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Advancing Austrian Economics, Liberty, and Peace

Advancing the scholarship of liberty in the tradition of the Austrian School

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1. Introduction

Money has entered into almost all our discussion so far. In chapter 3 we saw how the economy evolved from barter to indirect exchange. We saw the patterns of indirect exchange and the types of allocations of income and expenditure that are made in a monetary economy. In chapter 4 we discussed money prices and their formation, analyzed the marginal utility of money, and demonstrated how monetary theory can be subsumed under utility theory by means of the money regression theorem. In chapter 6 we saw how monetary calculation in markets is essential to a complex, developed economy, and we analyzed the structure of post-income and pre-income demands for and supplies of money on the time market. And from chapter 2 on, all our discussion has dealt with a monetary-exchange economy.

     The time has come to draw the threads of our analysis of the market together by completing our study of money and of the effects of changes in monetary relations on the economic system. In this chapter we shall continue to conduct the analysis within the framework of the free-market economy.

2. The Money Relation: The Demand for and the Supply of Money

     Money is a commodity that serves as a general medium of exchange; its exchanges therefore permeate the economic system. Like all commodities, it has a market demand and a market sup­ply, although its special situation lends it many unique features. We saw in chapter 4 that its “price” has no unique expression on the market. Other commodities are all expressible in terms of units of money and therefore have uniquely identifiable prices. The money commodity, however, can be expressed only by an array of all the other commodities, i.e., all the goods and services that money can buy on the market. This array has no uniquely expressible unit, and, as we shall see, changes in the array cannot be measured. Yet the concept of the “price” or the “value” of money, or the “purchasing power of the monetary unit,” is no less real and important for all that. It simply must be borne in mind that, as we saw in chapter 4, there is no single “price level” or measurable unit by which the value-array of money can be ex­pressed. This exchange-value of money also takes on peculiar im­portance because, unlike other commodities, the prime purpose of the money commodity is to be exchanged, now or in the future, for directly consumable or productive commodities.

     The total demand for money on the market consists of two parts: the exchange demand for money (by sellers of all other goods that wish to purchase money) and the reservation demand for money (the demand for money to hold by those who already hold it). Because money is a commodity that permeates the mar­ket and is continually being supplied and demanded by everyone, and because the proportion which the existing stock of money bears to new production is high, it will be convenient to analyze the supply of and the demand for money in terms of the total de­mand-stock analysis set forth in chapter 2.[1]

     In contrast to other commodities, everyone on the market has both an exchange demand and a reservation demand for money. The exchange demand is his pre-income demand (see chapter 6, above). As a seller of labor, land, capital goods, or consumers’ goods, he must supply these goods and demand money in exchange to obtain a money income. Aside from speculative considerations, the seller of ready-made goods will tend, as we have seen, to have a perfectly inelastic (vertical) supply curve, since he has no reservation uses for the good. But the supply curve of a good for money is equivalent to a (partial) demand curve for money in terms of the good to be supplied. Therefore, the (exchange) demand curves for money in terms of land, capi­tal goods, and consumers’ goods will tend to be perfectly inelas­tic.

     For labor services, the situation is more complicated. Labor, as we have seen, does have a reserved use—satisfying leisure. We have seen that the general supply curve of a labor factor can be either “forward-sloping” or “backward-sloping,” depending upon the individuals’ marginal utility of money and marginal disutil­ity of leisure forgone. In determining labor’s demand curve for money, however, we can be far more certain. To understand why, let us take a hypothetical example of a supply curve of a labor factor (in general use). At a wage rate of five gold grains an hour, 40 hours per week of labor service will be sold. Now sup­pose that the wage rate is raised to eight gold grains an hour. Some people might work a greater number of hours because they have a greater monetary inducement to sacrifice leisure for labor. They might work 50 hours per week. Others may decide that the increased income permits them to sacrifice some money and take some of the increased earnings in greater leisure. They might work 30 hours. The first would represent a “forward-sloping,” the latter a “backward-sloping,” supply curve of labor in this price range. But both would have one thing in common. Let us multi­ply hours by wage rate in each case, to arrive at the total money income of the laborers in the various situations. In the original case, a laborer earned 40 times 5 or 200 gold grains per week. The man with a backward-sloping supply curve will earn 30 times 8 or 240 gold grains a week. The one with a forward-slop­ing supply curve will earn 50 times 8 or 400 gold grains per week. In both cases, the man earns more money at the higher wage rate.

