CHAPTER 11 MONEY AND ITS PURCHASING POWER Chapter Summary

Like all goods, the price of money is determined by the interaction between supply and demand. Money is unique in that its “price” is not a single number—in this sense the price of an ounce of gold would always be one (oz. gold). Rather, the price of a unit of money is an entire vector of the money commodity’s exchange ratios with units of every other good and service available on the market. The purchasing power of money (PPM) is thus its “price.” At any given time, all units of money are in someone’s possession, i.e., comprise part of someone’s cash balance. There is no such thing as money “in circulation.” Thus it is arbitrary to denounce “hoarding.”

If the demand for money increases, this means that people wish to hold a stock of money balances higher than the actual stock in existence. This “shortage” of money balances can be eliminated through a rise in the PPM of money. A similar analysis holds for a drop in the demand for money. If the total stock of money changes, the PPM also adjusts until the quantity demanded of money equals the size of the new stock. The total stock of money increases with mining, etc., but decreases through wear and tear, and as the money commodity is devoted to industrial or consumption purposes.

Money is useful only insofar as it possesses purchasing power. Other things equal, it is always better to have more producer or consumer goods. In contrast, any stock of money can fully perform the functions of a medium of exchange.

Money would fade out of use in the ERE. With perfect certainty, people would loan out their cash balances and schedule repayment just in time for their planned expenditures.

The PPM and the rate of interest are not inherently connected. For example, the demand for money could increase (raising the PPM), yet if time preferences remain the same, this will not affect the (real) rate of interest.

New money always enters the economy at specific points; contrary to typical thought experiments, it is never the case that everyone’s cash balance suddenly increases by a certain percentage. Even in such an unrealistic scenario, money would still be “non-neutral”: Some people would spend their new money more quickly than others, and thus would experience a relative gain as the PPM adjusted to the new stock.

If there are two or more commonly accepted media of exchange, their exchange ratio will be such that no arbitrage opportunities are available in selling the moneys against other goods. This is termed purchasing power parity. For example, if an ounce of gold buys 1,000 DVDs while an ounce of platinum buys 2,500, then the equilibrium exchange rate must be 2.5 ounces of gold for 1 ounce of platinum.

Money is not a measure of value. When someone buys a TV for $50, we cannot conclude that he “values it” at $50; on the contrary we know that he values the TV more than he valued the $50. All price indices are arbitrary.

In reaction to the wild swings of the PPM (caused by government), many economists propose various schemes to “stabilize” the PPM. Yet such proposals are undesirable and unworkable.

Chapter Outline

1. Introduction

Earlier chapters dealt with the emergence of money out of barter, and the formation of money prices. In the present chapter we analyze the impact changes in the money relation have upon the (unhampered) market.

2. The Money Relation: The Demand for and the Supply of Money

Like all goods, the price of money is determined by the interaction between supply and demand. Money is unique in that its “price” is not a single number—in this sense the price of an ounce of gold would always be one (oz. gold). Rather, the price of a unit of money is an entire vector of the money commodity’s exchange ratios with units of every other good and service available on the market. The purchasing power of money (PPM) is thus its “price.”

The total demand for money consists of (1) the exchange demand for money (by sellers of all other goods who wish to purchase money) and (2) the reservation demand (by those who already hold money). As with all goods, the demand curve for money is downward sloping: as the PPM falls, people will demand a greater quantity of the money commodity.

At any given time, all units of money are in someone’s possession, i.e., comprise part of someone’s cash balance. There is no such thing as money “in circulation.” Thus it is arbitrary to denounce “hoarding.”

The supply of money at any given time is a vertical line; regardless of the PPM, there are just so many units of money in the economy. (Remember that we are using the total demand/total stock analysis.) The equilibrium PPM is then determined by the intersection of the total demand curve with the given total stock.

3. Changes in the Money Relation

If the demand for money increases, this means that people wish to hold a stock of money balances higher than the actual stock in existence. This “shortage” of money balances can be eliminated through a rise in the PPM of money; that is, if people want to hold higher money balances, they stop spending as liberally and thus the nominal money prices of other goods and services fall until equilibrium is reestablished. (Recall that people ultimately care about their real cash balances; a given nominal stock of money can represent any desired real cash balance with the appropriate PPM.) A similar analysis holds for a drop in the demand for money. If the total stock of money changes, the PPM also adjusts until the quantity demanded of money equals the size of the new stock.

4. Utility of the Stock of Money

In its capacity as a medium of exchange, money is useful only insofar as it possesses purchasing power. If producer or consumer goods were available for free, this would be a tremendous boon to humanity. But if money has a zero price, it is useless. Other things equal, it is always better to have more producer or consumer goods. In contrast, any stock of money can fully perform the functions of a medium of exchange. Increasing the money stock (aside from its nonmonetary uses) can’t make the community richer per capita; it can only redistribute wealth.

