7. The Concept of the Value of Money

CHAPTER 7 THE CONCEPT OF THE VALUE OF MONEY

Summary

The main task of economic theory is to explain money’s objective exchange value, or what is often called the purchasing power of money. This refers to the amount of goods that someone can obtain in the marketplace with a unit of money. This explanation in turn ultimately goes back to subjective valuations.

What sets money apart from all other goods is that money is useful (and hence valuable) to people only because of its purchasing power. In its capacity as a medium of exchange, a unit of money is only useful inasmuch as it can be used to acquire other goods and services.

When we say a particular good has objective exchange value, the term “objective” is not used to mean that this value inherently resides in the object. All market prices are ultimately determined by subjective human preferences, and therefore are subject to change whenever people’s valuations change. A typical good’s “objective” exchange value is still determined by the subjective use-values of the end user. (For example, a car manufacturer will produce cars based not on his personal whims, but on how much he can charge for them in the market. Yet these prices themselves are due to how much his customers enjoy driving the various vehicles.)

The one essential difference with money is that it has no subjective use-value, which could ultimately explain its objective exchange value. Its only value—qua money—derives from its ability to exchange for other goods in the market. This is why applying modern subjective value theory to the explanation of objective money prices is such a tricky affair. Those economists of Mises’s day who tried to explain the purchasing power of money based solely on its industrial applications, were completely evading the issue. In particular, they would be helpless to explain the purchasing power of fiat money.

Chapter Outline

1. Subjective and Objective Factors in the Theory of the Value of Money

When it comes to money, the main task of economic theory is to explain its objective exchange value, or what is often called the purchasing power of money. This refers to the amount of goods that someone can obtain in the marketplace with a unit of money. This is an objective fact: if Tom sees that a dollar bill can purchase three postage stamps, then Bill will observe the same purchasing power as well.

Even though economics focuses on the explanation of money’s objective exchange value, the explanation itself ultimately goes back to subjective valuations. For the economist grounded in the modern subjective value theory (developed by Carl Menger and his followers), all prices in the market must be explained by reference to individuals’ subjective valuations. This rule holds even for money.

When it comes to explaining the price of, say, an original painting by Picasso, the economist starts with the fact that some people place a very high subjective value on holding such artwork. The economist has no obligation to explain why people enjoy the mere possession of a canvas covered in paint; he or she takes this preference as a given, and proceeds to explain the exchange value of the Picasso in the marketplace. Yet when it comes to money, the economist can’t explain its “price” (i.e., purchasing power) merely by saying that people enjoy acquiring and holding cash balances. Such an argument—by itself—would be circular, because the reason people want to hold cash balances is that money has purchasing power. That is why explaining the “price” of money is a much subtler task than explaining the price of a Picasso.

2. The Objective Exchange Value of Money

The objective exchange value of goods can be defined as “their objective significance in exchange” or “their capacity in given circumstances to procure a specific quantity of other goods as an equivalent in exchange.” Nowadays we might use the term market value to express the same concept as objective exchange value.

When we say a particular good has objective exchange value, the term “objective” is not used to mean that this value inherently resides in the object. (In other words, we are not using the term the same way that a good might have an objective weight or color.) All market prices are ultimately determined by subjective human preferences, and therefore are subject to change whenever people’s valuations change. But a good’s market value is still “objective” in the sense that any individual can take it as a given fact.

The objective exchange value of money refers to the possibility of obtaining a certain quantity of other goods in exchange for the money, while the price of money is this actual quantity of other goods. (The terms are not identical, but are very similar, as Mises explains on page 101.)

3. The Problems Involved in the Theory of the Value of Money

In modern economies, producers as a rule evaluate their output on the basis of subjective exchange value, rather than subjective use-value. For example, the owner of an automobile factory doesn’t order his employees to produce cars that he himself wants to drive. On the contrary, he instructs his employees to make cars that he plans on selling to others, based on what his customers want to drive. When formulating his business plans, then, he is guided by his personal, subjective valuations of the other goods he will be able to buy (houses, fancy meals, yachts, etc.) with the revenues from the sale of his cars.