     This will always be true. In the first case, it is obvious, for the higher wage rate induces the man to sell more labor. But it is true in the latter case as well. For the higher money income per­mits a man to gratify his desires for more leisure as well, pre­cisely because he is getting an increased money income. There­fore, a man’s backward-sloping supply curve will never be “back­ward” enough to make him earn less money at higher wage rates.

     Thus, a man will always earn more money at a higher wage rate, less money at a lower. But what is earning money but an­other name for buying money? And that is precisely what is done. People buy money by selling goods and services that they possess or can create. We are now attempting to arrive at the demand schedule for money in relation to various alternative purchasing powers or “exchange-values” of money. A lower exchange-value of money is equivalent to higher goods-prices in terms of money. Conversely, a higher exchange-value of money is equivalent to lower prices of goods. In the labor market, a higher exchange­-value of money is translated into lower wage rates, and a lower exchange-value of money into higher wage rates.

     Hence, on the labor market, our law may be translated into the following terms: The higher the exchange-value of money, the lower the quantity of money demanded; the lower the ex­change-value of money, the higher the quantity of money de­manded (i.e., the lower the wage rate, the less money earned; the higher the wage rate, the more money earned). Therefore, on the labor market, the demand-for-money schedule is not verti­cal, but falling, when the exchange-value of money increases, as in the case of any demand curve.

     Adding the vertical demand curves for money in the other exchange markets to the falling demand curve in the labor mar­ket, we arrive at a falling exchange-demand curve for money.

     More important, because more volatile, in the total demand for money on the market is the reservation demand to hold money. This is everyone’s post-income demand. After everyone has ac­quired his income, he must decide, as we have seen, between the allocation of his money assets in three directions: consumption spending, investment spending, and addition to his cash balance (“net hoarding”). Furthermore, he has the additional choice of subtraction from his cash balance (“net dishoarding”). How much he decides to retain in his cash balance is uniquely determined by the marginal utility of money in his cash balance on his value scale. Until now we have discussed at length the sources of the utilities and demands for consumers’ goods and for producers’ goods. We have now to look at the remaining good: money in the cash balance, its utility and demand.

     Before discussing the sources of the demand for a cash balance, however, we may determine the shape of the reservation (or “cash balance”) demand curve for money. Let us suppose that a man’s marginal utilities are such that he wishes to have 10 ounces of money held in his cash balance over a certain period. Suppose now that the exchange-value of money, i.e., the pur­chasing power of a monetary unit, increases, other things being equal. This means that his 10 gold ounces accomplish more work than they did before the change in the PPM (purchasing power of the monetary unit). As a consequence, he will tend to remove part of the 10 ounces from his cash balance and spend it on goods, the prices of which have now fallen. Therefore, the higher the PPM (the exchange-value of money), the lower the quantity of money demanded in the cash balance. Conversely, a lower PPM will mean that the previous cash balance is worth less in real terms than it was before, while the higher prices of goods discourage their purchase. As a result, the lower the PPM, the higher the quantity of money demanded in the cash balance.

     As a result, the reservation demand curve for money in the cash balance falls as the exchange-value of money increases. This falling demand curve, added to the falling exchange-demand curve for money, yields the market’s total demand curve for money—also falling in the familiar fashion for every commodity.

     There is a third demand curve for the money commodity that deserves mention. This is the demand for nonmonetary uses of the monetary metal. This will be relatively unimportant in the advanced monetary economy, but it will exist nevertheless. In the case of gold, this will mean either uses in consumption, as for ornaments, or productive uses, as for industrial purposes. At any rate, this demand curve also falls as the PPM increases. As the “price” of money (PPM) increases, more goods can be ob­tained through expenditure of a unit of money; as a result, the opportunity-cost in using gold for nonmonetary purposes increases, and less is demanded for that purpose. Conversely, as the PPM falls, there is more incentive to use gold for its direct use. This demand curve is added to the total demand curve for money, to obtain the total demand curve for the money commodity.[2]

     At any one time there is a given total stock of the money com­modity. This stock will, at any time, be owned by someone. It is therefore dangerously misleading to adopt the custom of Amer­ican economists since Irving Fisher’s day of treating money as somehow “circulating,” or worse still, as divided into “circulat­ing money” and “idle money.”[3] This concept conjures up the image of the former as moving somewhere at all times, while the latter sits idly in “hoards.” This is a grave error. There is, actually, no such thing as “circulation,” and there is no mysterious arena where money “moves.” At any one time all the money is owned by someone, i.e., rests in someone’s cash balance. Whatever the stock of money, therefore, people’s actions must bring it into accord with the total demand for money to hold, i.e., the total demand for money that we have just discussed. For even pre­-income money acquired in exchange must be held at least momentarily in one’s cash balance before being transferred to some­one else’s balance. All total demand is therefore to hold, and this is in accord with our analysis of total demand in chapter 2.

