Prices and Production

LECTURE 1

Theories of the Influence of Money on Prices

He realized well that the abundance of money makes everything dear, but he did not analyze how that takes place. The great difficulty of this analysis consists in discovering by what path and in what proportion the increase of money raises the price of things.

Richard Cantillon (died 1734) Essai sur la nature du commerce en général, II, 6

(1) That monetary influences play a dominant role in deter mining both the volume and direction of production is a truth which is probably more familiar to the present generation than to any which have gone before. The experiences of the war-and postwar-inflation, and of the return to the gold standard, particularly where, as in Great Britain, it was accomplished by a contraction of the circulation, have given abundant evidence of the dependence on money of every productive activity. The widespread discussions of recent years concerning the desirability and practicability of stabilizing the value of money are due mainly to a general recognition of this fact. At the present moment many of the best minds believe the cause of the existing worldwide depression to be a scarcity of gold and seek accordingly for monetary means to overcome it.

And yet, if it were asked whether understanding of the connection between money and prices has made great progress during these years, at any rate until very recently, or whether the generally accepted doctrines on this point have progressed far beyond what was generally known a hundred years ago, I should be inclined to answer in the negative. This may seem paradoxical, but I think anyone who has studied the monetary literature of the first half of the nineteenth century will agree that there is hardly any idea in contemporary monetary theory which was not known to one or more writers of that period. Probably the majority of present-day economists would contend that the reason why progress has been so slight is that monetary theory has already reached such a state of perfection that further progress must of necessity be slow. But I confess that to me it still seems that some of the most fundamental problems in this field remain unsolved, that some of the accepted doctrines are of a very doubtful validity, and that we have even failed to develop the suggestions for improvement which can be found in the works of these early writers.

If that be true, and I hope to convince you that it is, it is surely somewhat astonishing that the experiences of the last fifteen years have not proved more fruitful. In the past, periods of monetary disturbance have always been periods of great progress in this branch of economics. The Italy of the sixteenth century has been called the country of the worst money and the best monetary theory. If recently that has not been true to the same extent, the reason seems to me to lie in a certain change of attitude on the part of most economists in regard to the appropriate methodology of economics, a change which in many quarters is hailed as a great progress: I mean the attempt to substitute quantitative for qualitative methods of investigation. In the field of monetary theory, this change has been made even by economists who in general reject the “new” point of view, and indeed several had made it some years before the quantitative method had become fashionable elsewhere.

(2) The best known instance, and the most relevant case in point, is the resuscitation by Irving Fisher some twenty years ago of the more mechanistic forms of the quantity theory of the value of money in his well-known “equation of exchange.” That this theory, with its apparatus of mathematical formulae constructed to admit of statistical verification, is a typical instance of “quantitative” economics, and that it indeed probably contributed a good deal to influence the methodology of the present representatives of this school, are propositions which are not likely to be denied. I do not propose to quarrel with the positive content of this theory: I am even ready to concede that so far as it goes it is true, and that, from a practical point of view, it would be one of the worst things which would befall us if the general public should ever again cease to believe in the elementary propositions of the quantity theory. What I complain of is not only that this theory in its various forms has unduly usurped the central place in monetary theory, but that the point of view from which it springs is a positive hindrance to further progress. Not the least harmful effect of this particular theory is the present isolation of the theory of money from the main body of general economic theory.

For so long as we use different methods for the explanation of values as they are supposed to exist irrespective of any influence of money, and for the explanation of that influence of money on prices, it can never be otherwise. Yet we are doing nothing less than this if we try to establish direct causal connections between the total quantity of money, the general level of all prices and, perhaps, also the total amount of production. For none of these magnitudes as such ever exerts an influence on the decisions of individuals; yet it is on the assumption of a knowledge of the decisions of individuals that the main propositions of non-monetary economic theory are based. It is to this “individualistic” method that we owe whatever understanding of economic phenomena we possess; that the modern “subjective” theory has advanced beyond the classical school in its consistent use is probably its main advantage over their teaching.

If, therefore, monetary theory still attempts to establish causal relations between aggregates or general averages, this means that monetary theory lags behind the development of economics in general. In fact, neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc. I would even go so far as to assert that, from the very nature of economic theory, averages can never form a link in its reasoning; but to prove this contention would go far beyond the subject of these lectures. I shall here confine myself to an attempt to show in a special field the differences between explanations which do and explanations which do not have recourse to such concepts.

