Interest and Prices

CHAPTER 3

RELATIVE PRICES AND MONEY PRICES

MODERN investigations in the field of the theory of value have thrown much light on the origin and determination of the exchange values, or relative prices, of commodities. But they have, unfortunately, done nothing to promote directly the theory of money—of the value of money and money prices.

It is true that many of the well-known workers on the theory of value, such as Jevons, Walras, and Menger, have entered fairly deeply into questions concerning money. But their treatment of such questions runs, for the most part, in the old ruts. For instance, Walras’ exposition consists fundamentally of nothing more than a mathematical version of the quantity theory which will be discussed below: there is no substantial development or extension of the theory itself. In most writings on the theory of value the question of the nature and origin of money prices is almost entirely neglected.

There is, however, nothing remarkable in this. For the whole study of relative prices is based on the conception of marginal utility; and in the determination of the average price level, and consequently of the actual level of money prices, this principle plays practically no part, or only a very indirect part.

To make this clear, let us try to recapitulate quite shortly the main conclusions of the modern theory of value.

Free exchange in an open market is governed by the general law of proportionality between the exchange values of commodities and their marginal utilities. The marginal utility is the utility of the last unit of a commodity that is acquired or disposed of (i.e. exchanged); or, what comes to the same thing, it is the strength of the least pressing need which is met by any unit of the commodity; or (still on the assumption of very small units, that is to say, of commodities that are perfectly divisible) the strength of the most pressing need which could be met by the acquisition (or retention) of an additional unit of the commodity but which in fact has to remain unsatisfied.

The existence of such a proportionality between relative exchange value and the utility of the last unit given or received in exchange, for each person engaged in the exchange, is immediately obvious. It follows from the economic principle by which there is a tendency for everyone to continue the process of exchange for so long as, but no longer than, he continues to acquire commodities which represent more than the equivalent of the commodities that he gives in exchange.

But it does not follow from this principle that the relation between marginal utilities must apply to the whole quantity of a commodity given in exchange. This is rather a consequence of what Stanley Jevons called The Law of Indifference, according to which only one price—only one ratio of interchange with other commodities—can rule for any commodity in an open market (competition between buyers and sellers being general and sufficiently keen).

This rule does not apply to an isolated exchange between two, or a small number of, individuals. Successive portions of the commodities may then be exchanged at varying prices. The problem of relative price in an isolated exchange is for this reason indeterminate, or insufficiently determined; according to the varying degree of calculating ability, cold-bloodedness, and so on, of the individuals engaged in the exchange, the average ratio of interchange of the commodities can fall anywhere within wide limits.

It is true that if on an open market the owners of a particular commodity hold back temporarily with the object of raising the price it can easily happen that some of them are able to get rid of their complete stocks (or so much of them as they desire to sell) at the higher price which they exact at the start. But the more pressing requirements of the buyers are now satisfied, and consequently the remaining owners of the commodity must eventually resign themselves to much lower prices for the greater part of their stocks. Similarly, if the buyers hold back temporarily with the purpose of lowering the price it can easily happen that some buyers are able to cover their full needs at a relatively low price. But the stocks of the sellers are now for the most part cleared out, and so the remaining buyers must eventually pay a correspondingly higher price.

As a result of the prevalence of competition on both sides, among the sellers and among the buyers, an approximately uniform price for each commodity soon pervades the market. This price is the one at which supply and demand just balance. Such a balance is only possible when the marginal utility is proportional to the price (ratio of interchange) for each commodity and for each individual who takes part in the market.

If longer periods of time are being considered, this equilibrium between supply and demand gives way to an equilibrium between production and consumption. As a corollary we find that the price and the cost of production of a commodity are proportional or equal—in so far as the phrase “cost of production” is capable of correct application, or of any application whatever.

It is evident that all this is only an approximation. This can be seen by examining the record of any market or exchange. The existence of a single market price, in the strictest sense, is merely a theoretical ideal, from which reality diverges to a more or less significant degree—particularly if the producers or owners of a commodity are united in a combination or cartel or if the consumers, in their turn, protect their interests by means of a consumers’ organisation or some similar body.

It can now be seen that money has a double rôle to play in relation to the exchange of commodities.

1.  If there are only two kinds of commodities they could, at any rate when appropriate quantities of each are at hand, be directly exchanged for one another in the market, without the intervention of money or any other medium of exchange; and the above law of exchange would operate. But as soon as more than two kinds of commodities appear on the market the situation is different (the general proof is due to Walras1). If the commodities are directly exchanged for one another in pairs, buyers only receiving what they require for their own consumption, it is no longer possible for the participants to attain complete satisfaction of their wants and there is no definite point of market equilibrium. In addition to, or instead of, the process of direct exchange, a process of indirect exchange must intervene.