     Total stock must therefore be brought into agreement, on the market, with the total quantity of money demanded. The diagram of this situation is shown in Figure 74.

     On the vertical axis is the PPM, increasing upward. On the horizontal axis is the quantity of money, increasing rightwards. De is the aggregate exchange-demand curve for money, falling and inelastic. Dr is the reservation or cash-balance demand for money. Dt is the total demand for money to hold (the demand for nonmonetary gold being omitted for purposes of convenience). Somewhere intersecting the Dt curve is the SS vertical line—the total stock of money in the community—given at quantity 0S.

     The intersection of the latter two curves determines the equi­librium point, A, for the exchange-value of money in the com­munity. The exchange-value, or PPM, will be set at 0B.

     Suppose now that the PPM is slightly higher than 0B. The demand for money at that point will be less than the stock. People will become unwilling to hold money at that exchange-value and will be anxious to sell it for other goods. These sales will raise the prices of goods and lower the PPM, until the equilibrium point is reached. On the other hand, suppose that the PPM is lower than 0B. In that case, more people will demand money, in exchange or in reservation, than there is money stock available. The consequent excess of demand over supply will raise the PPM again to 0B.

3. Changes in the Money Relation

     The purchasing power of money is therefore determined by two factors: the total demand schedule for money to hold and the stock of money in existence. It is easy to see on a diagram what happens when either of these determining elements changes. Thus, suppose that the schedule of total demand increases (shifts to the right). Then (see Figure 75) the total-demand-for-money curve has shifted from DtDt to Dt'Dt'. At the previous equilibrium PPM point, A, the demand for money now exceeds the stock available by AE. The bids push the PPM upwards until it reaches the equilibrium point C. The con­verse will be true for a shift of the total demand curve left­ward—a decline in the total demand schedule. Then, the PPM will fall accordingly.

     The effect of a change in the total stock, the demand curve remaining constant, is shown in Figure 76. Total quantity of stock increases from 0S to 0S'. At the new stock level there is an excess of stock, AF, over the total demand for money. Money will be sold at a lower PPM to induce people to hold it, and the PPM will fall until it reaches a new equilibrium point G. Conversely, if the stock of money is de­creased, there will be an excess of demand for money at the exist­ing PPM, and the PPM will rise until the new equilibrium point is reached.

     The effect of the quantity of money on its exchange-value is thus simply set forth in our analysis and diagrams.

     The absurdity of classifying monetary theories into mutually exclusive divisions (such as “supply and demand theory,” “quan­tity theory,” “cash balance theory,” “commodity theory,” “income and expenditure theory”) should now be evident.[4] For all these elements are found in this analysis. Money is a commodity; its supply or quantity is important in determining its exchange­-value; demand for money for the cash balance is also important for this purpose; and the analysis can be applied to income and expenditure situations.

4. Utility of the Stock of Money

     In the case of consumers’ goods, we do not go behind their subjective utilities on people’s value scales to investigate why they were preferred; economics must stop once the ranking has been made. In the case of money, however, we are confronted with a different problem. For the utility of money (setting aside the nonmonetary use of the money commodity) depends solely on its prospective use as the general medium of exchange. Hence the subjective utility of money is dependent on the objective exchange-value of money, and we must pursue our analysis of the demand for money further than would otherwise be required.[5] The diagrams above in which we connected the demand for money and its PPM are therefore particularly appropriate. For other goods, demand in the market is a means of routing com­modities into the hands of their consumers. For money, on the other hand, the “price” of money is precisely the variable on which the demand schedule depends and to which almost the whole of the demand for money is keyed. To put it in another way: without a price, or an objective exchange-value, any other good would be snapped up as a welcome free gift; but money, without a price, would not be used at all, since its entire use consists in its command of other goods on the market. The sole use of money is to be exchanged for goods, and if it had no price and therefore no exchange-value, it could not be exchanged and would no longer be used.

