on those whose income was not changed due to monetary inflation, possibly leading to unemployment or emigration. If the money supply increased due to a balance-of-payments surplus, then the additional money could cause an increase in manufacturing or expansion in whatever the new money holders chose to spend their money on.
Most importantly, changes in the supply of money can have effects on the interest rate and once again the effect will depend on how the money enters the economy. On the one hand, if it comes into the hands of traditional borrowers or lenders, such as developers, the rate of interest would initially fall. This is similar to the Austrian theory of the business cycle in that when banks expand the money supply and lower the interest rate below what it would have been, borrowers invest in longer-term capital projects. On the other hand, if the money came into the hands of consumers, the rate of interest might rise as suppliers attempt to meet the new demand for goods. In the Austrian view, changes in the interest rate change the relative price between longer-term capital projects and shorter-term capital projects. A lowering of the interest rate raises the prices of longer-term capital goods relative to shorter-term capital goods.
In response to the change in relative prices, more resources are allocated to long-term capital goods. Unlike other aspects of the self-adjusting market process, such as money, land, labor, and short-term or intermediate capital goods, these resources become suspended or fixed in long-term fixed capital goods. These resources become formulated in a highly specific capital good that may not be well suited to the alternative production processes of the postadjustment economy. As a result, all of the adjustment in these long-term fixed capital goods must come from a change in price and this will entail large losses and possible bankruptcies by the owners of these capital goods. To the extent that these types of adjustments are widespread, they pose a threat to capital markets and the banking system.
The above originally appeared at Mises.org.