5. The Demand for Money

A. Money in the ERE and in the Market

Money would fade out of use in the ERE. With perfect certainty, people would loan out their cash balances and schedule repayment just in time for their planned expenditures. But if everyone is doing this, then the demand for money (i.e., the desire to hold cash balances) would be virtually nonexistent. In the real world of uncertainty, “idle” cash balances perform a useful service, as they are a means to cope with unplanned expenditures.

B. Speculative Demand

People’s demand for money may be influenced by their speculation about future changes in the PPM. For example, if a woman expects that prices in general will rise greatly in a few months, this may lower her current demand for money (i.e., she will spend more). Thus her expectation of a future fall in the PPM will lead to a reduction in the current PPM of money.

C. Secular Influences on the Demand for Money

As an economy grows, there are more exchange opportunities and hence (ceteris paribus) an increase in the demand for money. On the other hand, the development of clearing systems reduces the demand for cash.

D. Demand for Money Unlimited?

Some reject the notion of a demand for money, because “people always want more money.” Yet this is true for all producer and consumer goods! It is simply not true that people always want more money (cash); indeed, anyone who owns any nonmonetary asset demonstrates that he or she does not want “more money.”

E. The PPM and the Rate of Interest

The PPM and the rate of interest are not inherently connected. For example, the demand for money could increase (raising the PPM), yet if time preferences remain the same, this will not affect the (real) rate of interest. Instead, each person could increase his cash balances by reducing expenditures on present and future goods in a proportion reflecting the original time preference.

F. Hoarding and the Keynesian System

“Hoarding” is a great evil in the Keynesian view. In this approach, macro equilibrium is achieved when two necessary conditions are satisfied: One the one hand, total income must of course equal total expenditures (since one man’s expenditure is another man’s income); this necessity corresponds to the 45-degree line on a graph. On the other hand, any individual’s expenditures are a certain function of income; at zero income, a person still needs to eat, and so there is a small expenditure. Then for every additional dollar of income, the person spends only a fraction of it. Thus an individual’s expenditure (graphed as a function of income) is a line with a positive intercept and slope between zero and one. The same holds for the community, and where the community’s line intersects the 45-degree line determines the equilibrium amount of income.

The unique feature of the Keynesian system was that this macro equilibrium could occur at a level where real output was less than necessary for “full employment.” In order to induce employers to hire more workers, the community needed to spend more and save less (thus increasing the slope of the expenditure line, so that it intersected the 45-degree line farther to the right).

The fundamental flaw with such reasoning is that there can only be unemployment if wage rates are higher than the market clearing level. This can occur either through union pressure or government edict. Only if we assume that workers do care about money (rather than real) wages could hoarding have such sinister effects.

G. The Purchasing-Power and Terms-of-Trade Components in the Rate of Interest

Following Irving Fisher’s canonical treatment, it is standard to explain the nominal interest rate as the real rate of interest plus a “purchasing power” component. For example, if price inflation is 5 percent and the real interest rate is 5 percent, then (Fisher would argue) the nominal interest rate will be 10 percent, because lenders need to be compensated for the decline in the PPM of their money during the time of the loan. One grave problem with this is that (obviously) the nominal rate can never be negative, and so Fisher’s explanation can’t be the whole story in times of severe price deflation. Moreover, to the extent that future changes in prices are fully anticipated, present prices will adjust. “The purchasing power component, then, is not the reflection, as has been thought, of expectations of changes in purchasing power. It is the reflection of the change itself” (p. 797).

6. The Supply of Money

A. The Stock of the Money Commodity

The total stock of money increases with mining, etc., but decreases through wear and tear, and as the money commodity is devoted to industrial or consumption purposes.

B. Claims to Money: The Money Warehouse

A warehouse may issue certificates entitling the bearer to a certain good stored in the warehouse. If the community has no reason to doubt the reliability of redemption, the certificates may circulate as goods-substitutes. In the case of money, the warehouse may realize that it can issue a greater number of certificates than it can redeem; this is “fractional reserve banking” (FRB), and explains banks’ current susceptibility to “runs.” In a free market, FRB would be illegal because of its fraudulent nature.

C. Money-Substitutes and the Supply of Money

Because the public may accept money-substitutes as readily as the original money commodity, they are a commonly accepted medium of exchange and hence must be classified as money. “Money in the broader sense” refers to the total supply of money (including money certificates) in people’s cash balances, while “money proper” or “standard money” refers only to the supply of the original money commodity.