(3) As I have said already, I do not want to criticize the doctrines of these theories so far as they go; I indicate their characteristics only in order to be able to show later on how much more another type of theory may accomplish. The central preoccupation of these theories is changes in the general price level. Now everybody agrees that a change of prices would be of no consequence whatever if all prices in the widest sense of the term were affected equally and simultaneously. But the main concern of this type of theory is avowedly, with certain suppositions “tendencies, which affect all prices equally, or at any rate impartially, at the same time and in the same direction.”4 And it is only after the alleged causal relation between changes in the quantity of money and average prices has thus been established that effects on relative prices are considered. But as the assumption generally is that changes in the quantity of money affect only the general price level, and that changes of relative prices are due to “disturbing factors” or “frictions,” changes in relative prices are not part of this explanation of the changes in the price level. They are mere accompanying circumstances which experience has taught us to be regularly connected with changes of the price level, not, as might be thought, necessary consequences of the same causes. This is very clear from the form of exposition and the concepts it employs. Certain “lags” are found to exist between the changes of different prices. The prices of different goods are said generally to be affected in a definite sequence, and it is always implied that all this would never take place if the general price level did not change.

When we come to the way in which the influence of prices on production is conceived by this theory, the same general characteristics are to be discovered. It is the price level, the changes of which are supposed to influence production; and the effect considered is not the effect upon particular branches of production, but the effect upon the volume of production in general. In most cases, no attempt is made to show why this must be so; we are referred to statistics which show that in the past a high correlation of general prices and the total volume of production has been present. If an explanation of this correlation is attempted, it is generally simply to the effect that the expectation of selling at higher prices than present costs will induce everybody to expand production, while in the opposite case the fear of being compelled to sell below costs will prove a strong deterrent. That is to say, it is only the general or average movement of prices which counts.

Now this idea that changes of relative prices and changes in the volume of production are consequent upon changes in the price level, and that money affects individual prices only by means of its influence on the general price level, seems to me to be at the root of at least three very erroneous opinions: First, that money acts upon prices and production only if the general price level changes, and, therefore, that prices and production are always unaffected by money—that they are at their “natural” level—if the price level remains stable. Second, that a rising price level tends always to cause an increase of production, and a falling price level always a decrease of production; and third, that “monetary theory might even be described as nothing more than the theory of how the value of money is determined.”5 It is such delusions, as we shall see, which make it possible to assume that we can neglect the influence of money so long as the value of money is assumed to be stable, and apply without further qualification the reasoning of a general economic theory which pays attention to “real causes” only, and that we have only to add to this theory a separate theory of the value of money and of the consequences of its changes in order to get a complete explanation of the modern economic process.

Further details are unnecessary. You are all sufficiently familiar with this type of theory to supply these for yourselves and to correct any exaggerations which I may have committed in my endeavor to make the contrast with the other types of theory as strong as possible. Any further strengthening of the contrast can best be carried out by my proceeding forthwith to the second of the major stages in the development of monetary theory. I wish only to emphasize, before I pass on to that, that henceforward when I speak of stages of development, I do not mean that each of these stages has in turn taken the place of the foregoing as the recognized doctrine. Quite on the contrary, each of these stages is still represented among contemporary monetary theorists and indeed in all probability the first has still the greatest number of adherents.

(4) As might be expected, the second stage arises by way of dissatisfaction with the first. This dissatisfaction makes its appearance quite early. Locke and Montanari, at the end of the seventeenth century, had stated quite clearly the theory I have been discussing. Richard Cantillon, whose criticism of Locke I have taken as the motto of this lecture, realized its inadequacy, and in his famous Essai sur le Commerce (published 1755), he provides the first attempt known to me to trace the actual chain of cause and effect between the amount of money and prices. In a brilliant chapter, which W.S. Jevons called “one of the most marvelous things in the book,” he attempts to show “by what path and in what proportion the increase of money raises the price of things.” Starting from the assumption of the discovery of new gold or silver mines, he proceeds to show how this additional supply of the precious metals first increases the incomes of all persons connected with their production, how the increase of the expenditure of these persons next increases the prices of things which they buy in increased quantities, how the rise in the prices of these goods increases the incomes of the sellers of these goods, how they, in their turn, increase their expenditure, and so on. He concludes that only those persons are benefited by the increase of money whose incomes rise early, while to persons whose incomes rise later the increase of the quantity of money is harmful.

