Money and Its Purchasing Power

0:00Okay, for most of my chapter, or rather for the part of the chapter on the purchasing power of money that I'm going to cover, Rothbard uses the assumption of neutral money. That is, that when there's a change in the money supply, it changes prices proportionally and therefore has no effect, and instantaneously, and therefore has no effect on the real economy. That is, that neutral money assumption is a working assumption. He doesn't believe, as neoclassical economists do today, as all macroeconomists do today, that in the long run, money is actually neutral after all of the short-run, interim effects work themselves out.

0:45But for the problems that he wants to analyze, neutral money is a very important assumption. Later on, in the part of the chapter that Professor Herbiner is covering, that assumption will be dropped. Now Rothbard has been criticized because people look at the first part of the chapter and they say, well, this is a very equilibrium analysis of money. But there are certain problems in monetary theory, certain important problems that have to be analyzed using an equilibrium construct of some kind. or to put it another way, forgetting about the intermediate effects that link the initial change to the final outcome. So we're going to suppress these initial effects and we're going to focus on what I think is a key diagram in monetary theory and this is the supply and demand for money.

1:39This diagram, believe it or not, I actually adapted it from the principal's text by N. Gregory Mankiw, who is one of the top macroeconomists writing in the U.S. today. Rothbard was probably one of the first people to have this diagram in the history of economic thought. Edwin Cannon in the 1920s wrote a book in which he verbally described this diagram, in which the demand for money was inversely related to the purchasing power of money. I'll explain that in a moment. Then later on, Rothbard had told me that after he wrote Man Economy and State, he realized that Richard Timberlake had a similar diagram in his textbook on money.

2:28But that very few others have used this diagram. So I was surprised in the principal's text that I used, Mankiw, that this diagram would appear. Now in his intermediate macroeconomics text, this is not there. He uses the straightforward quantity theory to explain the law and effects on the price level of a change in the money supply. And in the short run he uses the standard Keynesian liquidity preference diagram in which the demand for money is inversely related to the interest rate. So it's very interesting that he uses this introductory text. He then later on supplements it with the quantity theory of money or the quantity equation of Fisher. Now, Mankiw's diagram differs from Rothbard's in one respect, and it's a heuristic device, and I think it clarifies matters quite a bit.

3:20On the left y-axis, we have the purchasing power of money, and by the way, since we're making a neutral money assumption, we can take any good and use its price as a proxy for the price level, because all prices change proportionally when the money supply changes. Not quite proportionally, but we can suppress these sort of, as I said, intermediate distribution effects. In any case, the purchasing power of money is increasing as we move upward on the left side. I've used yogurt cones, Mancu uses pizza sometimes, sometimes he uses ice cream cones. I think one edition was different from the next edition. In any case, what that tells us is at point E, the equilibrium point for a moment, I'll explain that later, The equilibrium purchasing power of money is one yogurt cone.

4:13A dollar can purchase one yogurt cone. Now the reason being on the right axis is because we have the prices of yogurt cones. Now prices are increasing in a downward direction, thus the downward arrow. So that as the price of a yogurt cone is one dollar, well then the purchasing power of money is one over one dollar or one yogurt cone. As the price level rises, I was going to say as we have inflation, but it doesn't have to rise because of monetary inflation alone, but if we do have a monetary inflation, price is double, yogurt cones go from a dollar to two dollars, then the purchasing power of the dollar shrinks. That is, it can now purchase one over two or one half a yogurt cone.

5:00On the other hand, a fall or an appreciation in the value of money, which is a fall in prices, results in an increase in the purchasing power to two yogurt cones which corresponds to a price of 50 cents per yogurt cone. Okay, so I think relating prices to the purchasing power money in that way makes things a lot clearer. So Rothbard starts by pointing out that like all commodities, money, which is also a commodity, has its own supply and demand and its own price. One monetary economist once said that all errors relating to money stem from the view that money is either more than or less than a commodity.

5:49For Rothbard, money is a commodity. It's the most generally accepted or marketable or saleable commodity in the economy. So, all commodities have supply and demand, which determines their price. The difference between the monetary price or the price of money and all the prices is that money is still in a state of border with respect to the rest of the economy. Money is one half of every transaction. Therefore, money has a price in every single good traded in a monetary economy. So, money's price isn't a single price, though it can be represented as such under a regime of neutral money, or under the assumption of neutral money. It's an array of prices.