Let us suppose, to take the simplest case, that commodity (A) is desired only by the owners of commodity (B), that commodity (B) is desired by the owners, not of commodity (A), but of a third commodity (C), which, in its turn, is demanded by the possessors of commodity (A) and by no others. It is then obvious that no direct exchange can take place. Only an indirect exchange is possible. For instance, the possessors of (A) might exchange their commodity for commodity (B) with the intention, not of consuming it, but of offering it to the owners of commodity (C), and so of acquiring this commodity (C), which is the one that they desire.

But this kind of intermediate trade would soon prove too clumsy and troublesome for any developed economic system unless it were conducted on organised lines. It has therefore become an immemorial custom among all nations to hold stocks of some commodity for which there is a universal demand and to employ it as a medium of exchange (in the narrower sense of the term). A commodity is particularly suitable for this purpose if it can be easily transported and if it is not susceptible to rapid decay, so that everyone willingly accepts quantities that are in excess of his immediate requirements. Let us call such a commodity, (M). Then in our example the possessors of commodity (A), assuming that they were provided with a sufficient supply of (M), would obtain the commodity (C), which they desire, in direct exchange for a certain quantity of (M). Then the owners of (C) can use the quantity of (M) which they acquire in this way to buy the commodity (B), and the owners of (B) can then use it to buy the commodity (A). If the quantities that are exchanged of the commodities (A), (B), and (C) are exactly equivalent, commodity (M)—the money—has in this way merely executed a cyclical movement in the direction A—C—B, and so back to A. But the other commodities, which are the real objects of exchange, have each advanced one step of the reverse cycle.

2.  In actual practice, however, perfect equivalence of the quantities exchanged will not be immediately attained. It may be that some of the people engaged in the market do not for the moment possess any goods that are suitable for sale, or possess but a small quantity, and can temporarily cover their purchases only by means of money. Others may be in possession of a surplus of goods and may desire to provide themselves with money for the immediate, or more remote, future. In short, money as such serves the purpose not only of a medium of exchange in the narrow sense but also of a store of value; it is used to remunerate services, and it is only later, when the money once again changes hands, that, in exchange for these services, other services are rendered and received.

Nowadays the word “market” is commonly used in a purely metaphorical sense—it no longer denotes a concrete reality. Purchases and sales tend to be spread more or less uniformly over the whole year, and a considerable time often elapses after a man makes a sale before he makes the ensuing purchase. This function of money would thus be of considerable importance in the real world if it were not rendered unnecessary, for the most part, by the development of credit facilities, as will be explained later.

For the sake of simplicity, we shall now leave on one side the function that money fulfils as a store of value. We shall suppose that we are dealing with an actual, though indirect, exchange of goods which are already in existence and which are destined for immediate consumption. It is then obvious that the fundamental conditions of exchange are not affected by the intervention of money. For every buyer and seller there holds good, just as before, a direct proportionality between the price of each commodity and the marginal utility of the quantity that is acquired or retained. Moreover, the total value of the goods that are acquired is everywhere equal to the total value of the goods that are sold, so that in the end everyone pays out just as much money as he receives. Either each single coin returns to its original owner or it is replaced by one of equal value. So the function of money is here purely that of an intermediary; it comes to an end as soon as the ex-change has been effected.

Hence we arrive at an important, if self-evident, fact the neglect of which has constantly resulted in false conclusions. The exchange of commodities in itself, and the conditions of production and consumption on which it depends, affect only exchange values or relative prices: they can exert no direct influence whatever on the absolute level of money prices.

For a single commodity or group of commodities, the establishment on the market of an incorrect relative price results in an inequality between supply and demand, between production and consumption, and this sooner or later effects the necessary correction. But if, on the other hand, the prices of all commodities, or the average price level, is for any reason forced up or depressed there is nothing in the conditions of the commodity market that is calculated to bring about a reaction. After the exchange has taken place, each coin returns, on our assumption, either actually or virtually to its original owner, to whom it is a matter of complete indifference whether he pays more or less for the goods that are offered to him provided that at the same time he obtains a correspondingly higher price for his own goods.