Better known is the somewhat shorter exposition of the same idea which David Hume gave a little later in a famous passage of his Political Discourses,6 which so closely resembles the words of Cantillon that it is hard to believe that he had not seen one of those manuscripts of the Essai which are known to have been in private circulation at the time when the Discourses were written. Hume, however, makes it clear that, in his opinion, “it is only in this interval or intermediate situation, between the acquisition of money and the rise of prices, that the increasing quantity of gold and silver is favourable to industry.”

To the Classics, this line of reasoning did not seem susceptible of improvement. While Hume is often quoted, his method of approach was not amplified for more than a century. It was not until the increase of the supply of gold consequent upon the Californian and Australian discoveries that there was any new impetus to this type of analysis. J.E. Cairnes’s Essay on the Australian Gold Discoveries7 contains probably the most noteworthy refinement of the argument of Cantillon and Hume before it was finally incorporated into more modern explanations based upon the subjective theories of value.

It was inevitable that modern theory should be sympathetic toward a point of view which traces the effects of an increase of money to its influence on individual decisions. But a generation passed before serious attempts were made to base the explanation of the value of money and the effects of changes in the amount of money upon the fundamental concepts of marginal utility theory. I shall not dwell here at any length on the variety of forms this assumes in the different modern theories which base the explanation of the value of money on the subjective elements determining the demand for money on the part of the individual. In the form this theory has received at the hands of Professor Mises, it belongs already to the third and fourth of our main stages of development, and I shall have occasion to refer to it later. It is worth noticing, however, that, insofar as these theories are confined to an explanation of the manner in which the effects of increase in the amount of money are distributed through the various channels of trade, they still suffer from a not unimportant defect. While they succeed in providing a general scheme for the deduction of the successive effects of an increase or decrease of the amount of money, provided that we know where the additional money enters into circulation, they do not help us to make any general statements about the effects which any change in the amount of money must have. For, as I shall show later, everything depends on the point where the additional money is injected into circulation (or where money is withdrawn from circulation), and the effects may be quite opposite depending upon when the additional money comes first into the hands of traders and manufacturers or directly into the hands of salaried people employed by the state.

(5) Very early, and, in the beginning, with only little relation to the problem of the value of money, there had, however, sprung up a doctrine, or rather a number of closely related doctrines, the importance of which was not appreciated at the time, although in the end they were to be combined to fill the gap I have been discussing. I refer to the doctrines of the influence of the quantity of money on the rate of interest, and through it on the relative demand for consumers’ goods on the one hand and producers’ or capital goods on the other. These form the third stage in the development of monetary theory. These doctrines have had to surmount unusual obstacles and prejudices, and until recently they received very little attention. It almost seems as if economists had for so long a time struggled against the popular confusions between the value of money proper and the price for a money loan that in the end they had become almost incapable of seeing that there was any relation at all between the rate of interest and the value of money. It is therefore worthwhile attempting to trace their development in rather greater detail.

While the existence of some relation between the quantity of money and the rate of interest was clearly recognized very early—traces of an understanding could certainly be found in the writings of Locke and Dutot—the first author known to me to enunciate a clear doctrine on this point was Henry Thornton. In his Paper Credit of Great Britain, published in 1802 at the beginning of the discussion on Bank Restriction—a really remarkable performance, the true importance of which is only now beginning to be recognized—he struck for the first time one of the leading notes of the new doctrine. The occasion for his statement was an inquiry into the question whether there existed a natural tendency to keep the circulation of the Bank of England within the limits which would prevent a dangerous depreciation. Thornton denied that such a natural tendency existed and held that, on the contrary, the circulation might expand beyond all assignable limits if the bank would only keep its rate of interest low enough. He based his opinion on considerations so weighty that I cannot resist quoting them at some length:

In order to ascertain how far the desire of obtaining loans at the Bank may be expected at any time to be carried, we must enquire into the subject of the quantum of profit likely to be derived from borrowing there under the existing circumstances. This is to be judged of by considering two points: the amount, first, of interest to be paid on the sum borrowed; and, secondly, of the mercantile or other gain to be obtained by the employment of the borrowed capital. The gain which can be acquired by the means of commerce is commonly the highest which can be had; and it also regulates, in a great measure, the rate in all other cases. We may, therefore, consider this question as turning principally on a comparison of the rate of interest taken at the bank with the current rate of mercantile profit.8 (p. 287)