6:36It's the alternative quantities of other goods and services that can be purchased in exchange for money. So the purchasing power of money is either one yogurt cone, or one one-thousandth of an LCD, high definition LCD television, or one-twenty-thousandth of an automobile, or one-fifth of a McDonald's hamburger, and so on. So it's a whole array of alternative quantities. Now, Rothbard applies the total demand stock analysis. The reason why he does this, the reasons are twofold. Number one, everybody in the economy is a buyer and seller of money. Everyone is a dealer in money. I think Edwin Cannon may have said that.

7:22Everyone deals in money. They regularly give it away in exchange for goods. So they sell it and they regularly accept it in exchange for goods. They receive it for the things that they sell. That's number one. So at any point in time, there's a stock of money. Everyone is dealing in money. So everyone's holding it. So therefore, there isn't a specialized group of suppliers, a specialized group of demanders. as a Supplier and Demander, not at the same time, but in sequence. Secondly, the production of money, and this goes to really the qualities of money. The production of money is very, very small as a very, very small proportion, the annual production of the overall existing stock of money.

8:10So as I tell my class under a gold standard, for example, You still had all the quantity of gold that was dug up going to the time before, let's say, Jesus of Nazareth walked the earth. That gold is still in the world. The only gold that has been lost is that which is at the bottom of the sea where ships have sunk or that have been lost, has been lost in fires. Okay, so that production or that quantity, that sum of the annual production of gold has built up and is still in the world. And the annual production is a very small proportion of that. That's another reason why we would use the total stock, a total demand stock analysis. Okay, so that's what Rothbard uses. Now he immediately identifies two components of demand for money.

9:00This is one of his most important contributions in monetary theory. There are many of them, actually. The first point of the demand we all engage in when we go to work, and we sell our labor services in exchange for money, okay? Just as you demand apples or bottles of Dasani water, as Walter is now, of course he's not paying anything for it though, just as you would demand commodities by exercising a demand on the market, by giving something away from them, for them typically money, you demand money by selling stocks of goods that you own, or by selling your labor services. So that's the exchange demand for money. That tends to be pretty inelastic. In other words, if you have capital goods, consumers goods or natural resources, they don't tend to have any use value to you.

9:48So their supplies are very, very inelastic, which means that you're willing to sell all of them, regardless of what the prices would be. Labor is a little bit different. You have leisure preferences. There's this utility of labor. So, therefore, that introduces some elasticity into the so-called exchange demand for money curve, which is one of the two curves that make up the demand for money. Secondly, there's a reserve demand for money. We're actually all doing that right now by the very fact that we're not rushing out and going to local stores and spending it. That is, we're holding on to it. We've received it in the past and we've refrained from spending it. The money in your wallet, there had to be a conscious choice to refrain from spending the money you have in your wallet and the money that is now sitting in your checking accounts and other types of immediately convertible bank accounts or immediately redeemable bank accounts.

10:42That's known as reservation demand for money. That's what imparts the elasticity, the downward slope for the demand for money. So as Rothbard would point out, so if we add these two up, we get a downward sloping demand curve, which is elastic because of the reserve demand. I mean, I don't mean elastic in a slight sense of micro that it's, you know, has an elasticity greater than the absolute value of one or anything like that. I just mean that it's downward sloping. Why would the reservation demand for money, the amount of money that you want to hold in your checking accounts and wallets and so on, why would that be greater when the purchasing power of money is lower than it is when the purchasing power of money is higher? In this example, people in this economy want to hold 50 billion dollars when prices are low, 50 cents per yoga cone, or the purchasing power is high, and much, much, much more, 200 billion when the prices have quadrupled to 2 dollars.

11:42What explains that relationship? Well, people are interested not in the number of nominal money units that they're holding. Their interest is in how much they can purchase with that money. So they reserve to themselves a certain fund of purchasing power. So we have this total demand curve and we have the supply curve of money. I should put an M at the top of that. Maybe I did. No, I didn't. And that determines the equilibrium. Equilibrium is determined, though, at that point and no other point, by what we call monetary adjustment process, if I can just show you that symbolically.

