8. The Determinants of the Objective Exchange Value, or Purchasing Power, of Money

CHAPTER 8 THE DETERMINANTS OF THE OBJECTIVE EXCHANGE VALUE, OR PURCHASING POWER, OF MONEY

Summary>

The usefulness of money derives solely from its purchasing power. Therefore, today’s valuation of money is dependent on its purchasing power yesterday, which in turn was influenced by money’s purchasing power two days ago. Such reasoning does not lead to an infinite regress, because at some point in the past we arrive at the state of direct exchange, when goods were only valued for their direct use. This theory of the origin of money is the only one compatible with a subjectivist explanation.

The historical continuity in the value of money distinguishes it from all other commodities. People do not derive their utility from apples or oranges based on their prices, but people do evaluate the usefulness of a quantity of money based on its purchasing power.

The problem with many rival theories of the purchasing power of money—such as a simple quantity theory or “supply and demand” explanation—is that they have to take the value of money as given, and can only explain deviations from this stipulated starting point. They can’t explain the absolute level of money-prices, i.e., they can’t explain the actual exchange ratio between money and other goods at a particular time. The subjectivist, marginal-utility theory developed by Menger and his successors can explain the precise, absolute money-prices of the market today.

The exchange ratio between money and all other goods—in other words, the purchasing power of money—may be affected by changes in people’s valuations of the money side or the (other) commodities side of the ratio.

In its crudest form, the quantity theory of money is obviously wrong: It is simply not true that, say, a doubling in the quantity of money will lead to an exact doubling of all prices (quoted in money).

Modern value theory must explain the demand to hold money by starting with the subjective preferences of the individual. The community’s demand to hold money is simply the summation of the individual demands. No individual can make use of the popular “macro” approaches, which employ formulas involving “total volume of transactions” and “velocity of circulation.” Economists therefore should not use such concepts when explaining the purchasing power of money.

Money certificates are money substitutes that are fully “covered” by money proper, while fiduciary media are money substitutes that are issued above the redemption fund.

Chapter Outline

I. THE ELEMENT OF CONTINUITY IN THE OBJECTIVE EXCHANGE VALUE OF MONEY

1. The Dependence of the Subjective Valuation of Money on the Existence of Objective Exchange Value

In order for individuals to evaluate the subjective value of money, they must first consider its usefulness which is derived solely from its purchasing power. In this sense, today’s valuation of money is dependent on people’s observations of its purchasing power yesterday. And yesterday’s purchasing power, in turn, was influenced by money’s purchasing power two days ago.

Such reasoning does not lead to an infinite regress, because at some point in the past we arrive at the state of direct exchange, when goods were only valued for their direct use. At that time, goods such as gold and silver—which would become money, down the road—were valued exclusively for their industrial and ornamental purposes.

2. The Necessity for a Value Independent of the Monetary Function Before an Object can Serve as Money

The previous discussion has established that in order for individuals to place a value upon money, they must have some basis for forecasting its future purchasing power. The only way they can do this, is if the money good already has a history of objective exchange value, which the individuals can consult.

This reasoning shows the flaw in the myths about the creation of money being due to a social pact. Rather, Menger’s theory of the origin of money—in which the money commodities were originally used as ordinary commodities—is the only one compatible with a subjectivist explanation.

3. The Significance of Pre-Existing Prices in the Determination of Market Exchange Ratios

The historical continuity in the value of money distinguishes it from all other commodities. It is true that there appears to be “inertia” with respect to exchange ratios between goods; if 2 apples trade for 1 orange on Tuesday, it is unlikely that 20 apples will trade for 1 orange on Wednesday. But it is not true that Tuesday’s exchange ratio somehow influences Wednesday’s. Rather, the underlying determinants of Tuesday’s price (such as people’s subjective preferences for the two fruits) probably will not change very much by Wednesday.

In contrast, economic theory does need to rely on Tuesday’s purchasing power of money, in order to explain Wednesday’s purchasing power of money. People do not derive their utility from apples or oranges based on their prices, but people do evaluate the usefulness of a quantity of money based on its purchasing power.

