Causes and Consequences of the Value of Money

Excerpted from Theory of Money and Fiduciary Media edited by Jörg Guido Hülsmann

Mises found that the traditional literature on the purchasing power of money (PPM) had entirely focused on analyzing the impact of changes in the supply of and demand for money. But before even getting to this question it was necessary to explain the level of PPM in the first place. Only in a second step could one set out to explain the transition from one level to another. Mises provided this missing foundational analysis, highlighting the central role of the subjective value of money and formulating what he would later call the “regression theorem.” He argued that the PPM is directly determined by the subjective value of money—that is, the relative importance of money as compared to the non-monetary goods for which it is being exchanged, in the eyes of all the partners to these exchanges. Thus the subjective value of money explains the equilibrium level of the PPM.

Mises refuted the objections formulated by Wicksell and Helffering against the very possibility of this approach, stressing that they had analyzed the PPM from an overall point of view, whereas the pricing process could only be adequately understood by adopting the subjective point of view of the exchange partners. The subjectivist approach was not unproblematic. The central difficulty was the interdependence between the subjective value of money (SVM) and the PPM. Money was valuable because it had purchasing power, but the purchasing power resulted from the SVM. This seemed to be an instance of circular reasoning, not of causal analysis. But Mises could solve this problem by developing an explanation which he found in Wieser: SVM and PPM did not determine one another simultaneously—which would have precluded causal analysis—but diachronically. Today’s SVM determined today’s PPM, which in turn determines tomorrow’s SVM, which determines tomorrows PPM, etc.[7]
 
Mises then proceeded to analyze the consequences of changes in the demand for and supply of money. He first dealt with their impact on money prices, especially the price level, and then with their impact on the production and distribution wealth and income. He concluded this part of the book by discussing the policy implications of his findings. Let us highlight his chief contributions in turn.

Concerning the impact of changes in the demand for and supply of money on the price level, Mises made three contributions. First he delivered a subjectivist interpretation of the quantity theory of money, arguing that the money supply and the price level were positively correlated, but stressing at the same time that this relationship was not mechanical. There was no fixed quantitative relationship between an X% variation of the money supply and some Y% variation of the price level.

Second, then, Mises delivered an in-depth critique of the most important variants of the traditional rigid quantity theory, refuting the conceptions of Hume, Mill, and Fisher. Most notably, he argued that, even if one fictitiously assumed that increases in the money stock had no impact on the distribution of wealth and income, such increases would still modify individual value scales and therefore entail a different price structure than the one that had existed before. While the marginal value of money would diminish for each individual, it would not diminish in exactly the same proportion. [8]Again, the mechanical quantity theory does not apply. In the 1924 edition (C168, B126f.), Mises added an additional paragraph to clarify this argument:

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.

Third, he discussed various complications, considering most notably the impact of changes in the demand for money on the PPM (neglected in the traditional theory), as well as inter-local price differences (he denied that they could exist in equilibrium) and the theory of exchange rates (he resuscitated Ricardo’s purchasing-power-parity theorem).

Mises here also briefly touches upon the impact of changes in the demand for and the supply of money on interest rates, but does not yet present his views on the matter, which would have led him to discuss his business cycle theory already in this second part of the book (where it in fact belonged from a systematic point of view). He merely points out that, traditionally, the problem of the purchasing power of money had been completely neglected in inter-temporal exchanges, both by theoreticians and by investors and other practitioners.[9]
 
Mises proceeded to study the impact of changes in the demand for and supply of money on the production and distribution of wealth and income. Here he emphasizes right from the outset, and then repeatedly throughout the remainder of the book, that there is no relationship between the money supply and aggregate output. Increases of the money supply do not spur, and decreases of the money supply do not hamper the production of wealth. The first time he brings up this point is in the context of his discussion of the general differences between money and all other goods. Here he states:

Both changes in the available quantity of production goods or consumption goods and changes in the available quantity of money involve changes in values; but whereas the changes in the value of the production goods and consumption goods do not mitigate the loss or reduce the gain of satisfaction resulting from the changes in their quantity, the changes in the value of money are accommodated in such a way to the demand for it that, despite increases or decreases in its quantity, the economic position of mankind remains the same. An increase in the quantity of money can no more increase the welfare of the members of a community, than a diminution of it can decrease their welfare.[10]

Thus right from the outset he makes three fundamental points. One, the real money supply (the aggregate purchasing power of all cash balances) tends to adjust to the real demand for cash balances. Two, as a consequence, the nominal money supply is irrelevant for the services provided by money. Three, as a further consequence, changes in the nominal money supply are equally irrelevant for those services. Only under exceptional circumstances could an increase of the nominal money supply, directly or indirectly, bring about advantages from the overall point of view. Increases of the money supply usually did not tend to increase the supply of consumers’ goods (see A227, A335). They had just an impact on the distribution of those goods. Mises reiterated this point again and again as the starting point for all reflection on the social effects of money.[11]
 
However, Mises stressed almost in the same breath that any change in monetary conditions (demand for and supply of money) affects the distribution of income and wealth. In other words, although there is no causal relationship between the money supply level on the one hand and aggregate production on the other hand, any change in that level, and any change in the demand for money, entails a redistribution of real incomes and therefore also a redistribution of wealth. The reason is that any such change does not affect all prices at the same time and to the same extent. For example, the first users of newly produced money units tend to gain real revenue at the expense of later users, because they can spend these new units right away, while their purchasing power is still relatively high; whereas the later users have to spend them when their purchasing power has already somewhat decreased. These causal relations also play out in the international sphere and affect trade patterns and capital flows.

Based on these elements, Mises concludes the second part of his Theorie des Geldes und der Umlaufsmittel with an in-depth discussion of the nature and scope of monetary policy. He starts off by distinguishing between traditional and modern monetary policy (A246, B200). Traditional interventionism, which involved most notably the depreciation of silver and gold coins, had a purely fiscal motivation. By contrast, modern monetary policy does not necessarily have such a motivation. Rather, its characteristic feature is the hypothesis that changes in the “inner objective exchange value of money” (IOEVM)—especially a decreasing IOEVM—are beneficial. The explanation why they are beneficial varies from one author to another, but the common conviction is that such benefits exist.[12] Thus modern monetary policy is from the outset at crossroads with classical economics à la Ricardo, which rejected the notion that the value of money had anything to do with the wealth of nations. Modern monetary policy seeks to pursue its objectives by modifying the money supply. This presupposes that the modification of the money supply is technically feasible in the first place. It follows, therefore, that the most important tool of modern monetary policy is the choice of the kind of money to be used within the country. In Mises’s words:

The principal instrument of monetary policy at the disposal of the state is the exploitation of its influence on the choice of the kind of money. It has been shown above that the position of the state as controller of the mint and as issuer of money substitutes has allowed it in modern times to exert a decisive influence over individuals in their choice of the common medium of exchange. If the state uses this power systematically in order to force the community to accept a particular sort of money whose employment it desires for reasons of monetary policy, then it is actually carrying through a measure of monetary policy. . . . If a country has a metallic standard, then the only measure of currency policy that it can carry out by itself is to go over to another kind of money. It is otherwise with credit money and fiat money.[13]