12:28If we were at the, if we were at a point where we had an excess supply of money, let's say up here, if we were at point A, so that price were very low, people felt they only needed 50 billion dollars, But in fact, there was $100 billion worth of gold in the economy. People would feel that they have an excess supply of money. Money would exceed its demand. And as a result, people would get rid of money. They would rush out and they would begin to increase their demands for other goods and services. And as they did so, prices would rise. Naturally, the purchasing power money would fall. fall another way of stating as one over P since the denominator is increasing the that that ratio falls and as the value of each dollar falls people begin to realize that they need more and more okay so let's take an example if you were to tomorrow wake up and find that you had double the amount of money in

13:31your checking account in your wallets and so on okay that magically appears there you'd feel that you have excess amount of money in your wallet that is is that given your anticipated purchases over the course of the next few weeks and given any emergencies that may conceivably arise, you only need half the amount. Let's say you're holding 200, now you have 400. So you rush out and spend an extra 200. If everyone operates in that way, then there's a big increase in demand for goods and prices fall and the purchasing power of money falls. So that at the end of this process, as we'll see, the, what we call the real money supply, The amount that the entire billion dollars can buy has pretty much been cut in half. Prices are twice as high, so that a billion dollars can now buy half as many, I'm sorry, a billion dollars can now buy the same amount of yogurt cones and of pizzas and of other things,

14:26as 50 billion could have purchased under the higher purchasing power. Okay, so we move towards equilibrium through that process. On the other hand, if people in the economy are experiencing a shortage of money, This is a subjective state, that is, they feel that at a high price level of $2, they need more than the available $100 million worth of gold. They would then begin to economize on money. That is to say, they would stop spending as much now, and they would begin to hold more money, because their requirements for money, in nominal terms, are higher now. But as they did that, that would mean that they were refraining from purchasing goods.

15:12They could also increase their labor, by the way, and buy more money that way. But they're refraining from purchasing goods, prices fall, and the purchasing power of money rises. Eventually, the quantity demanded of money falls. Okay, they feel that they don't need as much at a purchasing power of one yogurt cone as they did at a half a yogurt cone, because now they have sufficient purchasing power. The real value of money has increased so that they are now satisfied at that lower price level. They can make their anticipated purchases and they have enough for any sort of buying opportunities that they might come across or emergencies that might arise during the period. Rothbard also talks about changes to the money relation, and that's simple enough to show that when the demand for money shifts to the right, I'm not actually going to do it on here, he does it in the book, but I'll just talk about it.

16:05If the demand for money shifts to the right, you're suddenly going to find that the equilibrium point of E, demand is to the right, quantity demanded of money is much more than it was greater than what it was before. Maybe people are more uncertain about the future, maybe they're fearing this recession, or they're fearing that they're going to be thrown out of work, or not get their bonuses, or possibly have their house in foreclosure. So the demand for money goes up due to greater uncertainty. And as a result, what you get is an increase in the purchasing power of money. So if the demand for money shifted to the right, so that people now demanded $200 billion rather than only $100 billion, you would get an increase in the purchasing power of money to the point where prices would fall because the way that people increase their demand is to refrain from spending money and we would have a higher purchasing power, okay?

17:01So now, yoga cones would have half the price. So, people, an increase of demand for money increases the real money supply, okay, which is M over P. You don't need the Fed to increase the money supply. The demand for money goes up, given a fixed supply of money, prices fall, we get an increase in purchasing power, and the real money supply, the amount of yogurt cones and pizzas that you can buy with the 100 billion dollars, the same 100 billion dollars, is now increased. So, since the real money supply increases, society is capable of increasing the real money supply, which is by having, by the market adjusting the purchasing power of money to the change in demand.

17:46Now, that change in demand or supply is called the change in the money relation. The term money relation was coined by Mises and Rothbard uses that relation because it's less cumbersome than saying a change in the demand for or supply of money. So we've talked about the money relation. That's what we are referring to. On the other hand, let's say now that somehow the government increases the money supply by, let's say, adding, you know, paper money to the money supply that is redeemable in gold with a fixed demand curve. Well, that drives down the purchasing power of money. People did not autonomously demand more money. Otherwise, they would have shifted their demand curve. As a result, as that new money comes into the economy, people begin spending it because it's in excess now.

18:36And as a result, that depreciates the dollar in terms of goods, causes purchasing power to fall, and it doesn't change the real supply of money. Because if money doubles, prices also double. So the numerator and the denominator increase by the same proportion. Therefore, as one economist, Charles Riess, a French economist once said, society is the master of velocity, and by that he meant demand for money. He says the state might be the master of the money supply, but society is the master of velocity. Which means that anything that the government can do with its money supply is really ineffective, okay? But the society is always effective in changing the purchasing power of money, and in that way changing the real supply of money.

19:28Whereas the state cannot necessarily change the real supply of money, it can temporarily. But in fact, when it sets off an inflationary process, it not only doesn't change the supply of money in the short run, It actually, the real supply, it causes the real supply to fall in the longer run, as people begin to demand, shift their demand for money back, because they expect higher and higher prices in the future, so they begin to spend down, OK? Right, so that's the changes in the supply of money and demand for money. I want to say just a bit about the utility of the stock of money. Remember, unlike any other good, the demand or the subjective value of money depends on it having a purchasing power, okay?