4. The Applicability of the Marginal-Utility Theory to Money

The problem with many rival theories of the purchasing power of money—such as a simple quantity theory or “supply and demand” explanation—is that they have to take the value of money as given, and can only explain deviations from this stipulated starting point. For example, it is correct to say, “If a car originally has a price of $1,000, then an increase in the stock of money will, other things equal, lead to a new car price that is higher than $1,000.”

Yet this isn’t really a full explanation; why wasn’t the car’s original price $10, or $100,000? The simple “supply and demand” approach—correct as far as it goes—by itself can’t explain the absolute level of money-prices, i.e., it can’t explain the actual exchange ratio between money and other goods at a particular time.

The subjectivist, marginal-utility theory developed by Menger and his successors can explain the precise, absolute money-prices of the market today, just as it can explain the precise exchange ratios between apples and oranges.

At first it appears that money is a peculiar case that cannot be handled this way, because people’s marginal utility of money is itself derived from its objective purchasing power. But once we introduce the time element, we are not arguing in a circle. We are explaining today’s purchasing power of money by reference to yesterday’s purchasing power, and so on. We can logically follow the chain all the way back in time, until the point at which the money commodity was valued solely for its nonmonetary uses, i.e., before it became a medium of exchange.

5. “Monetary” and “Nonmonetary” Influences Affecting the Objective Exchange Value of Money

The preceding sections have established the origin of the value of money. (Namely, subjective marginal utility analysis—coupled with Menger’s explanation of the origin of money—can explain today’s absolute level of the purchasing power of money.) It is now acceptable to focus on the laws or principles governing changes in the value of money. Economists usually start at this step, even though logically they should have explained the original value of money first.

The exchange ratio between two goods can be affected by changes in the valuation for just one of the goods. For example, on Tuesday Jim may choose to drink soda over cough medicine. But on Wednesday he may reverse his preferences, and choose the medicine over the soda. This obviously needn’t be due to Jim’s sudden distaste for soda.

In the same way, the exchange ratio between money and all other goods—in other words, the purchasing power of money—may be affected by changes in people’s valuations of the money side or the (other) commodities side of the ratio.

II. FLUCTUATIONS IN THE OBJECTIVE EXCHANGE VALUE OF MONEY EVOKED BY CHANGES IN THE RATIO BETWEEN THE SUPPLY OF MONEY AND THE DEMAND FOR IT

6. The Quantity Theory

The germ of truth in the historical expositions of the quantity theory is that a connection exists between variations in the value of money on the one hand, and variations in the relations between the demand for money and the supply of it on the other. Throughout history, writers have noted the patterns, but the task for the modern economist is to express these truisms with the tools of modern subjective value theory.

7. The Stock of Money and the Demand for Money

In certain cases it is useful to distinguish between the individual’s demand to hold money in the broader sense versus money in the narrower sense. The former is the individual’s demand to hold both money and money substitutes (i.e., perfectly secure and immediate claims on money). The latter is the individual’s demand to hold money proper.

Money certificates are money substitutes that are fully “covered” by money proper, while fiduciary media are money substitutes that are issued above the redemption fund. For example, if a particular commercial bank accepts 1,000 ounces of gold in deposits which it keeps in the vault, but issues 1,100 paper banknotes entitling the bearer to an ounce of gold upon presentation, then 1,000 of the notes are money certificates, while 100 are fiduciary media. (In commercial practice the notes are indistinguishable, and so we can say that about 91 percent of a given note is “covered” while the remainder is “unbacked.”)

8. The Consequences of an Increase in the Quantity of Money While the Demand for Money Remains Unchanged or Does Not Increase to the Same Extent

A crude, mechanical version of the quantity theory of money holds that a doubling of the stock of money will lead to a uniform doubling of the money prices of all other goods and services. The logic behind such a view rests on the true observation that any given quantity of money can perform all the services of money for the community, with the appropriate “price level.” For example, we can imagine two economies side-by-side, which are equal in all ways except that the second community has twice the amount of money as the first. It is clear that in the second community, the prices of all goods and services have to be exactly double their values in the first community, in order to render these economies equal in all “real” respects.