If there is any reaction whatever away from a general level of prices that is too high or too low, it must originate somehow or other from outside the commodity market proper. Either the commodity which serves as money, being traded on its particular market, where it appears as an article of use or of consumption, derives a marginal utility, and an exchange value against other commodities, depending on its properties in use and on the conditions of its production; or this exchange value is influenced by the circumstance, which we have hitherto neglected, that the exchange of commodities is never in actual practice an instantaneous process, but always extends over some period of time, during which money fulfils the function of a store of value. We shall later undertake a closer examination of both these views, one of which is connected with the so-called Cost of Production Theory of Money and the other with the so-called Quantity Theory. Whichever of these views may be regarded as the more correct (they are in no sense opposed to one another) one thing is certain: money prices, as opposed to relative prices, can never be governed by the conditions of the commodity market itself (or of the production of goods); it is rather in the relations of this market to the money market, in the widest sense of the term, that it is necessary to search for the causes that regulate money prices.

These considerations are sufficient to enable us to examine a view which is so widespread that to question it at all would seem almost paradoxical. In discussions of the causes that have led to the fall of commodity prices during recent decades, it is constantly asserted that in part, perhaps for the most part, the cause resides “on the side of goods”. By this is meant that technical progress in production and transport must have led pro tanto to a cheapening of all, or of most, commodities, and so to a fall in the general price level.

Such a statement can be formally derived from one or other of the independent theories of the origin and causes of the value of money, for instance, from the Cost of Production Theory or from the Quantity Theory, which have just been mentioned. On the basis of the Cost of Production Theory, it could be said that the cost of production of commodities has fallen more than the cost of production of gold, or that the former has fallen while the latter has remained unchanged. From the point of view of the Quantity Theory, one would refer to the fact that the total volume of production, and still more the volume of commodities exchanged, has expanded enormously—on account of an increase in population, greater efficiency of production, a more general use of money, and so on—while no corresponding expansion has taken place in the total stock of money. Such explanations obviously stand or fall with the particular theory on which they are based.

But the decrease in the cost of production of commodities, the improvements in transport, etc., are often put forward without further explanation as independent causes of the fall of commodity prices by writers who actually reject the theories that have just been referred to as well as every other independent theory of money. It is as though this kind of explanation replaces every other theory of the value of money. The reasoning is somewhat as follows: Technical progress results in a fall in the cost of production, and so in the price, first of one group of commodities, then of another. The extension of this fall in price to all, or to most, groups of commodities means a fall in the general level of prices and a corresponding rise in the purchasing power of money over commodities. When, on the other hand, the question is one of a rise in the prices of commodities an explanation is looked for (as in the case of Thomas Tooke and his followers) in bad harvests, in an increase in the demand for particular commodities of which the supply remains unaltered, and in the effect of tariffs and indirect taxes in raising the prices of such commodities. In short, the same causes which can, as a matter of experience, be cited to account for a rise or fall in the price of any single commodity are put forward without further explanation, as soon as they extend to several of the most important groups of commodities, as the source of changes in the general level of prices.

This conclusion comes to grief over a logical fallacy, the nature of which is easily made clear in the light of the above discussion. When a single commodity can be produced more “cheaply” than was formerly the case—that is to say, when its production involves the use of less labour, land, or capital—its price, on the assumption of perfect competition, must certainly fall in relation to the prices of the other commodities, of which the costs of production are supposed to remain appreciably unaltered. But this by itself does not necessarily imply that the money price of the commodity is lowered by the whole of the difference between the former and the present exchange values. It may easily happen that the actual fall in price accounts for only a part of this difference, though most probably for a very large part; the remainder being made up by a small rise in the prices of the other groups of commodities. If this is so the changes that occur in prices may result in a rise of the average price level just as easily as in a fall; or it might remain unaltered. The same is true if the production of each of the other commodities in turn becomes successively facilitated.

Whether the price level will actually rise or fall cannot be decided a priori. The decisive factors are obscure and complicated, but so far as they lend themselves to a general survey, it appears that the outcome must chiefly depend on the temporal sequence of the changes in the supply of the particular commodity and in the demand of the producers of this commodity for all other commodities, and in the supply and demand of commodities in general. This sequence must in its turn depend on what happens to be the condition of the money market. If the money market is in a fluid condition producers are provided with ample funds or can easily procure them by borrowing; supply then follows a more restrained course, and producers can satisfy their need for raw materials, labour, etc., without having first to await the sale of their own goods. In other words, the demand for commodities increases, directly and indirectly, while the supply is restricted or expands only by degrees; demand moves ahead of supply and prices tend to rise. Although a relative fall in the price of the commodity that is now produced more cheaply is in the long run inevitable, the absolute fall is relatively insignificant whilst the prices of all other commodities have gone up.

