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11. Money and Its Purchasing Power

8. The Determination of Prices: The Goods Side and the Money Side

We are now in a position to draw together all the strands determining the prices of goods. In chapters 4 through 9 we analyzed all the determinants of the prices of particular goods. In this chapter we have analyzed the determination of the purchasing power of money. Now we can see how both sets of determinants blend together.

A particular price, as we have seen, is determined by the total demand for the good (exchange and reservation) and the stock of the good, increasing as the former increases and decreasing as the latter increases. We may therefore call the demand a “factor of increase” of the price, and the stock a “factor of decrease.” The exchange demand for each good—the amount of money that will be spent in exchange for the good—equals the stock of money in the society minus the following: the exchange demands for all other goods and the reservation demand for money. In short, the amount spent on X good equals the total money supply minus the amount spent on other goods and the amount kept in cash balances.

Suppose we overlook the difficulties involved and now consider the price of “all goods,” i.e., the reciprocal of the purchasing power of money. The price of goods-in-general will now be determined by the monetary demand for all goods (factor of increase) and the stock of all goods (factor of decrease). Now, when all goods are considered, the exchange demand for goods equals the stock of money minus the reservation demand for money. (In contrast to any specific good, there is no need to subtract people's expenditures on other goods.) The total demand for goods, then, equals the stock of money minus the reservation demand for money, plus the reservation demand for all goods.

The ultimate determinants of the price of all goods are: the stock of money and the reservation demand for goods (factors of increase), and the stock of all goods and the reservation demand for money (factors of decrease). Now let us consider the obverse side: the PPM. The PPM, as we have seen, is determined by the demand for money (factor of increase) and the stock of money (factor of decrease). The exchange demand for money equals the stock of all goods minus the reservation demand for all goods. Therefore, the ultimate determinants of the PPM are: the stock of all goods and the reservation demand for money (factors of increase), and the stock of money and the reservation demand for goods (factors of decrease). We see that this is the exact obverse of the determinants of the price of all goods, which, in turn, is the reciprocal of the PPM.

Thus, the analysis of the money side and the goods side of prices is completely harmonious. No longer is there need for an arbitrary division between a barter-type analysis of relative goods-prices and a holistic analysis of the PPM. Whether we treat one good or all goods, the price or prices will increase, ceteris paribus, if the stock of money increases; decrease when the stock of the good or goods increases; decrease when the reservation demand for money increases; and increase when the reservation demand for the good or goods increases. For each individual good, the price will also increase when the specific demand for that good increases; but unless this is a reflection of a drop in the social reservation demand for money, this changed demand will also signify a decreased demand for some other good, and a consequent fall in the price of the latter. Hence, changes in specific demands will not change the value of the PPM.

In a progressing economy, the secular trend for the four determining factors is likely to be: the money stock increasing gradually as gold production adds to the previous total; the stock of goods increasing as capital investment accumulates; the reservation demand for goods disappearing because short-run speculations disappear over the long run, and this is the main reason for such a demand; the reservation demand for money unknown, with clearing, for example, working to reduce this demand over a period of time, and the greater number of transactions tending to increase it. The result is that we cannot precisely say how the PPM will move in a progressing economy, though the best summary guess would be that it declines as a result of the influence of the increased stock of goods. Certainly, the influence of the goods side is in the direction of falling prices; the money side we cannot predict.

Thus, the ultimate determinants of the PPM as well as of specific prices are the subjective utilities of individuals (the determinants of demand) and the given objective stocks of goods—thereby vindicating the Austrian-Wicksteedian theory of price for all aspects of the economic system.

A final note of warning: It is necessary to remember that money can never be neutral. One set of conditions tending to raise the PPM can never precisely offset another set of factors tending to lower it. Thus, suppose that an increase in the stock of goods tends to raise the PPM, while at the same time, an increase in the money supply tends to lower it. One change can never offset the other; for one change will lower one set of prices more than others, while the other will raise a different set within the whole array of prices. The degrees of change in the two cases will depend on the particular goods and individuals affected and on their concrete valuations. Thus, even if we can make an historical (not an economic-scientific) judgment that the PPM has remained roughly the same, the price relations have shifted within the array, and therefore the judgment can never be exact.

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