The Theory of Money and Credit

Those variations in the ratio between the individual’s demand for money and his stock of it that arise from purely individual causes cannot as a rule have a very large quantitative influence in the market. In most cases they will be entirely, or at least partly, compensated by contrary variations emanating from other individuals in the market. But a variation in the objective exchange value of money can arise only when a force is exerted in one direction that is not canceled by a counteracting force in the opposite direction. If the causes that alter the ratio between the stock of money and the demand for it from the point of view of an individual consist merely in accidental and personal factors that concern that particular individual only, then, according to the law of large numbers, it is likely that the forces arising from this cause, and acting in both directions in the market, will counterbalance each other. The probability that the compensation will be complete is the greater, the more individual economic agents there are.

It is otherwise when disturbances occur in the community as a whole, of a kind to alter the ratio existing between the individual’s stock of money and his demand for it. Such disturbances, of course, cannot have an effect except by altering the subjective valuations of the individual; but they are social economic phenomena in the sense that they influence the subjective valuations of a large number of individuals, if not simultaneously and in the same degree, at least in the same direction, so that there must necessarily be some resultant effect on the objective exchange value of money.

In the history of money a particularly important part has been played by those variations in its objective exchange value that have arisen in consequence of an increase in the stock of money while the demand for it has remained unchanged or has at least not increased to the same extent. These variations, in fact, were what first attracted the attention of economists; it was in order to explain them that the quantity theory of money was first propounded. All writers have dealt most thoroughly with them. It is perhaps justifiable, therefore, to devote special attention to them and to use them to illuminate certain important theoretical points.

In whatever way we care to picture to ourselves the increase in the stock of money, whether as arising from increased production or importation of the substance of which commodity money is made, or through a new issue of fiat or credit money, the new money always increases the stock of money at the disposal of certain individual economic agents. An increase in the stock of money in a community always means an increase in the money incomes of a number of individuals; but it need not necessarily mean at the same time an increase in the quantity of goods that are at the disposal of the community, that is to say, it need not mean an increase in the national dividend. An increase in the amount of fiat or credit money is only to be regarded as an increase in the stock of goods at the disposal of society if it permits the satisfaction of a demand for money which would otherwise have been satisfied by commodity money instead, since the material for the commodity money would then have had to be procured by the surrender of other goods in exchange or produced at the cost of renouncing some other sort of production. If, on the other hand, the nonexistence of the new issue of fiat or credit money would not have involved an increase in the quantity of commodity money, then the increase of money cannot be regarded as an increase of the income or wealth of society.

An increase in a community’s stock of money always means an increase in the amount of money held by a number of economic agents, whether these are the issuers of fiat or credit money or the producers of the substance of which commodity money is made. For these persons, the ratio between the demand for money and the stock of it is altered; they have a relative superfluity of money and a relative shortage of other economic goods. The immediate consequence of both circumstances is that the marginal utility to them of the monetary unit diminishes. This necessarily influences their behavior in the market. They are in a stronger position as buyers. They will now express in the market their demand for the objects they desire more intensively than before; they are able to offer more money for the commodities that they wish to acquire. It will be the obvious result of this that the prices of the goods concerned will rise, and that the objective exchange value of money will fall in comparison.

But this rise of prices will by no means be restricted to the market for those goods that are desired by those who originally have the new money at their disposal. In addition, those who have brought these goods to market will have their incomes and their proportionate stocks of money increased and, in their turn, will be in a position to demand more intensively the goods they want, so that these goods will also rise in price. Thus the increase of prices continues, having a diminishing effect, until all commodities, some to a greater and some to a lesser extent, are reached by it.38

The increase in the quantity of money does not mean an increase of income for all individuals. On the contrary, those sections of the community that are the last to be reached by the additional quantity of money have their incomes reduced, as a consequence of the decrease in the value of money called forth by the increase in its quantity; this will be referred to later. The reduction in the income of these classes now starts a countertendency, which opposes the tendency to a diminution of the value of money due to the increase of income of the other classes, without being able to rob it completely of its effect.

Those who hold the mechanical version of the quantity theory will be the more inclined to believe that the increase in the quantity of money must eventually lead to a uniform increase in the prices of all economic goods, the less clear their concept is of the way in which the determination of prices is affected by it. Thorough comprehension of the mechanism by means of which the quantity of money affects the prices of commodities makes their point of view altogether untenable. Since the increased quantity of money is received in the first place by a limited number of economic agents only and not by all, the increase of prices at first embraces only those goods that are demanded by these persons; further, it affects these goods more than it afterward affects any others. When the increase of prices spreads farther, if the increase in the quantity of money is only a single transient phenomenon, it will not be possible for the differential increase of prices of these goods to be completely maintained; a certain degree of adjustment will take place. But there will not be such a complete adjustment of the increases that all prices increase in the same proportion. The prices of commodities after the rise of prices will not bear the same relation to each other as before its commencement; the decrease in the purchasing power of money will not be uniform with regard to different economic goods.