Yet from this thought experiment, we cannot conclude that if we started with the first community, and then magically doubled everyone’s holding of money, that we would end up with the second community. For one thing, different individuals would respond differently to the increase in their holdings of money. Everyone would of course revise downward his or her marginal utility for a unit of money—because the stock in possession increased—but these downward movements would not be equal for all people. Because the marginal unit of money would be less valuable than before the magical increase, people would now go out and buy more goods, tending to push up prices. But different people would increase their purchases in different ways, and (in any realistic scenario) would push up the prices of some goods more than others.

Another complication is that in the real world, new influxes of money do not magically augment the cash balances of everyone in the community proportionally. Instead, new money enters the community through increased holdings of a small group of people (such as the owners of gold mines, or the customers who borrow money from a bank issuing fiduciary media). Thus the new money ripples out into the economy, as the first recipients spend the new money, then the second recipients spend it, and so on.

Nobody would ever be so foolish as to claim that, say, a doubling of the quantity of sugar would lead to an exact halving of the exchange ratio of sugar against all other goods and services. Yet that is precisely what the crude Quantity Theorists assert when it comes to money.

9. Criticism of Some Arguments Against the Quantity Theory

Although in its crude form, the quantity theory is erroneous, even so we can defend it from some invalid objections. For example, some writers object that the quantity theory only holds ceteris paribus (i.e., when “other things are held equal”). Yet this is hardly a good objection against the quantity theory, since a critic could say the same thing about any law or principle in economic science.

Another objection people have raised against the quantity theory is that its predictions are in actual practice nullified by the behavior of “hoards.” For example, the critic of the quantity theory might say that a large influx of new money won’t have a tendency to push up prices, because some people in the community will simply expand their holdings of cash. On the other hand, say these critics, if the demand to hold money (for reasons of commerce) should suddenly increase, this won’t lead to a fall in prices (as the quantity theory would predict), because the hoards will release some of their cash into the community to satisfy the new demand.

The fundamental problem with this view is that economically, there is no distinction between the normal demand to hold cash versus “hoarding.” At any moment in time, every unit of money in the community is in someone’s cash balance; there is no such thing as money “in circulation” that could be contrasted with money “sitting idle.”

The money held by a hoarder performs the same economic function as the money held by a normal businessperson; they are both holding the money because they expect to achieve greater satisfactions from what it can buy in the future, than from what it could buy in the present. Because of uncertainty, people do not necessarily “earmark” every unit of money for a particular future purchase. Nonetheless, when we analyze why people hold money at all, we realize that there is no qualitative difference between the hoarder and the nonhoarder. All hoarding really means, is that someone carries cash balances larger than his peers’.

10. Further Applications of the Quantity Theory

Generally speaking, the demand for money increases over time, due to population increases and the intensification of the division of labor (and hence the need for exchange transactions). For this reason, it was only a theoretical curiosity for economists to try to explain what would happen if the demand for money fell, while the stock of money remained the same.

If we were to mechanically apply the quantity theory to such a situation, we would conclude that prices would rise (i.e., the purchasing power of money would fall) uniformly, in direct proportion to the drop in demand for money. However, a more satisfactory explanation needs to take into account the subjective valuations of individuals. Rather than focusing merely on crude aggregates, it is better to analyze the scenario by saying that when the demand for money falls (while the stock of it remains constant), individuals discover that they are holding larger cash balances than they desire. To improve their position, they seek to exchange some of their excess cash holdings for other goods or services. In doing so, they push up the prices of these items.

Eventually, the fall in money’s purchasing power reduces the “real” size of an individual’s cash balance until he is happy with it. If everyone in the community decides he or she is holding “too much money,” the only way to restore equilibrium is for prices to rise. If one person reduces his cash balance by spending, the seller necessarily increases his cash balance by the same amount. The given stock of money is rearranged among the people in the community; per capita cash balances have to remain the same. Even so, the rise in prices can satisfy everyone’s desire to hold smaller cash balances, because cash is held for the purpose of acquiring other goods and services. People evaluate the size of their cash holdings in terms of its purchasing power, not really by how many units of money they possess.

Although historically the demand for money itself generally grows—except perhaps for financial crises—there are cases where the demand for particular kinds of money may fall dramatically. A notable example is the demonetization of silver. As this precious metal ceased being used as a medium of exchange, and became valued solely for its industrial and ornamental applications, its exchange value fell.