20:18What if all other goods had zero prices on the market? What if suddenly BMW, you know, was it 300 series, Mercedes 300 series, what if that was zero, okay? Would that make any difference to you on your value scales? No, okay, you'd rush out and you'd grab one. Or if producers goods of various kinds, if stocks suddenly had zero value, or zero price, not a zero price, that is, title ownership of ongoing concerns, you'd pick up those stocks, you'd grab up those stocks. So any real goods or non-monetary goods that have zero prices do not affect their usefulness and their utility to you. However, if dollars had a zero price, a zero purchasing power, you wouldn't want them, okay?

21:13And the reason is this, the sole purpose of buying money is the fact that you are going to re-exchange it in the less remote or more remote future. It could be tomorrow, it could be two weeks from now, okay? So, money is accepted and demanded to be exchanged. So it has to therefore have an exchange value. If it has no exchange value, no one's going to give you anything for it. That's how money differs fundamentally from consumer goods and producer's goods. We can also conduct the experiment of the economically ignorant but benevolent angel that wants to help society and passes up the opportunity. He could double consumer's goods or he could double producer's goods, but instead he doubles the money supply.

22:00Doubles the money supply, what happens? Everybody wakes up, they have excess cash balances, they rush out, spend those cash balances, prices pretty quickly double, and there is no ambiguous social benefit from that. Okay, yes, the people who get up earlier and spend before the monies, before the prices have risen benefit, whereas the people who get up later, the late risers, okay, like college professors, get beat out of some of their purchasing power because they're now spending at the higher prices, okay. However, had the angel doubled consumer goods, there is an unambiguous social benefit there. We can say there is an increase in social utility in the following sense. More human wants are satisfied for some people, while for others there has been no decrease in the satisfaction of human wants.

22:48On the other hand, if they double supply of capital goods and natural resources, the same thing is true. In the future, more human wants are satisfied and no fewer human wants, for other people, are impaired, okay? So, increase in consumer and producer's goods, unambiguously, increase social welfare for some, or increase utility for some without impairing welfare for others and therefore increase social utility wealth. That is not true of money, okay? doesn't change the real money supply. So Rothbard arrives at this rule which was first clearly stipulated or stated by Ricardo, David Ricardo, the British economist, who had problems in sort of his value theory, but on monetary theory he was extremely good.

23:42And basically it's this rule that every supply of money, whether it's 50 billion, 100 billion, $200 billion yields the maximum usefulness of a medium of exchange, and an increase in money yields no social benefit. So in other words, compare three economies with the exact same makeup of the labor force, the exact same amount of capital goods, exact same amount of consumer goods. Is the economy with $200 billion in money better off than the economy with $50 billion? No, this is simply a difference in the price level. What about the demand for money? Why is there demand for money? We'll briefly touch on this. As I said, money is desired to be exchanged, and really for no other reason. But that does not imply that we want to immediately rush out and exchange money.

24:30We do not want to rush out and spend all the money. None of us, as soon as we get our paycheck, rush out and spend it all. We always retain or reserve some for our cash balance. Balance. So the utility in money rests in the fact that it gives us a fund of purchasing power that allows us to plan for the future, to make anticipated purchases in the future, to meet certain emergencies that are sort of unpredictable, to take advantage of sales opportunities that we see in stores and so on. If we have ready cash on us, it's easier to do that, and so on. If you contrast that to ERE, in the ERE, the timing and the size of all an individual's expenditures and receipts are known with certainty, which means that when an individual receives his or her income, they'll immediately either spend it on present consumer goods or invest it for periods that correspond to the times when they will need that money

25:33back for the completely known expenditures, the perfectly known expenditures, okay? So in the ERE, there is no utility for money, for money holding, and therefore, no one would accept money. So that's another contradiction in the ERE, but it shows, again, that it's uncertainty that lies, that is the root cause of the holding of cash balances, okay, uncertainty of the future. Now, that's not to say there are not many reasons for holding money, but the fundamental cause for holding money is uncertainty of the future, which brings us to speculative demand.

26:18One of the very important influences on the demand for money in the real world is the expectation that prices could rise in the future or fall in the future. So during the 1970s and 1980s when the prices were sort of the first housing bubble, I recall, I was a graduate student during that time, for a good part of that time, then a young faculty member. And many of my colleagues, our salaries weren't that high and so on, especially as teaching assistants or graduate assistants, began to run out and purchase houses that they were going to save up for the down payment on. So they began to purchase houses today that they would really optimally like to have purchased two years or three years down the road. People begin to purchase automobiles now. In other words, people move their purchases into the present when money has a higher purchasing power than it's expected to have.