Thornton restated these doctrines in the first of his two speeches on the Bullion Report, which were also published as a booklet9 and would deserve being recovered from oblivion. In this speech he attempts to call the attention of the House of Commons to the subject of the rate of interest as “a very great and turning point,” and, after restating his theory in a shorter form, adds a new and different theory on the relations between prices and interest (which must on no account be confused with his other theory) namely a theory of the influence of an expectation of a rise of prices on the money rate of interest, a theory which later on was to be re-discovered by A. Marshall and Irving Fisher. This theory, however, does not concern us here.10

Thornton’s theory seems to have been generally accepted among the “bullionists,” though it appears to have been forgotten by the time that the doctrine of this school became the target of those attacks of the Banking School to which it would have been a sufficient answer. Within the next two years it had been restated by Lord King11 and J.L. Foster,12 and, what is much more important, it was accepted by David Ricardo, in his pamphlet of 1809, who gave it a still more modern ring by speaking of the rate of interest falling below its natural level in the interval between the issues of the bank and their effects on prices.13 He repeated this also in his Principles14 which should have been sufficient to make it generally known. The doctrine makes its appearance in the Bullion Report,15 and it remained familiar to economists for some time after the restriction period.

In 1823, Thomas Joplin, the inventor of the currency doctrine, enunciates the same principle which a few years later he elaborated into a peculiar but very interesting theory of the “pressure and anti-pressure of capital upon currency” and propounds it as a new discovery.16 Though his theory is interwoven with some quite erroneous opinions, which probably prevented his contemporaries from recognizing the real contributions contained in his writings, yet, nevertheless, he succeeds in providing the clearest explanation of the relations between the rate of interest and the fluctuations of the note circulation which had been given up to that time. The principle which, in Joplin’s opinion, neither Thornton nor those who adopted his opinions discovered, and which probably was responsible for “every great fluctuation in prices that has occurred since the first establishment of our banking system,” is that when the supply of capital exceeds the demand, it has the effect of compressing the country circulation: when the demand is greater than the supply, it has the effect of expanding it again.17 He devotes some pages to an exposition of how the rate of interest operates to equalize the demand for and the supply of capital, and how any change of that rate affects productive activity, and then proceeds:

But, with our currency, or rather the currency of the country banks... the effects are different. The interest of money, when it is abundant, is not reduced, but the circulation... is diminished; and on the contrary, when money is scarce, an enlargement of issues takes place, instead of a rise in the rate of interest. The Country Bankers never vary the interest they charge. ... He must, of necessity, have one fixed charge, whatever it may be: for he never can know what the true rate is. With a metallic currency, on the contrary, the Banker would always know the state of the market. In the first place, he could not lend money until it had been saved and placed in his hands, and he would have a particular amount to lend. On the other hand, he would have more or fewer persons wanting to borrow, and in proportion as the demand would exceed or fall short of the amount he had to lend, he would raise or lower his terms. ... But, in consequence of the Country Banks being not only dealers in incipient capital, but issuers of currency, the demand for currency and the demand for capital are so mingled together that all knowledge of either is totally confounded.18

For the next seventy-five years there was hardly any progress in this connection. Three years after Joplin, in 1826, Thomas Tooke (who eighteen years later was to enlarge upon the erroneousness of what he then could already call the commonly received doctrine that a low rate of interest is calculated to raise prices and a high rate to depress them)19 accepted Thornton’s doctrine, and developed it in some minor points.20 In 1832 J. Horlsey Palmer reproduced it before the parliamentary committee on the Renewal of the Bank Charter,21 and as late as 1840 the doctrine that the “demand for loans and discounts at a rate below the usual rate is insatiable” was treated almost as a matter of course by N.W. Senior,22 and it even entered, though in a somewhat emasculated form, into J.S. Mill’s Principles of Political Economy.23

(6) Before following the more modern development of this theory, I must, however, trace the origins of the second strand of thought which in the end became interwoven with the one just considered to constitute modern doctrine in this matter. While the line of thought we have already considered pays attention only to the relation between the rate of interest, the amount of money in circulation and, as a necessary consequence of the latter, the general price level, the second pays attention to the influence which an increase in the amount of money exercises upon the production of capital, either directly or through the rate of interest. The theory that an increase of money brings about an increase of capital, which has recently become very popular under the name of “forced saving,” is even older than the one we have just been considering.