Under 100-percent reserve banking, deposits in the banking system do not influence the total supply of money, but merely change its composition (between certificates and money proper). Under FRB, however, the deposit of money proper can lead to an increase in the overall supply of money.

D. A Note on Some Criticisms of 100-Percent Reserve

Under 100-percent reserve, banks could still earn an income by charging for their warehouse services (i.e., checking accounts). They could still operate as credit intermediaries by borrowing from individuals (i.e., savings accounts) and lending the funds to borrowers at a higher interest rate. This latter activity is consistent with 100-percent reserve banking because the deposited funds are not the lenders’ money for the duration of the loan; the depositor (into a savings account) has sold present money for future money.

7. Gains and Losses During a Change in the Money Relation

New money always enters the economy at specific points; contrary to typical thought experiments, it is never the case that everyone’s cash balance suddenly increases by a certain percentage. Even in such an unrealistic scenario, money would still be “non-neutral”: Some people would spend their new money more quickly than others, and thus would experience a relative gain as the PPM adjusted to the new stock.

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

The ultimate determinants of the PPM are: (1) the stock of all goods, (2) the reservation demand for money, (3) the stock of money, and (4) the reservation demand for goods. The first two determinants increase the PPM, while the latter two decrease it.

9. Interlocal Exchange

A. Uniformity of the Geographic Purchasing Power of Money

As with all goods, the money commodity will tend to have one price in the market. Some allege that the PPM of money can differ from region to region; is not the price of a movie higher in New York than in Boise? Yet a movie in New York is not the same good as one in Boise.

B. Clearing in Interlocal Exchange

The use of clearing houses greatly facilitates interregional trade. If French consumers had to ship gold to Russia every time they wished to buy a Russian good, and vice versa, then there would be a lower volume of trade. In contrast, with clearing only the net surplus of gold needs to be shipped from one country to the other.

10. Balances of Payments

An individual’s “balance of payments” must always be in balance, so long as cash balances and credit transactions are included. In general an individual will always have huge “trade deficits” with the owners of retail shops and huge “trade surpluses” with his employer. The balance of payments for an entire nation is simply the aggregation of all the individual citizens’ balances of payments.

11. Monetary Attributes of Goods

A. Quasi Money

Some goods (such as jewels and high-grade debentures) are very liquid and hence function as quasi money. However, they are not actually money because they cannot be used to settle debts at par. Nonetheless, their high marketability raises their demand even further, and investment in them will carry a lower rate of return.

B. Bills of Exchange

Bills of exchange are credit instruments, not money substitutes.

12. Exchange Rates of Coexisting Money

If there are two or more commonly accepted media of exchange, their exchange ratio will be such that no arbitrage opportunities are available in selling the moneys against other goods. This is termed purchasing power parity. For example, if an ounce of gold buys 1,000 DVDs while an ounce of platinum buys 2,500, then the equilibrium exchange rate must be 2.5 ounces of gold for 1 ounce of platinum.

13. The Fallacy of the Equation of Exchange

The holistic approach to money is epitomized in the equation of exchange, MV=PT. This is an identity that states that the number of money units multiplied by the average rate of turnover (“velocity”), must equal the average price times the number of transactions. Apart from its lack of subjective marginal theory, there are grave flaws with this approach. The concepts of velocity and average price are completely empty; they are really just placeholders necessary to fill out the equation.

14. The Fallacy of Measuring and Stabilizing the PPM

A. Measurement

Money is not a measure of value. When someone buys a TV for $50, we cannot conclude that he “values it” at $50; on the contrary we know that he values the TV more than he valued the $50. All price indices are arbitrary.

B. Stabilization

In reaction to the wild swings of the PPM (caused by government), many economists propose various schemes to “stabilize” the PPM. Yet such proposals are undesirable and unworkable. In any event, if businesspeople really wanted to substitute a basket of commodities as the standard unit of account (rather than the money commodity), they could do so in their contracts.

15. Business Fluctuations

Particular businesses may fail because of entrepreneurial misjudgment. But during the bust phase of the “business cycle,” we see evidence of widespread error. This cannot occur on an unhampered market; its explanation will be postponed until the next chapter.

16. Schumpeter’s Theory of Business Cycles

Schumpeter’s explanation of the business cycle, though better than many others, suffers from its reliance on overlapping cycles, and it ultimately lays the blame on innovation. But Schumpeter doesn’t explain why there should be sudden clusters of innovation that trigger the boom-bust cycle.

17. Further Fallacies of the Keynesian System

A. Interest and Investment

The interest rate has no causal relation to investment; both are determined by time preferences.

