Money and More Money

I've been thinking about a conceptual approach for explaining (to myself) how a money supply can be increased to avoid deflation. I understand fractional-reserve lending, and I've visited Wikipedia, economics.about.com and other sites trying to figure out the answer to this problem.

Here's the scenario--I'll use science fiction just to keep it as a thought experiment and hopefully reduce the emotional involvement.

Suppose we have an isolated colony, far from Earth. By "far," I mean light-years, well beyond any ability to communicate real-time. Pick your reason for why it's isolated; any of a dozen books will do. This group understands the basics of market economics, and knows that money is much more efficient than a barter system--it avoids the need to find someone who has what I want and wants to trade for what I have. How would an isolated colony create more currency in order to support a growing economy and get it into the economy? Sure, they can print it or mint it--but how does it get into circulation?

The classic answer, with a central banking system, is that reserve banks obtain currency from the government by posting it against their own accounts--but that doesn't actually increase the money supply. The money supply does increase when that money is loaned, over and over. All well and good. But, what if there just aren't physically enough dollars to chase the available goods and services?

After I posted this question originally, I spent a lot of time researching, both on the web and reading economics books. I was, frankly, surprised at how poorly understood this issue was. That matters, because it also hits upon the real problem behind government borrowing affecting the money supply.

The answer, briefly, is that they would need a central bank, like the US Federal Reserve, and the reserve bank would, per the classic answer, obtain currency by posting it against their own accounts. But, its account has no limit, so it can obtain whatever amount it desires. How does it get that currency into circulation? By buying debt instruments. When the government borrows, it sells Treasury securities, which the central bank can buy. But, if there were no Treasury securities, the reserve bank would still be able to buy anything necessary to inject the currency--it could buy stock in the colony, using our current example. It could buy mortgages from the colony's commercial banks. It could simply "buy" parcels of unused land, for whatever amount seemed reasonable.

If that doesn't surprise you, you either really understand the system, or you don't understand it at all. My sense is that this is part of the disquiet people express when they argue in favor of the gold standard--you can physically control the amount of currency in that type of system, and you can physically go get more when you need it (i.e. when it makes economic sense to go mine it). When a government using a gold standard "buys" gold, it is purchasing a limited resource to get currency into the system, and the limitated nature ensures the central bank doesn't go crazy issuing money. But, in our colony, it would have to be very careful not to just buy whatever it wanted.

If it worked, that would be a very disciplined system.