The first author clearly to state this doctrine and the one who elaborated it in greater detail than any of his successors up to very recent times was J. Bentham. In a passage of his Manual of Political Economy written in 1804 but not published until 1843, he deals in some detail with the phenomenon which he calls “Forced Frugality.” By this he means the increased “addition to the mass of future wealth” which a government can bring about by applying funds raised by taxation or the creation of paper money to the production of capital goods. But interesting and important as this discussion by Bentham is, and although it is more than probable that it was known to some of the economists of this circle, the fact that it appeared in print only so many years later reduces its importance for the development of the doctrine very much.24

The honor of first having discussed the problem in some detail in print is apparently due to T.R. Malthus, who, in 1811, in an unsigned review25 of Ricardo’s first pamphlet, introduces his remarks with the complaint that no writer he is acquainted with “has ever seemed sufficiently aware of the influence which a different distribution of the circulating medium of the country must have on those accumulations which are destined to facilitate future production.” He then demonstrates on an assumed “strong case” that a change of the proportion between capital and revenue to the advantage of capital so “as to throw the produce of the country chiefly in the hands of the productive classes” would have the effect that “in a short time, the produce of the country would be greatly augmented.” The next paragraph must be quoted in full. He writes:

Whenever, in the actual state of things, a fresh issue of notes comes into the hands of those who mean to employ them in the prosecution and extension of profitable business, a difference in the distribution of the circulating medium takes place, similar in kind to that which has been last supposed; and produces similar, though of course comparatively inconsiderable effects, in altering the proportion between capital and revenue in favour of the former. The new notes go into the market as so much additional capital, to purchase what is necessary for the conduct of the concern. But, before the produce of the country has been increased, it is impossible for one person to have more of it, without diminishing the shares of some others. This diminution is affected by the rise of prices, occasioned by the competition of the new notes, which puts it out of the power of those who are only buyers, and not sellers, to purchase as much of the annual produce as before: While all the industrious classes—all those who sell as well as buy—are, during the progressive rise of prices, making unusual profits; and, even when this progression stops, are left with the command of a greater portion of the annual produce than they possessed previous to the new issues.

The recognition of this tendency of an increased issue of notes to increase the national capital does not blind Malthus to the dangers and manifest injustice connected with it. He simply offers it, he says, as a rational explanation of the fact that a rise of prices is generally found conjoined with public prosperity.

With a single exception this suggestion of Malthus does not seem to have been appreciated at the time—though the mere fact that Ricardo replied to it at length should have made it familiar to economists. The exception is a series of memoranda on the Bullion Report which Dugald Stewart prepared in 1811 for Lord Lauderdale and which were later reprinted as an appendix to his lectures on political economy.26 Objecting to the oversimplified version of the quantity theory employed in the reasoning of the Bullion Report, he attempts to explain the more “indirect connection between the high prices and an increased circulating medium.” In the course of this discussion he comes very near to the argument employed by Malthus and in one of the later memoranda actually refers to the article which in the meantime had come to his notice, and reproduces the paragraph quoted above.

There are further allusions to the problem by other authors of the early nineteenth century, notably by T. Joplin and R. Torrens, and John Stuart Mill in the fourth of his Essays on Some Unsettled Questions of Political Economy—“On Profits and Interest”—(written in 1829 or 1830) goes at least so far as to mention that, as the result of the activity of bankers, “revenue” may be “converted into capital; and thus, strange as it may appear, the depreciation of the currency, when effected in this way, operates to a certain extent as a forced accumulation.”27

But he believed then that this phenomenon belonged to the “further anomalies of the rate of interest which have not, so far as we are aware, been hitherto brought within the pale of exact science.” The first edition of his Principles seems to contain nothing on this point. But in 1865, in the sixth edition, he added to his chapter on “Credit as a Substitute for Money” a footnote which so closely resembles the statement by Malthus that it seems very probable that something—perhaps the publications of D. Stewart’s Collected Works—had directed his attention to the earlier discussion of the point.28