27:09So during a period of, or during, when there's an expectation of a fall in the value of money, a fall in the purchasing power of money, you get a fall in the demand to hold money. doesn't disappear except if you have a hyperinflation but it falls people want to people economize on their cash balances on the other hand if next year if within six months we were all to expect that Bush but right before he goes out of office so whenever he's leaving office was going to immediately repeal all tariffs so he could be known in history as the greatest greatest free trading politician all barriers to trade we would know that many goods would fall So many of the things that we were planning on purchasing today, durable goods, we would then postpone the purchases to the future.

28:00That means that we would hold more money in our checking accounts and in our pockets and so on. Then Rothbard talks a little bit about the secular influences on the demand for money. Over time there are certain factors that cause the demand for money to increase and to decrease. For example, economic growth, increases in the supplies of goods and services. What that leads to is an increase in the amount of goods and services for sale on the market. That's an increase in the exchange demand for money, and therefore that shifts the demand curve to the right.

28:45If people are paid less frequently, and as the economy goes from a blue-collar economy to a white-collar economy, let's say from the 1950s, the transition that took place until today, what was happening was people were getting paid less and less frequently because office workers would get paid instead of every week or even every day, office workers would get paid every two weeks or every month. So as we have shifted from a manufacturing economy to a service economy, people get paid less frequently, so they have to hold larger cash balances to finance their anticipated purchases between pay periods. So that increases the demand for money. Just think of a professor who is a consultant to some firm and gets $100,000 at the beginning of the year.

29:39and that has to last him to his next consulting contract, let's say a year down the road, right? In the beginning, he's going to start with $100,000 and he's going to hold the average cash balance that he holds over the course of that year is going to be huge. If he spends that money evenly over the year, his average cash balance is $50,000. Whereas if he was getting his paycheck every two weeks, then it would be much, much smaller, okay? be the average over that two-week period.

30:11Now, there's often a confusion about the demand for money. People say, what do you mean, demand for money? I want as much money as I can get. Okay. Well, they're, in making that statement, they're confusing money with wealth. Yes, everyone wants as much wealth as possible because the greater the amount of wealth, If people really did have an unlimited demand for money, as opposed to an unlimited demand for wealth, well, then what would we see? What would we observe counterfactually? If people had an unlimited demand for money, as soon as they received any money, what would they do with it? They would hold on to it. They would never spend it.

30:56They would hold onto it, they would never spend it, and then it would all starve to death and then everybody would be dead and there would be any demand for money. But at least in the short run, people would never spend any of their money income. But in fact, we know that people don't act in that way. What people do do is to allocate their income on three different margins. They allocate it to spending it on consumption, by saving and investing it, and what's called in a non-normative way or non-positive way, they hoard it, okay, which simply means they add to their cash balance, they build up the amount of money they're holding. Those are three options open to them, okay, and, you know, I pose a question to my students, I say, you know, my students who say, no, there's unlimited demand for money.

31:45I said, well, what if you won $100 million in the lottery tomorrow? I said, you know, would you hold on to all of that? No, of course, I'd buy a boat, buy a better house to quit my job and so on, right? So, you see that they don't have an unlimited demand for money, okay? Whether, in fact, you're spending it or giving it away means that your demand is limited. It's always limited by your supplies of things that you can sell on the market as an exchange amount for money and even more narrowly by the amount or the proportion of that money that you receive in exchange that you keep in your cash balances. Now we come to the purchasing power and the rate of interest. Because of the influence of Keynesian economics, people still think, including many, many economists, that changes in the demand for money, if the demand for money increases, somehow that will increase, for example, will increase the interest rate.

32:40the interest rate. If on the other hand, there's a full demand for money, well then the interest rate will drop. Okay, well that's confusing a demand for loanable funds or for a savings on the part of someone who wants to use it for consumer purposes or investor purposes. That's confusing that with the demand for money itself. As I said, money is allocated on three margins. Consumption, investment and cash balances. What if, let me just give you a little numerical example here. What if we had an economy in which income, I want to be a heretic here and write Y for income, which is the Keynesian symbol for income, is a hundred ounces or a hundred dollars worth of gold.

33:27And let's say that in that time period, T1, People spend 20 on consumption and they save 80, okay? They don't add anything to their cash balances, they don't hoard any, they spend all their current income, okay? They're holding cash balances, okay, but they're keeping them the same, they're not changing their cash balance. Okay, and then suddenly we have an act of hoarding, that is in the next period, T2, People decide, because of greater uncertainty of the future, that they're going to spend less of that $100 in income on consumption goods. So let's say that falls to $15 and proportionally less on saving.