     We are now on the threshold of a great economic law, a truth that can hardly be overemphasized, considering the harm its neglect has caused throughout history. An increase in the supply of a producers’ good increases, ceteris paribus, the supply of a consumers’ good. An increase in the supply of a consumers’ good (when there has been no decrease in the supply of another good) is demonstrably a clear social benefit; for someone’s “real income” has increased and no one’s has decreased.[6]

     Money, on the contrary, is solely useful for exchange purposes. Money, per se, cannot be consumed and cannot be used directly as a producers’ good in the productive process. Money per se is therefore unproductive; it is dead stock and produces nothing. Land or capital is always in the form of some specific good, some specific productive instrument. Money always remains in some­one’s cash balance.

     Goods are useful and scarce, and any increment in goods is a social benefit. But money is useful not directly, but only in exchanges. And we have just seen that as the stock of money in society changes, the objective exchange-value of money changes inversely (though not necessarily proportionally) until the money relation is again in equilibrium. When there is less money, the exchange-value of the monetary unit rises; when there is more money, the exchange-value of the monetary unit falls. We con­clude that there is no such thing as “too little” or “too much” money, that, whatever the social money stock, the benefits of money are always utilized to the maximum extent. An increase in the supply of money confers no social benefit whatever; it simply benefits some at the expense of others, as will be detailed further below. Similarly, a decrease in the money stock involves no social loss. For money is used only for its purchasing power in exchange, and an increase in the money stock simply dilutes the purchasing power of each monetary unit. Conversely, a fall in the money stock increases the purchasing power of each unit.

     David Hume’s famous example provides a highly oversimpli­fied view of the effect of changes in the stock of money, but in the present context it is a valid illustration of the absurdity of the belief that an increased money supply can confer a social benefit or relieve any economic scarcity. Consider the magical situation where every man awakens one morning to find that his monetary assets have doubled. Has the wealth, or the real income, of society doubled? Certainly not. In fact, the real in­come—the actual goods and services supplied—remains unchanged. What has changed is simply the monetary unit, which has been diluted, and the purchasing power of the monetary unit will fall enough (i.e., prices of goods will rise) to bring the new money relation into equilibrium.

     One of the most important economic laws, therefore, is: Every supply of money is always utilized to its maximum extent, and hence no social utility can be conferred by increasing the supply of money.

     Some writers have inferred from this law that any factors devoted to gold mining are being used unproductively, because an increased supply of money does not confer a social benefit. They deduce from this that the government should restrict the amount of gold mining. These critics fail to realize, however, that gold, the money-commodity, is used not only as money but also for nonmonetary purposes, either in consumption or in production. Hence, an increase in the supply of gold, although conferring no monetary benefit, does confer a social benefit by increasing the supply of gold for direct use.

5. The Demand for Money

A. Money in the ERE and in the Market

     It is true, as we have said, that the only use for money is in exchange. From this, however, it must not be inferred, as some writers have done, that this exchange must be immediate. Indeed, the reason that a reservation demand for money exists and cash balances are kept is that the individual is keeping his money in reserve for future exchanges. That is the function of a cash bal­ance—to wait for a propitious time to make an exchange.

     Suppose the ERE has been established. In such a world of certainty, there would be no risk of loss in investment and no need to keep cash balances on hand in case an emergency for consumer spending should arise. Everyone would therefore al­locate his money stock fully, to the purchase of either present goods or future goods, in accordance with his time preferences. No one would keep his money idle in a cash balance. Knowing that he will want to spend a certain amount of money on con­sumption in six months’ time, a man will lend his money out for that period to be returned at precisely the time it is to be spent. But if no one is willing to keep a cash balance longer than instantaneously, there will be no money held and no use for a money stock. Money, in short, would either be useless or very nearly so in the world of certainty.

     In the real world of uncertainty, as contrasted to the ERE, even “idle” money kept in a cash balance performs a use for its owner. Indeed, if it did not perform such a use, it would not be kept in his cash balance. Its uses are based precisely on the fact that the individual is not certain on what he will spend his money or of the precise time that he will spend it in the future.

     Economists have attempted mechanically to reduce the demand for money to various sources.[7] There is no such mechanical de­termination, however. Each individual decides for himself by his own standards his whole demand for cash balances, and we can only trace various influences which different catallactic events may have had on demand.

