In a standard free-banking model an increase in the demand for money will show up to banks as an increased willingness to hold their notes and increased balances held in accounts. This will give the banks extra reserves that can then choose to lend out. Other things being equal they will increase lending by lowering interest rates. In this way , by acting to maximize profits, they will tend to stabilize AD and allow the economy to avoid having to deal with a situation of monetary disequilibrium. Market Monetarists who favor free banking emphasize that this process is similar to the actions of the CB in an NGDP-targeting regime who will expand the money supply and reduce interest rates when the economy shows signs of falling short of its NGDP trend.
However I think there are significant differences that I will now take a closer look at.
For a Free Bank to extend a new loan it needs to find a potential customer who it thinks is a good risk at the rate of interest the market allows.
First of all lets look at the demand for loans. Other things being equal a lower interest rate should increase demand both for business and consumer loans. However in a time of increased demand for money other things may not be equal. Demand for consumer loans may fall off sharply. The demand for business loans will depend upon entrepreneurs perception of there being profitable business opportunities available. In a time of high demand for money entrepreneurs may perceive that there is additional risk. They will demand bigger profit spreads before they will embark on new borrowing and this will drive down the interest rate they are prepared to pay. We may have a scenario where banks need to lower interest rates to clear excess reserves coinciding with a time when demand for business and consumer loans is also low.
At low interest-rates banks will not consider it worth the risk to lend and they will instead choose to sit on unused reserves. We have hit the zero-bound. It is possible that they may also buy other assets such as bonds but it is likely that here too rates will be driven too low for the banks to continue with this purchase strategy .
At this point (the zero bound) there is a fundamental difference between what needs to happen under a free banking regime and what would happen under NGDP-targeting.
Under Free Banking: AD has fallen from its previous levels. Entrepreneurs, facing falling demand for their product, need to develop strategies to address this by cutting costs and finding ways to keep their customers. Workers , faced with falling demand for labor, need to recognize the need to cut wages in response. This will increase profit margins and allow the demand for labor (and the demand for loans) to increase. The economy can move back to health.
Under NGDP-targeting: NGDP has fallen away from its target and the money supply needs to be increased further. Conventional means have been exhausted as interest rates have approached zero. Unconventional means needs to be adopted of purchasing other assets , and relentlessly continuing to do so , until spending increases sufficiently to get NGDP back on target. Partially this will move demand for goods up the demand curve and thereby stimulate greater supply. However to a large part his will also be achieved by creating inflation that will deter individuals from holding the money balances that have indicated they desire to hold and by turning low nominal interest rates into negative real rates in order to force investment.
In my view this policy is dangerous. Inflation is a bad way to stimulate output as it distorts market pricing signals and creates additional business costs. Once the expectations of further inflation has been created it can be hard to eliminate without a forced recession, especially if the increase in the money supply has created large quantities of cash held in reserve.