34:12Let's say that falls to $60. Well, what happens to the other $25 in income? They use that to build up their cash balances, to add to their purchasing power that they're holding. So, now you have hoarding of, let's put that in here, zero here, hoarding of $25. Now, Rothbard says is as long as the proportion of consumption to saving stays the same, as long as the CS ratio remains at 1 to 4, which it does, 20 to 80, and 15 to 60. As long as that ratio holds, that means that the stream of income, the way income is being divided between consumption goods...

35:06Walter, you're not a mathematical economist, I want to hear from you. Consumption-saving ratio, right? Am I correct? Yeah. Now I lost my train of thought, all right. That as long as that holds, the stream of income is being divided in such a way that the same proportion is being spent on investment goods in the structure of production as is being spent on consumer goods. So there's no greater profits to be made, no greater profit margin in any stage of production than there was before, okay? So the production structure remains the same. What Rothbard goes on to say is in time T3, of course, net income, in nominal terms, falls. It falls to the money paid out for consumers' goods and the money paid out on investment goods.

35:55So this falls to 75, and then this would be 15 and 60, and hoarding would fall back to zero. In other words, if people don't continually hoard, they wanted 25 more dollars in their cash balances, economy-wide, to meet the greater uncertainty that they feel existed, let's say, after 9-11, or when Y2K was upon them, or today, when they don't know what's going to happen to their houses and their jobs, and so on. So now what does happen? All nominal values in the economy fall, but they fall proportionally. Now, can hoarding cause a change in the interest rate? Absolutely. But that's hoarding in conjunction with a change in time preferences. What if instead of this, people decided they're just going to cut back on their consumption?

36:45So, let me think. I want to do it that way. Let's see, an increase in demand. Let's say there's an increase in demand for money, so that would raise interest rates. So let's do it in a way that it will raise interest rates. Let's cut back on people's savings. So now, what the people do is they cut back, the whole $25 comes out of saving, so we get another T2 prime, and so we have the same amount spent on consumption, but, I'm sorry, 20 on consumption, yeah. But instead of 80, we have 25 less, which is what, 65? No, 55. Okay, so saving equals 55, hoarding equals 25. Now look what has happened.

37:31The consumption-saving ratio has gone way up. The relative demand for consumer goods in the present has gone up in relation to consumer goods in the future, okay? Resources now shift out of the higher stages into the lower stages to supply the relatively greater demand for consumer goods. And as a result, the price spreads between the various stages of production increase, the natural rate of interest increases, and we see that being reflected on the loan market. But there, you had an increase in demand for money and a rise in the CS ratio. The CS ratio is a reflection of people's time preferences. So you've got a rise and it led to, sideways out, to an increase in time preferences, okay?

38:20Okay, I'm going to skip over the Keynesian, His critique of the Keynesian system will all entertain questions on that because I want to get to one other topic that's very important here. I will say, though, the whole Keynesian system, as Rothbard points out in his brilliant critique there, depends on confusing the notion of saving with hoarding. For Keynes, there was only... He could only think on two margins. He was accused of this by one of his fellow Cambridge economists, D.H. Robertson, who was actually a good monetary economist. Not a very good value theorist, though. And so what Robertson pointed out is that what Keynes believed was this, that people got income and they spent it on consumption, or they saved it, okay? Then, they went, and of course consumption was, they were sort of robots, whatever the current income was, depending on their marginal propensity to consume, that determined their consumption.

39:14In the case of saving, they then decided to save it as cash balances, or to buy bonds. So if they bought bonds, then the money was invested and so on. But if they put in cash balances, that then brought about a full money income. But Keynes, there's another area here. So let's even accept that kind of thinking on two margins. In fact, we know people simultaneously have one value scale. They don't have a value scale for consumption and saving, and then another value scale for, oh, should I take that and should I put it into my cash or should I buy bonds with it? They compared all of these things simultaneously on the single unitary value scale.

40:03But the other problem with this is that even if they did cause hoarding or hoard a lot of what they've saved, what difference does that make? As we've seen, all that does is to decrease nominal values in the economy. The Change of Purchasing Powered Money. The implicit assumption in Keynes was that wages were rigid. In fact, Keynesian economists, particularly Franco Modigliani, was a mathematical Keynesian economist and was sort of a general equilibrium thinker in a sense that he thought on all margins at least, saw right away that, and wrote a famous article, I think it was 1949, Henry Hazlitt actually reprinted it in his book, Critics of Keynesian Economics, ten years later, But he blew up the Keynesian system in 1949.