Hume, it may be remarked, bases his argument concerning this matter on the supposition that every Englishman is miraculously endowed with five pieces of gold during the night.39  Mill rightly remarks on this, that it would not lead to a uniform increase in the demand for separate commodities; the luxury articles of the poorer classes would rise more in price than the others. All the same, he believes that a uniform increase in the prices of all commodities, and this exactly in proportion to the increase in the quantity of money, would occur, if “the wants and inclinations of the community collectively in respect to consumption” remained the same. He assumes, no less artificially than Hume, that “to every pound, or shilling, or penny, in the possession of any one, another pound, shilling, or penny were suddenly added.”40  But Mill fails to see that even in this case a uniform rise of prices would not occur, even supposing that for each member of the community the proportion between stock of money and total wealth was the same, so that the addition of the supplementary quantity of money did not result in an alteration of the relative wealth of individuals. For, even in this quite impossible case, every increase in the quantity of money would necessarily cause an alteration in the conditions of demand, which would lead to a disparate increase in the prices of the individual economic goods. Not all commodities would be demanded more intensively, and not all of those that were demanded more intensively would be affected in the same degree.41

There is no justification whatever for the widespread belief that variations in the quantity of money must lead to inversely proportionate variations in the objective exchange value of money, so that, for example, a doubling of the quantity of money must lead to a halving of the purchasing power of money.

Even assuming that in some way or other—it is confessedly difficult to imagine in what way—very individual’s stock of money were to be increased so that his relative position as regards other holders of property was unaltered, it is not difficult to prove that the subsequent variation in the objective exchange value of money would not be proportioned to the variation in the quantity of money. For, in fact, the way in which an individual values a variation in the quantity of money at his disposal is by no means directly dependent on the amount of this variation; but we should have to assume that it was, if we wished to conclude that there would be a proportionate variation in the objective exchange value of money. If the possessor of a units of money receives b additional units, then it is not at all true to say that he will value the total stock a + b exactly as highly as he had previously valued the stock a alone. Because he now has disposal over a larger stock, he will now value each unit less than he did before; but how much less will depend upon a whole series of individual circumstances, upon subjective valuations that will be different for each individual. Two individuals who are equally wealthy and who each possess a stock of money a, will not by any means arrive at the same variation in their estimation of money after an increase of b units in each of their stocks of money. It is nothing short of absurdity to assume that, say, doubling the amount of money at the disposal of an individual must lead to a halving of the exchange value that he ascribes to each monetary unit. Let us, for example, imagine an individual who is in the habit of holding a stock of a hundred kronen and assume that a sum of a further hundred kronen is paid by somebody or other to this individual. Mere consideration of this example is sufficient to show the complete unreality of all the theories that ascribe to variations in the quantity of money a uniformly proportionate effect on the purchasing power of money. For it involves no essential modification of this example to assume that similar increases in the quantity of money are experienced by all the members of the community at once.

The mistake in the argument of those who suppose that a variation in the quantity of money results in an inversely proportionate variation in its purchasing power lies in its starting point. If we wish to arrive at a correct conclusion, we must start with the valuations of separate individuals; we must examine the way in which an increase or decrease in the quantity of money affects the value scales of individuals, for it is from these alone that variations in the exchange ratios of goods proceed. The initial assumption in the arguments of those who maintain the theory that changes in the quantity of money have a proportionate effect on the purchasing power of money is the proposition that if the value of the monetary unit were doubled, half of the stock of money at the disposal of the community would yield the same utility as that previously yielded by the whole stock. The correctness of this proposition is not disputed; nevertheless, it does not prove what it is meant to prove.

In the first place, it must be pointed out that the levels of the total stock of money and of the value of the money unit are matters of complete indifference as far as the utility obtained from the use of the money is concerned. Society is always in enjoyment of the maximum utility obtainable from the use of money. Half of the money at the disposal of the community would yield the same utility as the whole stock, even if the variation in the value of the monetary unit was not proportioned to the variation in the stock of money. But it is important to note that it by no means follows from this that doubling the quantity of money means halving the objective exchange value of money. It would have to be shown that forces emanate from the valuations of individual economic agents which are able to bring about such a proportionate variation. This can never be proved; in fact, its contrary is likely. We have already given a proof of this for the case in which an increase of the quantity of money held by individual economic agents involves at the same time an increase of their income or wealth. But even when the increase in the quantity of money does not affect the wealth or income of the individual economic agents, the effect is still the same.

Let us assume that a man gets half his income in the form of interest-bearing securities and half in the form of money; and that he is in the habit of saving three-quarters of his income, and does this by retaining the securities and using that half of his income which he receives in cash in equal parts for paying for current con sumption and for the purchase of further securities. Now let us assume that a variation in the composition of his income occurs, so that he receives three-quarters of it in cash and only one-quarter in securities. From now on this man will use two-thirds of his cash receipts for the purchase of interest-bearing securities. If the price of the securities rises or, which is the same thing, if their rate of interest falls, then in either case he will be less willing to buy and will reduce the sum of money that he would otherwise have employed for their purchase; he is likely to find that the advantage of a slightly increased reserve exceeds that which could be obtained from the acquisition of the securities. In the second case he will doubtless be inclined to pay a higher price, or more correctly, to purchase a greater quantity at the higher price, than in the first case. But he will certainly not be prepared to pay double as much for a unit of securities in the second case as in the first case.