B. The “Consumption Function”

In contrast to investment, Keynesians consider consumption a very “stable” function of income, and find a high correlation between the two. But since consumption is a very large fraction of income, it is no wonder! If instead Keynesians had run regressions comparing income with investment, and income with saving, they would not have classified investment as “unstable.”

C. The Multiplier

Using the exact same logic as the Keynesians, one could “prove” that the way to boost GDP by $100,000 is to give the reader an extra dollar bill.

18 The Fallacy of the Acceleration Principle

The so-called acceleration principle is best illustrated with an example: If a laundromat has ten dryers with an average life of ten years, then on average the owner will buy a new dryer every year. If his business picks up 10 percent, such that he needs to carry eleven dryers, he will have to buy two additional dryers in the first year—an increase of 100 percent. Hence the increased consumer demand has been “accelerated” by a factor of ten in the higher orders. But as Hutt first pointed out, such scenarios completely rely on the time period under consideration. If we adopt a ten-year framework, then there is no “acceleration” at all: a 10 percent increase in business translates into a 10 percent increase in sales for the producers of industrial dryers.

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Notable Contributions

• Rothbard’s critique of the Fisher relation (which equates the nominal interest rate with the real rate plus a purchasing power component) is quite unorthodox yet irresistible.

• The discussion of free coinage and 100-percent reserve banking (pp. 799–811) anticipate much of the modern Austro-libertarian literature.

• Rothbard’s critiques of Fisher’s equation of exchange (pp. 831–42), and various Keynesian concepts (pp. 859–68) are simply brilliant, and should put to rest the frequent allegation that Austrians are incapable of mathematical reasoning.

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Technical Matters

1. When Rothbard decomposes the total demand for money into the “exchange demand” and the “reservation demand” (p. 756), the former technically includes the nonmonetary demand for the money commodity (p. 760). For example, someone who sells labor services in order to acquire gold for use as fillings in his teeth would be exerting an “exchange demand” for money, even though this person does not intend to use the acquired gold as a medium of exchange.
2. In Keynes’s view, the demand for money is a downward sloping function of the nominal interest rate, not the PPM. The idea is that the opportunity cost of holding cash (as opposed to investing the money in a bond, for example) rises with the nominal interest rate: At 10 percent holding a $10 bill means forfeiting $1 in future cash, whereas at 20 percent the decision costs $2 in forgone future money. Austrians reject this explanation because (1) the (pure) interest rate is determined by time preferences and (2) the true opportunity cost of holding money is not simply (the value of) a bond but (the value of) all other goods and services that could have been purchased with the cash.
3. The reductio ad absurdum on p. 839 may have lost the reader. Rothbard arrives at the middle fraction (which has “(hats) (pounds of sugar)” in the denominator) by adding the two fractions at the top of the page. But the reader must recall from algebra that in order to add two fractions, a common denominator is necessary; Rothbard achieves it here by multiplying the left fraction by [(hats) / (hats)] and the right fraction by [(pounds of sugar) / (pounds of sugar)].

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Study Questions

1. Why does Rothbard say that the exchange demand curves for money will tend to be perfectly inelastic? (p. 757)
2. Why is each of the components of the total demand curve for money downward sloping? (pp. 757–60)
3. The total demand for money is the summation of the (pre-income) exchange demand and the (post-income) reservation demand (pp. 756–61). Suppose a man sells a car for 10 ounces of gold, and then decides to hold this 10 ounces of money in his cash balance. Do his actions count as the demand for 20 ounces of gold?
4. Why does Rothbard depict the supply of money as a vertical line? (p. 763) As the PPM of money rises, wouldn’t that induce people to mine more gold, etc.? Is Rothbard saying that the supply of money, unlike other goods, isn’t upward sloping?
5. Rothbard says that “the ‘price’ of money is precisely the variable on which the demand schedule depends” (p. 765). Isn’t this true of all commodities?
6. Is speculation in money simply a matter of “self-fulfilling prophecies”? (pp. 769–71)
7. When the demand for money changes, this alters the PPM and restores equilibrium. But does this translate into anything “real”? For example, if everyone doubles his or her cash balance, has anything really changed? If not, what purpose does it serve besides accommodating everyone’s arbitrary whims?
8. In criticizing Keynes, Rothbard argues that, “Speculation... disappears in the ERE, and hence no fundamental causal theory can be based upon it” (p. 789). Does this argument eliminate Rothbard’s ability to explain the earnings of stockbrokers or advertising executives?
9. What is the likely secular trend for the four determinants of the PPM in a progressing economy? (p. 817)
10. What are the problems with index numbers to measure the PPM? (pp. 845–46)

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