III. A SPECIAL CAUSE OF VARIATIONS IN THE OBJECTIVE EXCHANGE VALUE OF MONEY ARISING FROM THE PECULIARITIES OF INDIRECT EXCHANGE

11. “Dearness of Living”

Thus far in the chapter the analysis of the objective exchange value of money has only relied on determinants that could have just as well been applied to any commodity, not just the commonly accepted medium of exchange (i.e., the money commodity). In contrast, section III examines possible changes in the objective exchange value of money that can only apply because it is a medium of exchange. The context of the discussion is the layperson’s complaint of the “dearness of living,” meaning that every generation prices seem to be higher than before.

12. Wagner’s Theory: The Influence of the Permanent Predominance of the Supply Side over the Demand Side on the Determination of Prices

Wagner explains the general rise in prices—or what is the same thing, the general fall in the purchasing power of a unit of money—by the alleged superior power of the “supply side” of the economy. The sellers of goods and services stand more to gain from price hikes than their customers stand to lose, because the price of beef (say) affects the livelihood of the butcher far more than it affects the fortunes of the average household. Wagner’s theory is flawed, however, because it cannot easily incorporate the fact that retail prices must also respond to changes in wholesale prices.

13. Wieser’s Theory: The Influence on the Value of Money Exerted by a Change in the Relations Between Natural Economy and Money Economy

Wieser attempts to explain the persistent rise in prices over time by the gradual transformation of a “Natural Economy” into a “Money Economy.” As more and more people and regions are brought into the practice of monetary exchange, Wieser argues that certain things that were previously handled through home production must now be included in the final price of goods intended for market. Wieser offers a specific example of the prices of milk and eggs rising in a rural village, once the villagers become involved with frequent trade with the much larger town. However, Wieser ignores the obvious flip-side of the development: the prices of milk and eggs will be lower in the town because of the new source of supply. The integration of the rural village into the monetary nexus gives no reason for a general rise in prices, it merely explains why the gap in prices (between the town and village) should be whittled away.

14. The Mechanism of the Market as a Force Affecting the Objective Exchange Value of Money

In direct exchange, if a potential buyer believes that the asking price of the seller is too high, the exchange will not occur. However, with the use of money, there is another possible outcome, that seems to happen in the real world. The buyer may go ahead and pay a price (in money) that he originally deemed “too high,” but will compensate by increasing the asking price for the goods that he has to sell. Thus wage earners might acquiesce in higher food prices, yet demand pay increases from their employers. The employers, in turn, might agree, knowing that they will raise prices themselves.

None of this discussion renders the basic theory of price determination invalid. It merely underscores that with the special case of money, peculiar situations can affect its valuation that simply cannot occur in the case of direct exchange.

IV. EXCURSUSES

15. The Influence of the Size of the Monetary Unit and Its Subdivisions on the Objective Exchange Value of Money

It is often asserted that the size of the monetary unit can affect its purchasing power, i.e., the general height of prices. In regard to wholesale prices, this is clearly absurd: merchants would adjust their large-scale transactions to achieve their desires, regardless of the unit.

However, there is some truth to the assertion when it comes to retail trade. For practical reasons, everyday purchases that have very low prices compared to most other goods (such as letter postage or pieces of fruit) must correspond somewhat to the lowest available denomination of the money. The use of token coinage (which can represent fractions of the standard monetary unit) and money substitutes, as well as the practice of selling multiple units of goods (e.g., a dozen eggs) as a package, can provide a wide range of flexibility, but even so it must be admitted that the size of the monetary unit does have an influence on prices quoted at the retail level.

16. A Methodological Comment

In a review of the first edition of the book, Professor Walter Lotz defended Laughlin from the critique leveled by Mises (on pages 125–28 in the present edition of the book). To review, Laughlin had tried to explain the value of paper gulden (which for a time were not redeemable in precious metal) by the prospect of their eventual redemption. Mises examined the discount investors placed on bonds issued by the same government and concluded that there must be some other factor at work, to explain the premium investors placed on the paper gulden. The answer, of course, was that the paper gulden were used as money, whereas the bonds were not. Therefore the paper gulden were valued on account of their use as media of exchange.