In order for the owner of the automobile factory (and other producers) to accurately envision the tradeoffs of different production decisions, he needs to know the objective exchange value of the various cars he could manufacture. It’s not enough that the car producer knows that he values yachts and steak dinners; he also needs to know how much money he can raise by selling different models of his cars, and how much money he will need to spend if he wants to acquire yachts and steak dinners. Thus most production decisions involve a complex interdependence on both subjective and objective valuations.

The one essential difference with money is that it has no subjective use-value, which could ultimately explain its objective exchange value. In contrast, when it comes to the automobiles, yachts, and steak dinners, the economist ultimately could explain their relative exchange values (i.e., how many automobiles would trade for one yacht, etc.) by reference to individuals’ subjective use-values from them (i.e., how much people liked driving cars, versus piloting yachts or eating steak).

But with money, its only value—qua money—derives from its ability to exchange for other goods in the market. This is why applying modern subjective value theory to the explanation of objective money prices is such a tricky affair. Those economists of Mises’s day who tried to explain the purchasing power of money based solely on its industrial applications, were completely evading the issue. In particular, they would be helpless to explain the purchasing power of fiat money.

Technical Notes

• In the beginning of this chapter, Mises spends time placing his analysis of money within the framework of subjective value theory, as it had been developed by his Austrian predecessors (notably Menger, Böhm-Bawerk, and Wieser). Some of the terminology may appear quaint to modern economists, even those who have studied Austrian economics. But to properly explain the process by which subjective individual valuations generate objective market prices, it is necessary to distinguish between use-value and exchange value, and these concepts in turn both come with a subjective and an objective dimension. For example, the objective use-value of a pig would include the collection of bacon strips it could physically yield, while the objective use-value of a tomato seed would include the tomatoes it could physically yield. These would be empirical facts, not subject to opinion. However, a vegetarian would probably assign a lower subjective use-value to the pig than to the tomato seed, while a meat-lover might do the opposite. On the other hand, both the vegetarian and the meat-lover would agree that the objective exchange value of the pig is much higher than that of the tomato seed. For example, it would be an indisputable fact that the pig could fetch more grams of gold (or dollar bills) than the tomato seed, if both were put up for sale.

• Applying these concepts to money, Mises explains (pp. 97-98) that there are two acceptable ways of making an important point. One way is to claim that money’s subjective use-value is the same as its subjective exchange-value. (That is, the significance that a particular individual attributes to a quantity of money, must be the same significance that he or she attributes to the goods for which the money can be exchanged, because the money can’t be used to satisfy wants directly.) A different way to make the point is to say that money has no use-value at all, because any value it possesses necessarily derives from its exchange value. Mises doesn’t take a position on which of these alternate descriptions is better; he merely wants to stress the fundamental point that people consider money useful and valuable only because they expect to use it to acquire other goods. (Of course Mises is talking about money qua money. A bar of gold, for example, can still possess use-value for its industrial or ornamental applications.)

New Terminology

Exchange value: The significance of a good due to its ability to be traded for other goods. (Exchange value can be qualified as either subjective or objective.)

Market value: Synonymous with the objective exchange value of a good, typically quoted in money terms.

Objective exchange value of money: The possibility of obtaining a certain quantity of other goods in exchange for a unit of money.

Price of money: The quantity of goods (or services) that must be given up in exchange to acquire a unit of money.

Use-value: The significance of a good due to its ability to be directly used by the owner in consumption or production. (Use-value can be qualified as either subjective or objective.)

Study Questions

1. What is the central element in the economic problem of money? (p. 97)

2. Does the subjective theory of value apply to the case of money, as to all other goods? (p. 97)

3. Explain: “In the case of money, subjective use-value and subjective exchange value coincide.” (p. 97)

4. Explain: “It should be observed that even objective exchange value is not really a property of the goods themselves, bestowed on them by nature....” (p. 100)

5. If money (e.g., gold) has an industrial use as well as a monetary use, what will be the relation between its objective exchange values in those two different applications? (pp.104–05)

Study Guide to the Theory of Money and Credit