B. Speculative Demand

     One of the most obvious influences on the demand for money is expectation of future changes in the exchange-value of money. Thus, suppose that, at a certain point in the future, the PPM of money is expected to drop rapidly. How the demand-for-money schedule now reacts depends on the number of people who hold this expectation and the strength with which they hold it. It also depends on the distance in the future at which the change is expected to take place. The further away in time any economic event, the more its impact will be discounted in the present by the interest rate. Whatever the degree of impact, however, an expected future fall in the PPM will tend to lower the PPM now. For an expected fall in the PPM means that present units of money are worth more than they will be in the future, in which case there will be a fall in the demand-for-money schedule as people tend to spend more money now than at the future date. A general expectation of an imminent fall in the PPM will lower the demand schedule for money now and thus tend to bring about the fall at the present moment.

     Conversely, an expectation of a rise in the PPM in the near future will tend to raise the demand-for-money schedule as people decide to “hoard” (add money to their cash balance) in expec­tation of a future rise in the exchange-value of a unit of their money. The result will be a present rise in the PPM.

      An expected fall in the PPM in the future will therefore lower the PPM now, and an expected rise will lead to a rise now. The speculative demand for money functions in the same manner as the speculative demand for any good. An anticipation of a future point speeds the adjustment of the economy toward that future point. Just as the speculative demand for a good speeded adjustment to an equilibrium position, so the anticipation of a change in the PPM speeds the market adjustment toward that position. Just as in the case of any good, furthermore, errors in this speculative anticipation are “self-correcting.” Many writers believe that in the case of money there is no such self-correction. They assert that while there may be a “real” or underlying de­mand for goods, money is not consumed and therefore has no such underlying demand. The PPM and the demand for money, they declare, can be explained only as a perpetual and rather meaning­less cat-and-mouse race in which everyone is simply trying to anticipate everyone else’s anticipations.

     There is, however, a “real” or underlying demand for money. Money may not be physically consumed, but it is used, and there­fore it has utility in a cash balance. Such utility amounts to more than speculation on a rise in the PPM. This is demonstrated by the fact that people do hold cash even when they anticipate a fall in the PPM. Such holdings may be reduced, but they still exist, and as we have seen, this must be so in an uncertain world. In fact, without willingness to hold cash, there could be no mon­etary-exchange economy whatever.

     The speculative demand therefore anticipates the underlying nonspeculative demands, whatever their source or inspiration. Suppose, then, that there is a general anticipation of a rise in the PPM (a fall in prices) not reflected in underlying supply and demand. It is true that, at first, this general anticipation raises, ceteris paribus, the demand for money and the PPM. But this situation does not last. For now that a pseudo “equilibrium” has been reached, the speculative anticipators, who did not “really” have an increased demand for money, sell their money (buy goods) to reap their gains. But this means that the underlying demand comes to the fore, and this is less than the money stock at that PPM. The pressure of spending then lowers the PPM again to the true equilibrium point. This may be diagramed as in Figure 77.

     Money stock is 0S; the true or underlying money demand is DD, with true equilibrium point at A. Now suppose that the people on the market erroneously anticipate that true demand will be such in the near future that the PPM will be raised to 0E. The total demand curve for money then shifts to DsDs, the new total demand curve including the speculative demand. The PPM does shift to 0E as predicted. But now the speculators move to cash in their gain, since their true demand for money really reflects DD rather than DsDs. At the new price 0E, there is in fact an excess of money stock over quantity demanded, amount­ing to CF. Sellers rush to sell their stock of money and buy goods, and the PPM falls again to equilibrium. Hence, in the field of money as well as in that of specific goods, speculative anticipa­tions are self-correcting, not “self-fulfilling.” They speed the mar­ket process of adjustment.

C. Secular Influences on the Demand for Money

     Long-run influences on the demand for money in a progressing economy will tend to be manifold, and in both directions. On the one hand, an advancing economy provides ever more occasions for new exchanges as more and more commodities are offered on the market and as the number of stages of production increases. These greater opportunities tend greatly to increase the demand-for-money schedule. If an economy deteriorates, fewer opportunities for exchange exist, and the demand for money from this source will fall.

     The major long-run factor counteracting this tendency and tending toward a fall in the demand for money is the growth of the clearing system.[8] Clearing is a device by which money is economized and performs the function of a medium of exchange without being physically present in the exchange.