40:49He basically said, well, you know what? This is only all true if on the labor market, we'll make labor, forget about this utility of labor, there's a supply of labor, there's the demand for labor on the part of firms. If suddenly you had hoarding, then the demand for labor would shift down and everybody could keep working, the same number of workers would keep working, whatever it might be, X, zero X. As long as wages fell from W1 to W2, to the new equilibrium point. So what Modigliani said was that when this happened, this decrease in the demand for labor, wages were stuck up here. Okay, so there was, suddenly there was a surplus of labor.

41:36I didn't do it very well, but I'll do it over here for you. It's the labor market, thick supply, demand, okay, D1, D2, and we have a W1 and W2, the new equilibrium. So, if wages cannot fall from W1, then the number of workers hired falls from X to Y, okay, OX to OY. So Modigliani showed that the Keynesian system only made sense on the basis of this assumption, but he believed that the assumption was true, but at least he showed that theoretically it only made sense on the basis of that assumption. Was Keynes denied that in the general theory, and many of his followers denied that, okay?

42:24Today, the only economists that deny that are the so-called post-Keynesians, or the so-called new Keynesians like Paul Krugman and Mankiw and others. They all believe that you need this assumption. All the macro textbooks have this assumption. But they say this assumption holds in the short run. In the long run, markets clear. But why should we lose production and employment in the short run when we can easily cure it by having the government offset the hoarding or offset what they would call the fall in velocity and simply push the demand curve back this way? So, Rothbard shows this in great detail. Okay, the last thing I wanted to talk about, because I think it's so important, it's one of his most important contributions, one of his many important contributions to monetary theory.

43:23It's an area in which he corrected both Mises and Irving Fischer, father of modern monetarism, And he's still really the only economist that has grasped this point. And even he himself, I'll tell you about the conversation I had with him, didn't fully always adhere to this point because I had a little argument with him once about it. What Rothbard said was this, OK, if you've had macroeconomics, Next you know the standard story about how inflationary expectations or deflationary expectations affects the so-called nominal interest rate. The story is this, that if people expect inflation, this is called the Fisher equation.

44:14The Fisher equation is going to sum up their reactions to that expectation. And that is that the nominal interest rate will always equal the real interest rate, the pure interest rate, the underlying interest rate, plus the percent change in prices that are expected. So if the sort of pure time preference rate was 3% or something like that, whatever was determined by people's time preferences, and people in general had an expectation of a 5% increase in prices, well then no one in their right mind would make a loan at 3%. Why? Because that person wouldn't even have the same amount of purchasing power at the end of the year as he started with at the beginning of the year, if it's a one-year loan.

45:06In other words, at 3%, he would receive back, let's say, $103 for the $100 he'd lent. But in the meantime, the cost of goods that he was purchasing with those $100 would go up to $105. So, and borrowers would acquiesce in this so-called purchasing power, what they call the price premium, what Fischer and Mises call the price premium. They acquiesce in paying that premium. Is that all on there? Yeah. And the reason why they would, because they themselves, when they had that $100, would experience by investing it in goods, an automatic 5% increase in prices over and above whatever real return they were expecting. So for Mises and for Fisher, they both believed that when you had an expectation of a decline in the parking car money, And that would be discounted into, or that would be folded into the nominal interest rate as a premium on the pure rate.

46:10Well, Rothbard looks at it a little differently. He says, no, wait a minute. He says, let's say that people, entrepreneurs expect an increase in prices. What are they going to do? He says, if it's expected, this isn't going to happen. He says, let's say someone's going to invest $100, and they expect that at the end of the year, they'll receive $105. That was the initial real expectation, that they'll get 5%. But now, suddenly, they realize that the money price will double to $210. Will we see appearing in loan markets a 100% price premium, or what Rothbard calls purchasing power premium, on the interest rate?

47:05Rothbard says, actually not. If these are the factors of production, so this is the total factor prices, the sum of factor prices, and this is the sum of the product prices, or you can just call this as the total revenue we'll get from spending that money on factor prices. What they're going to do is everyone's going to immediately rush out and do what? They're going to say, look, I'm going to make a huge return of 110% of my money. If everyone expected that, what would they do? They'd rush out and they'd bid up the prices of the factors of production so that they doubled to $200 because at that, their return is then still 5%. So Rothbard claimed that when you focus on the natural rate of interest, which is the fundamental or basic rate of interest, that is, that the rate of interest is formed in the structural production and the loan rate is simply a pale reflection of the structure of production, it's going to reflect itself in the natural rate first, it's going to affect the natural rate first, it's going to bid up, entrepreneurs will bid up the prices of the factors of production.