As far as the earlier exponents of the quantity theory are concerned, the assumption that variations in the quantity of money would have an inversely proportionate effect on its purchasing power may nevertheless be excusable. It is easy to go astray on this point if the attempt is made to explain the value phenomena of the market by reference to exchange value. But it is inexplicable that those theorists also who suppose they are taking their stand on the subjective theory of value could fall into similar errors. The blame here can only be laid to the account of a mechanical conception of market processes. Thus even Fisher and Brown, whose concept of the quantity theory is a mechanical one, and who attempt to express in mathematical equations the law according to which the value of money is determined, necessarily arrive at the conclusion that variations in the ratio between the quantity of money and the demand for it lead to proportionate variations in the objective exchange value of money.42  How and through what channels this comes about is not disclosed by the formula, for it contains no reference at all to the only factors that are decisive in causing variations of the exchange ratios, that is, variations in the subjective valuations of individuals.

Fisher and Brown give three examples to prove the correctness of their conclusions. In the first, they start with the supposition that the government changes the denomination of the money, so that, for example, what was previously called a half-dollar is now called a whole dollar. It is obvious, they say, that this will cause an increase in the number of dollars in circulation and that prices reckoned in the new dollars will have to be twice as high as they were previously. Fisher and Brown may be right so far, but not in the conclusions that they proceed to draw. What their example actually deals with is not an increase in the quantity of money but merely an alteration in its name. What does the “money” referred to in this example really consist of? Is it the stuff of which dollars are made, the claim that lies behind a credit dollar, the token that is used as money, or is it the word dollar?

The second example given by Fisher and Brown is no less incorrectly interpreted. They start from the assumption that the government divides each dollar into two and mints a new dollar from each half. Here again all that occurs is a change of name.

In their third example they do at least deal with a real increase in the quantity of money. But this example is just as artificial and misleading as those of Hume and Mill which we have already dealt with in some detail. They suppose that the government gives everybody an extra dollar for each dollar that he already possesses. We have already shown that even in this case a proportionate change in the objective exchange value of money cannot follow.

One thing only can explain how Fisher is able to maintain his mechanical quantity theory. To him the quantity theory seems a doctrine peculiar to the value of money; in fact, he contrasts it outright with the laws of value of other economic goods. He says that if the world’s stock of sugar increases from a million pounds to a million hundredweight, it would not follow that a hundredweight would have the value that is now possessed by a pound. Money only is peculiar in this respect, according to Fisher. But he does not give a proof of this assertion. With as much justification as that of Fisher and Brown for their mechanical formula for the value of money, a similar formula could be set out for the value of any commodity, and similar conclusions drawn from it. That nobody attempts to do this is to be explained simply and solely by the circumstance that such a formula would so clearly contradict our experience of the demand curves for most commodities, that it could not be maintained even for a moment.

If we compare two static economic systems, which differ in no way from one another except that in one there is twice as much money as in the other, it appears that the purchasing power of the monetary unit in the one system must be equal to half that of the monetary unit in the other. Nevertheless, we may not conclude from this that a doubling of the quantity of money must lead to a halving of the purchasing power of the monetary unit; for every variation in the quantity of money introduces a dynamic factor into the static economic system. The new position of static equilibrium that is established when the effects of the fluctuations thus set in motion are completed cannot be the same as that which existed before the introduction of the additional quantity of money. Consequently, in the new state of equilibrium the conditions of demand for money, given a certain exchange value of the monetary unit, will also be different. If the purchasing power of each unit of the doubled quantity of money were halved, the unit would not have the same significance for each individual under the new conditions as it had in the static system before the increase in the quantity of money. All those who ascribe to variations in the quantity of money an inverse proportionate effect on the value of the monetary unit are applying to dynamic conditions a method of analysis that is only suitable for static conditions.

It is also entirely incorrect to think of the quantity theory as if the characteristics in question affecting the determination of value were peculiar to money. Most of both the earlier and the later adherents of the theory have fallen into this error, and the fierce and often unfair attacks that have been directed against it appear in a better light when we know of this and other errors of a like kind of which its champions have been guilty.

• 38See Hume, Essays, ed. Frowde (London), pp. 294 ff.; Mill, op. cit., pp. 298 ff.; Cairnes, Essays in Political Economy, Theoretical and Applied (London, 1873), pp. 57 ff.; Spiethoff, “Die Quantitätstheorie insbesondere in ihrer Verwertbarkeit als Haussetheorie,” Festgaben für Adolf Wagner (Leipzig, 1905), pp. 250 ff.
• 39Hume, op. cit., p. 307
• 40Mill, op. cit., p. 299.
• 41See Conant, “What Determines the Value of Money?” Quarterly Journal of Economics 18 (1904): 559 ff.
• 42See Fisher and Brown, op. cit., pp. 28 ff., 157 ff.