Lotz defends Laughlin by referring to statements from influential figures that they truly did speculate on the eventual redemption of the paper gulden. Mises points out that this entirely misses the point of his critique: Even if it is admitted that the paper gulden would eventually be redeemable for gold, that fact wouldn’t explain why the notes traded at a premium to bonds issued by the same government. More generally, Lotz approaches economic problems not through theoretical reasoning, but by appeal to historical circumstances, a procedure that Mises rejects on methodological grounds.

Important Contributions

• On page 108, Mises alludes to Menger and Böhm-Bawerk’s explanations of how prices are determined in direct exchanges (i.e., what most people call “barter”). For example, suppose people in a community own horses, and others own cows. Each person will rank various units of each animal on his own subjective scale of values. Bill might consider his first horse as the most important animal, then his first cow, and then his second horse. John, in contrast, might consider his first and then second cows to occupy the highest- and second-highest ranks in his scale of values, while his first horse comes in at the third slot. (Note that everyone exhibits diminishing marginal utility in each animal.) People will trade horses for cows so long as there are mutually beneficial trades; perhaps Bill will trade his 17th and 18th cows for John’s 6th horse, because such a trade makes both men better off in their own subjective views. (In this case, the “price” of one horse is two cows.) To understand the description Mises gives to the range of possible market prices under bilateral competition, the reader should consult the numerical example in Murray Rothbard, Man, Economy, and State (scholar’s edition, 2nd edition; Auburn, Ala.: Mises Institute, 2009, pp. 106-26).

• The first sections of this chapter lay out Mises’s famous regression theorem, which successfully applies subjective value theory to the case of money. Earlier economists had been unable to accomplish this feat, because they thought the approach would lead to a circular argument in the case of money. (How can we explain the objective purchasing power of money by reference to subjective valuations, when those subjective valuations in turn are completely dependent on money’s objective purchasing power? It seemed to Mises’s predecessors that this approach said, “Money is valuable because money is valuable.”) Mises broke out of the circularity by introducing the time element: People are willing to sell other goods and services for money today because they expect that same money to command purchasing power tomorrow. (This explains money’s purchasing power today.) But people’s expectations about the future purchasing power of money are formed by their observations of the recent past, i.e., their observations of money’s purchasing power yesterday. We can push the explanation all the way back until the point at which (commodity) money had an objective exchange value due entirely to its use in nonmonetary applications.

• On page 160 Mises gives a simple illustration (involving a pear, lemonade, etc.) of how an individual’s scale of values can be transformed with the possibility of market exchange.

New Terminology

Quantity theory of money: An old doctrine explaining changes in the purchasing power of money by reference to the quantity of money and the demand to hold it. (There are many versions of the quantity theory, with the more mechanical ones—which posit that a doubling of the money stock will lead to a doubling of all prices—being obviously wrong.)

Money certificates: Money substitutes that are fully backed by money (in the narrower sense).

Fiduciary media: Money substitutes issued over and above the money (in the narrower sense) held in the redemption fund. Fiduciary media are “unbacked.”

Hoards (noun): People who accumulate large cash balances in certain circumstances, allegedly counteracting the predictions of a naïve quantity theory of money.

Regression Theorem: Mises’s argument that the current purchasing power of money is influenced by people’s memory of yesterday’s purchasing power. The causality is traced back in time, until the point at which the money good was valued as a regular commodity in direct exchange.

Study Questions

1. Explain: “The subjective value of money must be measured by the marginal utility of the goods for which the money can be exchanged.” (p. 109)

2. If all types of money must have originally had a nonmonetary source of valuation, how can Mises explain fiat money? (pp. 110–11)

3. If the “past value of money is taken over by the present,” does that mean current conditions and expectations have no influence on the value of money today? (p. 111)

4. Explain: “If all the exchange ratios of the past were erased from human memory, the process of market-price-determination might certainly become more difficult ... but it would not become impossible.” (p. 113)

5. Explain: “[A] mechanical theory of price-determination was arrived at—a doctrine of Supply and Demand.... It is correct or incorrect, according to the content given to the words Supply and Demand.” (pp. 128-29)

Study Guide to the Theory of Money and Credit