48:12So, for Rothbard, this was anticipated inflation. In fact, he stood Mises-Fischer on their heads. He says, actually, the premiums will appear when it's an anticipated inflation. Let's say now that no one expects it, so that we have $100 bringing in $210. People don't expect the doubling in prices. The sum of factor prices is 100, but the total revenue that the entrepreneurs receive for this investment is 210, okay? What has happened? There is a 100% premium in effect, inflation premium or purchasing power premium, on the natural rate of interest, okay?

49:06So that's when you get the is unexpected, but you get it. Now, there's an interesting implication of this for modern macro controversies, and I'll stop at this point. And that is the case of deflation. Bernanke and other economists are deflationphobes. And there are a number of reasons why they fear deflation. So let's talk a little bit about deflationphobia. I coined this term, I think, and Mark had it translated into Greek, so it sounded really cool. What was it called? Yeah, something like that. So it could actually be some sort of psychological disorder. Okay, the fear of falling prices is what was translated.

49:52Okay. In any case, one of the reasons why they fear inflation so much, and this is particularly Milton Friedman who makes this argument, is the following. If you expect, you have the Fisher equation here, plus percent change expected in prices. If you expect prices to fall by 10% in a year, and let's say you have 5% as the real rate of interest, so it's negative, Then, the nominal rate would be minus five percent. But no one would make a loan at minus five percent. Why? Because those people would rather just hold the money and then they would earn an automatic ten percent in the form of the increased purchasing power of their dollar.

50:40So, all investment would stop and we'd have a massive depression. This is the fear. This so-called lower bound of the nominal interest rate that cannot be pierced, okay? Well, of course, that's not a problem, because if in fact, we go back to our example here, factor prices, sum, I should have wrote total cost, but, all right, total revenue here, if factor prices are 100, and people suddenly expect not $105, but the price is to fall by half, so that it can now be sold for $52.5, okay, instead of 105, Wouldn't everyone stop investing and simply hold on to the $100, which would be twice as much purchasing power as they had at the beginning of the year, rather than giving up, rather than earning just a little bit of 5%.

51:37Well, the point is, yes, they would stop investing, but that wouldn't cause recession. They would stop spending money on their demands based on what they believe the discounted marginal revenue product to the factors, okay, which is P times marginal product discounted by the discount, by the interest rate. What they would do is they would, everyone would, the demand curve would shift the labor, would shift down. And I guess it would shift down so that, you know, wages would fall and prices and rents of all other goods that are used in production, and Capital Goods, and so on, would fall and land. And they would fall to the point where the return was, again, 5%.

52:26So it's precisely if deflation was expected that it wouldn't have any effect. You don't have to worry about the fact that the nominal interest rate cannot be less than zero. Rothbard pointed out that the whole problem with that Fisher-Mises analysis is that they don't focus on the natural rate of interest, okay? That is the interest determined as the rate of return on investment in the structure of production. And even if, what if inflation was unanticipated? If it was unanticipated, people would invest because they don't anticipate it, and instead of 105, they get 52.5. Would entrepreneurs go bankrupt as a result? No, because all prices are what? Half is high, so they're still earning five percent, okay?

53:14There would be a deflation premium though, or a deflation discount, retrospectively, retrospectively, okay? They earned in nominal terms, I don't know, about minus fifty percent, whatever it is. But they, in real terms, what did they earn? 2.5 in real terms over 50 because what $100 bought before, $50 can buy today, so they earn 5% in real terms. Now the story about Rothbard, I'll stop. During the 1980s, the interest rate on bonds went very, very high after the inflation was stopped by Paul Volcker during the Reagan regime. And so, there was a big, a very high interest rate of, I don't know, 8 or 9% on bonds, on long-term bonds.

54:09So, I asked him, have you thought about it? And he says, well, you know, Joey says, they anticipate, you know, the bond market is anticipating inflation. And so, therefore, we have this premium. So, I said, wait a minute. I said, didn't you write in Human Action? I explained it to him. He goes, well, I'm just trying to work out the logical, the purely logical implications. He never really answered the question. He still thought, though, because he wrote something later on in Libertarian Forum or RRR, where he still had that inflation premium, the fiscal inflation premium in there. So it was even hard for Rothbard to be as rigorously logical as this book. The book is incredibly logical.

54:55It's just logical deductions, but this is the correct analysis.