(7) In the period after the publication of J.S. Mill’s Principles for a long time attention was paid only to the first of the two related ideas we have been analyzing. For many years there was very little progress at all. Occasional restatements of the views of the earlier authors occurred, but added nothing and received little attention.29 The doctrine of the “indirect chain of effects connecting money and prices,” as developed by Sidgwick, Giffen, Nicholson, and even Marshall,30 adds hardly anything to what had been evolved from Thornton to Tooke. More significant is the further development and perhaps independent rediscovery of the forced saving doctrine by Léon Walras in 1879.31 Although his contribution had been practically forgotten and has only recently been recovered from oblivion by Professor Marget, it is of special interest because it is probably through Walras that this doctrine reached Knut Wicksell. And it was only this great Swedish economist who at the end of the century finally succeeded in definitely welding the two, up to then, separate strands of thoughts into one. His success in this regard is explained by the fact that his attempt was based on a modern and highly developed theory of interest: that of Böhm-Bawerk. But by a curious irony of fate, Wicksell32 has become famous, not for his real improvements on the old doctrine, but for the one point in his exposition in which he definitely erred: namely, for his attempt to establish a rigid connection between the rate of interest and the changes in the general price level.

Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural33 rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks.

Now, so long as the money rate of interest coincides with the equilibrium rate, the rate of interest remains “neutral” in its effects on the prices of goods, tending neither to raise nor to lower them. When the banks, however, lower the money rate of interest below the equilibrium rate, which they can do by lending more than has been entrusted to them, i.e., by adding to the circulation, this must tend to raise prices; if they raise the money rate above the equilibrium rate—a case of less practical importance—they exert a depressing influence on prices. From this correct statement, however, which does not imply that the price level would remain unchanged if the money rate corresponds to the equilibrium rate, but only that, in such conditions, there are no monetary causes tending to produce a change in the price level, Wicksell jumps to the conclusion that, so long as the two rates agree, the price level must always remain steady. There will be more to say about this later. For the moment, it is worth observing a further development of the theory. The rise of the price level, which is supposed to be the necessary effect of the money rate remaining below the equilibrium rate, is in the first instance brought about by the entrepreneurs spending on production the increased amount of money loaned by the banks. This process, as Malthus had already shown, involves what Wicksell now called enforced or compulsory saving.34

That is all I need to say here in explanation of the Wicksellian theory. Nor shall I here discuss the important development of this theory added by the Austrian economist, Professor Mises.35 An exposition of the present form of this theory will form the main subject of my next two lectures. Here it is only necessary to point out that Professor Mises has improved the Wicksellian theory by an analysis of the different influences which a money rate of interest different from the equilibrium rate exercises on the prices of consumers’ goods on the one hand, and the prices of producers’ goods on the other. In this way, he has succeeded in transforming the Wicksellian theory into an explanation of the credit cycle which is logically satisfactory.

(8) But this brings me to the next part of my discussion. For it is partly upon the foundations laid by Wicksell and partly upon criticism of his doctrine that what seems to me the fourth of the great stages of the progress of monetary theory is being built. (I ought, perhaps, expressly to warn you that while up to this point of our survey I have been describing developments which have already taken place, what I am about to say about the fourth stage concerns rather what I think it should be than what has already taken definite shape.)

It would take too much time to trace chronologically the steps by which, by degrees, the Wicksellian theory has been transformed into something new. You will be better able to appreciate this change if I turn immediately to the discussion of those deficiencies of his doctrine which eventually made it necessary definitely to break away from certain of the fundamental concepts in the theory which had been taken over by him from his predecessors.

I have mentioned already that, according to Wicksell, the equilibrium rate of interest was a rate which simultaneously restricted the demand for real capital to the amount of savings available and secured stability of the price level. His idea is obviously one which is very generally held even at the present time, namely, that as, at an equilibrium rate of interest, money would remain neutral toward prices, therefore in such circumstances there could be no reason at all for a change of the price level.

Nevertheless, it is perfectly clear that, in order that the supply and demand for real capital should be equalized, the banks must not lend more or less than has been deposited with them as savings (and such additional amounts as may have been saved and hoarded). And this means naturally that (always excepting the case just mentioned) they must never allow the effective amount of money in circulation to change.36 At the same time, it is no less clear that, in order that the price level may remain unchanged, the amount of money in circulation must change as the volume of production increases or decreases. The banks could either keep the demand for real capital within the limits set by the supply of savings, or keep the price level steady; but they cannot perform both functions at once. Except in a society in which there were no additions to the supply of savings, i.e., a stationary society, to keep the money rate of interest at the level of the equilibrium rate would mean that in times of expansion of production the price level would fall. To keep the general price level steady would mean, in similar circumstances, that the loan rate of interest would have to be lowered below the equilibrium rate. The consequences would be what they always are when the rate of investment exceeds the rate of saving.