     A simplified form of clearing may occur between two people. For example, A may buy a watch from B for three gold ounces; at the same time, B buys a pair of shoes from A for one gold ounce. Instead of two transfers of money being made, and a total of four gold ounces changing hands, they decide to perform a clearing operation. A pays B two ounces of money, and they exchange the watch and the shoes. Thus, when a clearing is made, and only the net amount of money is actually transferred, all parties can engage in the same transactions at the same prices, but using far less cash. Their demand for cash tends to fall.

     There is obviously little scope for clearing, however, as long as all transactions are cash transactions. For then people have to exchange one another’s goods at the same time. But the scope for clearing is vastly increased when credit transactions come into play. These credits may be quite short-term. Thus, suppose that A and B deal with each other quite frequently during a year or a month. Suppose they agree not to pay each other immediately in cash, but to give each other credit until the end of each month. Then B may buy shoes from A on one day, and A may buy a watch from B on another. At the end of the period, the debts are canceled and cleared, and the net debtor pays one lump sum to the net creditor.

     Once credit enters the picture, the clearing system can be ex­tended to as many individuals as find it convenient. The more people engage in clearing operations (often in places called “clear­inghouses”) the more cancellations there will be, and the more money will be economized. At the end of the week, for example, there may be five people engaged in clearing, and A may owe B ten ounces, B owe C ten ounces, C owe D, etc., and finally E may owe A ten ounces. In such a case, 50 ounces’ worth of debt trans­actions and potential cash transactions are settled without a single ounce of cash being used.

     Clearing, then, is a process of reciprocal cancellations of money debts. It permits a huge quantity of monetary exchanges without actual possession and transfer of money, thereby greatly reducing the demand for money. Clearing, however, cannot be all-encom­passing, for there must be some physical money which could be used to settle the transaction, and there must be physical money to settle when there is no 100-percent cancellation (which rarely occurs).

D. Demand for Money Unlimited?

     A popular fallacy rejects the concept of “demand for money” because it is allegedly always unlimited. This idea misconceives the very nature of demand and confuses money with wealth or income. It is based on the notion that “people want as much money as they can get.” In the first place, this is true for all goods. People would like to have far more goods than they can procure now. But demand on the market does not refer to all possible entries on people’s value scales; it refers to effective demand, to desires made effective by being “demanded,” i.e., by the fact that something else is “supplied” for it. Or else it is reservation de­mand, which takes the form of holding back the good from being sold. Clearly, effective demand for money is not and cannot be unlimited; it is limited by the appraised value of the goods a per­son can sell in exchange and by the amount of that money which the individual wants to spend on goods rather than keep in his cash balance.

     Furthermore, it is, of course, not “money” per se that he wants and demands, but money for its purchasing power, or “real” money, money in some way expressed in terms of what it will purchase. (This purchasing power of money, as we shall see below, cannot be measured.) More money does him no good if its pur­chasing power for goods is correspondingly diluted.

E. The PPM and the Rate of Interest

     We have been discussing money, and shall continue to do so in the current section, by comparing equilibrium positions, and not yet by tracing step by step how the change from one posi­tion to another comes about. We shall soon see that in the case of the price of money, as contrasted with all other prices, the very path toward equilibrium necessarily introduces changes that will change the equilibrium point. This will have important the­oretical consequences. We may still talk, however, as if money is “neutral,” i.e., does not lead to such changes, because this as­sumption is perfectly competent to deal with the problems ana­lyzed so far. This is true, in essence, because we are able to use a general concept of the “purchasing power of money” without trying to define it concretely in terms of specific arrays of goods. Since the concept of the PPM is relevant and important even though its specific content changes and cannot be measured, we are justified in assuming that money is neutral as long as we do not need a more precise concept of the PPM.

     We have seen how changes in the money relation change the PPM. In the determination of the interest rate, we must now modify our earlier discussion in chapter 6 to take account of al­locating one’s money stock by adding to or subtracting from one’s cash balance. A man may allocate his money to consumption, in­vestment, or addition to his cash balance. His time preferences govern the proportion which an individual devotes to present and to future goods, i.e., to consumption and to investment. Now suppose a man’s demand-for-money schedule increases, and he therefore decides to allocate a proportion of his money income to increasing his cash balance. There is no reason to suppose that this increase affects the consumption/investment proportion at all. It could, but if so, it would mean a change in his time pref­erence schedule as well as in his demand for money.