If, on the other hand, conditions in the money market are tight, producers hasten to dispose of their stocks of goods in order to obtain money; supply moves ahead of demand and prices give way. The fall in price is, of course, greatest and most noticeable for those commodities of which the production has been cheapened as a result of technical improvements, and it may therefore easily look as though it was these improvements that constituted the true cause of the general fall in prices.

We may examine the matter from a different aspect. The well-known law that the prices of commodities tend towards their costs of production is comprehensible only if it refers to relative costs and prices. In its essence it is only a corollary—in fact, merely an alternative expression—of the approximately correct observation that under free competition the returns to the factors of production—wages, rent of land, and earnings of capital—are equal in all occupations, or at any rate are continually tending towards equality. Provided that the improvements in production are introduced only over a small area, so that there is no appreciable influence on the general level of remuneration of the factors of production, it is certainly justifiable to state that wages or profits over this area, which begin by being raised, must sooner or later be forced down by competition to the level of wages and profits elsewhere. We may now employ the usual argument in regard to the effect on commodity prices. But here too it would be more correct to state that there is in reality a rise, even though it may be a very small rise, in (real) wages or profits over the whole field of production.

If, however, the technical improvements apply over a considerable range of total production, it would be quite absurd to continue to suppose that the general level of wages, rents, and earnings of capital remains unchanged. It must, on the contrary, rise (in this connection it is a matter of indifference whether one category rises more than the others or even at the expense of the others); for increased productivity of labour and natural resources is in general synonymous with greater remuneration of the factors of production. This may be secured through commodity prices falling while wages, rents, etc., as measured in money, remain temporarily unchanged; but it may just as well happen that these are increased while commodity prices remain unchanged or even rise a little. The law of equality between prices and costs of production is not capable of being utilised to determine what will happen in actual fact. It depends rather on whether entrepreneurs’ demand for labour, land, etc., and so finally the demand, direct or indirect, for commodities, is more vigorous and pronounced than the supply of commodities. And this, as we have seen, must depend on the conditions that prevail in the money market.

These considerations, which to some extent forestall the discussion that follows, cannot here be pursued any further. We now proceed to a short treatment of the most important of the actual theories which have hitherto been advanced concerning the causes affecting the value of money.

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2 Walras, Éléments d’économie politique pure, Lec. 19-21. Cf. also Launhardt, Mathematische Begründung der Volkswirtschaftslehre, § 12, and my own work Über Wert, Kapital und Rente, p. 50. The problem is very inadequately treated by Jevons (Theory of Political Economy, p. 124).

• 1See, for instance, his preface to the German edition of his Vorlesungen, II.: Geld und Kredit, 1922.
• 2Wicksell always insisted that this reasoning did not mean more than an amplification of the old quantity theory. Moreover, he always regarded his own contribution as a doubtful hypothesis and never became as convinced of its tenability as did some of his pupils. He explicitly rejected the idea that his theory provided an explanation of the business cycle. He was critical of Mises’ idea that mistaken credit policy is the origin of the tendencies towards booms and depressions. A brief quotation will indicate his position: “Our conclusion is, therefore, that although the changes in the purchasing power of money, caused by credit policy, are under present conditions intimately bound up with the business cycle and without any doubt also influence the latter, above all by giving rise to crises, yet it does not seem essential to assume that there is, by the nature of things, any necessary connection between these two phenomena. The main cause of the business cycle, and a sufficient cause, seems to be the fact that technical and commercial progress cannot by its very nature give rise to a series which proceeds as evenly as the growth in our time of human needs—due above all to the organic increase in population—but is now accelerated now retarded. In the former case ... a mass of circulating capital is transformed into fixed capital, a process which, as I have said, accompanies every rising business cycle: it seems as a matter of fact to be the one really characteristic sign, or one in any case which it is impossible to conceive as being absent.”. . . “If the banks already at the beginning of a rising period sufficiently raised their interest rates, but on the other hand reduced them energetically when the depression was about to set in”, then the price level would probably remain stable, although raw materials for fixed capital would rise in price during periods of good trade and fall during times of bad trade. “Under such circumstances the chief crises-causing factor would probably have disappeared, and what remained would be only a quiet wave movement between periods of accelerated formation of fixed capital and periods when the new capital assumed . . . other forms.” . . . “Increase in commodity stocks is probably the most important form of real investment during so-called bad trade.”