It would be possible to cite other cases where the influence of money on prices and production is quite independent of the effects on the general price level. But it seems obvious as soon as one once begins to think about it that almost any change in the amount of money, whether it does influence the price level or not, must always influence relative prices. And, as there can be no doubt that it is relative prices which determine the amount and the direction of production, almost any change in the amount of money must necessarily also influence production.

But if we have to recognize that, on the one hand, under a stable price level, relative prices may be changed by monetary influences, and, on the other that relative prices may remain undisturbed only when the price level changes, we have to give up the generally received opinion that if the general price level remains the same, the tendencies toward economic equilibrium are not disturbed by monetary influences, and that disturbing influences from the side of money cannot make themselves felt otherwise than by causing a change of the general price level.

This doctrine, which has been accepted dogmatically by almost all monetary theorists, seems to me to lie at the root of most of the shortcomings of present-day monetary theory and to be a bar to almost all further progress. Its bearing on various proposals for stabilization is obvious. In these lectures, however, it is in the theoretical foundations of these schemes rather than in the formulation of alternative practical proposals that we are interested. And here, it may be suggested, it is possible very greatly to underestimate the changes in economic theory which are implied once we drop these unjustified assumptions. For when we investigate into all the influences of money on individual prices, quite irrespective of whether they are or are not accompanied by a change of the price level, it is not long before we begin to realize the superfluity of the concept of a general value of money, conceived as the reverse of some price level. And, indeed, I am of the opinion that, in the near future, monetary theory will not only reject the explanation in terms of a direct relation between money and the price level, but will even throw overboard the concept of a general price level and substitute for it investigations into the causes of the changes of relative prices and their effects on production. Such a theory of money, which will be no longer a theory of the value of money in general, but a theory of the influence of money on the different ratios of exchange between goods of all kinds, seems to me the probable fourth stage in the development of monetary theory.

This view of the probable future of the theory of money becomes less startling if we consider that the concept of relative prices includes the prices of goods of the same kind at different moments, and that here, as in the case of interspatial price relationships, only one relation between the two prices can correspond to a condition of “intertemporal” equilibrium, and that this need not, a priori, be a relation of identity or the one which would exist under a stable price level. (This has a particular bearing on the problem of money as a standard of deferred payments, because in this function money is to be conceived simply as the medium which effects an intertemporal exchange.) If this view is correct, the question which in my opinion will take the place of the question whether the value of money has increased or decreased will be the question whether the state of equilibrium of the rates of intertemporal exchange is disturbed by monetary influences in favor of future or in favor of present goods.37

(9) It will be the object of the following lectures to show how it is possible to solve at least some of the most important problems of monetary theory without recourse to the concept of a value of money in general. It will then remain for you to make up your mind whether we can conceivably entirely dispense with it. For the moment, I wish only to remind you of one further reason why it seems that, in the case of money, in contrast to any other good, the question of its value in general is of no consequence.

We are interested in the prices of individual goods because these prices show us how far the demand for any particular good can be satisfied. To discover the causes why certain needs, and the needs of certain persons, can be satisfied to a greater degree than others is the ultimate object of economics. There is, however, no need for money in this sense—the absolute amount of money in existence is of no consequence to the well-being of mankind—and there is, therefore, no objective value of money in the sense in which we speak of the objective value of goods. What we are interested in is only how the relative values of goods as sources of income or as means of satisfaction of wants are affected by money.

The problem is never to explain any “general value” of money but only how and when money influences the relative values of goods and under what conditions it leaves these relative values undisturbed, or, to use a happy phrase of Wicksell, when money remains neutral relatively to goods.38 Not a money which is stable in value but a neutral money must therefore form the starting point for the theoretical analysis of monetary influences on production, and the first object of monetary theory should be to clear up the conditions under which money might be considered to be neutral in this sense. We stand as yet at the very beginning of this kind of investigation. And, though I hope that what I say in the next lectures may help a little, I am fully conscious that all results we obtain at this stage should only be regarded as tentative. So far as I am concerned, it is the method of approach more than the details of the results which is of importance in what follows.