     If the demand for money increases, there is no reason why a change in the demand for money should affect the interest rate one iota. There is no necessity at all for an increase in the de­mand for money to raise the interest rate, or a decline to lower it—no more than the opposite. In fact, there is no causal connec­tion between the two; one is determined by the valuations for money, and the other by valuations for time preference.

     Let us return to the section in chapter 6 on Time Preference and the Individual’s Money Stock. Did we not see there that an increase in an individual’s money stock lowers the effective time-preference rate along the time-preference schedule, and conversely that a decrease raises the time-preference rate? Why does this not apply here? Simply because we were dealing with each individ­ual’s money stock and assuming that the “real” exchange-value of each unit of money remained the same. His time-preference schedule relates to “real” monetary units, not simply to money itself. If the social stock of money changes or if the demand for money changes, the objective exchange-value of a monetary unit (the PPM) will change also. If the PPM falls, then more money in the hands of an individual may not necessarily lower the time-preference rate on his schedule, for the more money may only just compensate him for the fall in the PPM, and his “real money stock” may therefore be the same as before. This again demon­strates that the money relation is neutral to time preference and the pure rate of interest.

     An increased demand for money, then, tends to lower prices all around without changing time preference or the pure rate of interest Thus, suppose total social income is 100, with 70 al­located to investment and 30 to consumption. The demand for money increases, so that people decide to hoard a total of 20. Expenditure will now be 80 instead of 100, 20 being added to cash balances. Income in the next period will be only 80, since expenditures in one period result in the identical income to be allocated to the next period.[9] If time preferences remain the same, then the proportion of investment to consumption in the society will remain roughly the same, i.e., 56 invested and 24 consumed. Prices and nominal money values and incomes fall all along the line, and we are left with the same capital structure, the same real income, the same interest rate, etc. The only things that have changed are nominal prices, which have fallen, and the propor­tion of total cash balances to money income, which has increased.

     A decreased demand for money will have the reverse effect. Dishoarding will raise expenditure, raise prices, and, ceteris pari­bus, maintain the real income and capital structure intact. The only other change is a lower proportion of cash balances to money income.

     The only necessary result, then, of a change in the demand-for-money schedule is precisely a change in the same direction of the proportion of total cash balances to total money income and in the real value of cash balances. Given the stock of money, an increased scramble for cash will simply lower money incomes until the desired increase in real cash balances has been attained.

     If the demand for money falls, the reverse movement occurs. The desire to reduce cash balances causes an increase in money income. Total cash remains the same, but its proportion to in­comes, as well as its real value, declines.[10]

[1]Cf. Edwin Cannan, “The Application of the Theoretical Analysis of Supply and Demand to Units of Currency” in F.A. Lutz and L.W. Mints, eds., Readings in Monetary Theory   (Philadelphia: Blakiston, 1951), pp. 3–12, and Cannan, Money (6th ed.; London: Staples Press, 1929), pp. 10–19, 65–78.

[2]From this point on, this nonmonetary demand is included, for con­venience, in the “total demand for money.”

[3]Cf. Irving Fisher, The Purchasing Power of Money (2nd ed.; New York: Macmillan & Co., 1913).

[4]A typical such classification can be found in Lester V. Chandler, An Introduction to Monetary Theory (New York: Harper & Bros., 1940).

[5]See Mises, Theory of Money and Credit, p. 98. The entire volume is indispensable for the analysis of money. Also see Mises, Human Action, chap. xvii and chap. xx.

[6]See chapter 12 below for a discussion of the concept of social benefit or social utility.

[7]J.M. Keynes’ Treatise on Money (New York: Harcourt, Brace, 1930) is a classic example of this type of analysis.

[8]On the clearing system, see Mises, Theory of Money and Credit, pp. 281–86.

[9]Since no one can receive a money income unless someone else makes a money expenditure on his services. (See chapter 3 above.)

[10] Strictly, the ceteris paribus condition will tend to be violated. An increased demand for money tends to lower money prices and will there­fore lower money costs of gold mining. This will stimulate gold mining production until the interest return on mining is again the same as in other industries. Thus, the increased demand for money will also call forth new money to meet the demand. A decreased demand for money will raise money costs of gold mining and at least lower the rate of new production. It will not actually decrease the total money stock unless the new production rate falls below the wear-and-tear rate. Cf. Jacques Rueff, “The Fallacies of Lord Keynes’ General Theory” in Henry Haz­litt, ed., The Critics of Keynesian Economics (Princeton, N.J.: D. Van Nostrand, 1960), pp. 238–63.

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