Cantillon Effect: How the Concept Describes the Money Supply

The Cantillon effect explains the relationship between the general money supply and the prices of goods.

According to the Cantillon effect, when new money circulates into the economy, asset prices increase at varying rates. As new money initially enters the economy through central banks, private equity firms, and government institutions, these organizations have a greater purchasing power over the general public. Thus, the Cantillon effect describes the disproportionate outcome money injection has on different stakeholders.

The Cantillon effect explains the impact of inflation on financial markets and business cycles. Individuals and organizations who receive the new money first have the opportunity to purchase goods and services at pre-inflation prices. Once the new money supply flows down to the general public, price levels increase and everyday citizens must buy goods at higher prices.

Economists view the Cantillon effect as a way for policymakers to impose a regressive tax without creating new legislation; however, since a money injection often magnifies the disparities between big businesses and wage earners, the main beneficiaries are banks and government institutions. As a result, the Cantillon effect demonstrates how the supply of money is not neutral.

Here are examples of how the Cantillon effect impacts everyday life:

1. 1. Cost of living: The Cantillon effect has a significant impact on the cost of living. When the amount of money in the economy increases, good prices rise to reflect inflation. This creates a higher cost of living even as most salaries remain the same.
2. 2. Gold: In his original essay, An Essay on Economic Theory, economist Richard Cantillon uses gold as an example to describe his theory. If a nation discovers a new gold mine in its territory, the price of gold is not the only factor that changes. Cantillon believed the people who find the gold will spend their new money on luxuries, driving up prices for the general public. Until the new money circulates, the general population pays higher prices without having the same money access as the gold miners.
3. 3. Stock market: Private equity firms and investors can purchase shares of a stock at pre-inflation prices to then sell the same shares at inflated prices. This form of trading occurs due to the way money first enters capital markets.
   

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