Economics Volume II: Modern Economic Problems

by Frank A. Fetter

§ 7. #The money-material in its commodity uses#. We are now prepared to take up the question: What determines the ratio at which money exchanges for other goods? And, as money comes to be the unit in which prices are generally expressed, the question becomes: What determines the general level of monetary prices? We have this problem in its simplest form in the case of a commodity-money such as gold. It may be looked upon merely as so much precious metal. The problem of its value as bullion is the same as that of the value of pig iron or of zinc, of meat or of potatoes. There is here no special monetary problem. The value of gold as bullion and its value as money are kept in equilibrium by choice and by substitution. The several uses of gold are constantly competing for it: its uses for rings, pens, ornaments, championship cups, photography, dentistry, delicate instruments, and as a circulating medium. If the metal becomes worth more in any one use, its amount is increased there and is correspondingly diminished in other uses.[3]

When coinage is free and gratuitous[4] the standard money is a commodity. Such coinage is essentially but the stamp and certificate that the coin contains a certain weight and fineness of metal. Where coinage is free and gratuitous each coin will be worth the same as the bullion that is in it so far as the citizens exercise their choice. They will not long keep uncoined metal in their possession when it is worth more in the form of money, nor will they long keep money from the melting-pot when it is worth more as bullion. Yet there may be a slight disparity between the bullion value and the monetary value before the metal is converted into coin or the coin melted down into metal.

This adjustment of the value of commodity-money to other things is made also on the side of supply, in the use of labor and material agents to produce the precious metals and to produce other things. Gold-mining, for example, is one among various industries to which men may apply their labor and their available material agents. Some mines are superior, others medium, others marginal which it barely pays to work. There is, therefore, a rise and fall of the margin of gold production with changes in prices and changes in the cost of production. Large new deposits of gold are discovered from time to time and new methods of extracting gold are invented. If, when it barely pays to work a mine, such changes occur, gold becomes worth less, and the poorer mines eventually must go out of use. As gold rises in value some abandoned mines again come into use. A similar variation may be noted in the utilization of marginal land, marginal factories, marginal forges, and marginal agents of every kind.[5]

§ 8. #The general level of prices#. We come now to a more peculiar aspect of the monetary value problem. In performing its function as general medium of trade, money determines the general level of monetary prices. We have the idea of a general level of prices whenever we contrast the price ratio of money to other commodities at one time with its ratio at another time. Now the monetary prices of the various commodities are constantly changing, and in somewhat different degrees, but on the average there may be a general trend upward or downward, and this is called a change in the general scale (or level) of prices, as contrasted with changes in the values of any two commodities in terms of each other. The general price level will be more fully discussed below (Chapter 6, section 3) in connection with the method of measuring by index numbers its changes. This brief explanation may, perhaps, be enough for our present purpose. Our question now is: What is the effect of changes in the quantity of money (considered apart from chance accompanying changes) upon the general level of prices?

§ 9. #Effect of increasing gold production#. Let us take a case where gold is in general use as money, and where for some time there has been no noticeable change in the amount of business, the methods of trade, and the general scale of prices. What would happen when new gold mines were found that were much easier to operate, and gold began to be produced at a much more rapid rate than formerly? The amount of gold as compared with other forms of wealth evidently would be increased. What if all the increase went into the industrial arts? The value of gold in its industrial uses would fall. Then a part of the increase must be diverted to monetary uses. When any man, by reason of the increasing gold supplies, gets a larger stock of money than he had before, the proportion formerly existing between his use for money and his monetary stock is altered. He has more money than meets his monetary demand at the existing prices. As he seeks to reduce his stock of money to due proportions by buying more goods, he thereby distributes a part of the excess of money to others. This bids up the prices of goods further until the total value of goods exchanged again bears the same ratio as before to the average monetary demand of each individual.

Take an extreme case: if twice as many dollars get into circulation in a community, either some few men may have far more dollars than before, while others have nearly the same number; or every man may have his due proportion of the new supplies, just twice as many as before in proportion to his income. The latter result, "other things being equal," is the logical one after equilibrium has been restored. If prices of goods remained the same as before, there would be twice as many pieces of money available to effect the same number of trades at the same prices. There is no reason why each person should tie up twice as large a proportion of his income in the form of money. If, however, there is a concerted movement to spend the surplus money, there results a general bidding down of the value of money, a general bidding up of the prices of goods. At what point will this movement stop? The rational conclusion must be that, other things being equal, the new equilibrium will be established when the ratio between the value of money and the price of the goods which each individual is purchasing becomes the same as before. The money being doubled, prices must be doubled, and likewise for any other change in quantity.

§ 10. #The quantity theory of money.# This explanation of the effect of changes in the quantity of money in a country upon prices (the general scale of prices) is known as the quantity theory of money. This theory has, for a century, been very generally accepted by competent students of the money problem. It may be summed up thus: other things being equal, the value of the monetary unit, expressed in terms of all other commodities, falls as the quantity of money increases, and vice versa. That is, prices rise and fall in direct proportion to changes in the total quantity. This is a simple explanation of a complex and difficult set of conditions. The phrase, "other things being equal," betokens the statement of a tendency where there are several factors. The quantity theory explains what happens when there is a change in one of the factors—the number of pieces of money. There are three large sets of facts to be brought into relationship with each other in the quantity theory: (1) the amount of business, or the number of trades effected; (2) the rapidity of circulation, depending on the methods by which business is done; (3) the amount of money available. According to the quantity theory we must expect that, when conditions (1) and (2) remain fixed, the value of money will vary inversely as its quantity. This quantity theory may be expressed in the formula P = MR/N when P is the symbol for price, or the general price level, N is (1) above, R is (2), and M is (3). P, therefore, changes directly with either M or R, or inversely with N.[6]

§ 11. #Interpretation of the quantity theory.# The quantity theory must be carefully interpreted to avoid various misunderstandings of it that have appeared again and again in economic discussion.

(1) It does not mean that the price level changes with the absolute quantity of money, independently of growth of population and of the corresponding growth in the volume of exchanges.

(2) It is not a mere per capita rule to be applied at a certain moment to different countries. For example, Mexico may have $9 per capita and the United States $35, while average prices may not differ in anything like that proportion. But in these two countries not only the amounts of exchanges per capita but the methods of exchange and the rapidity of the circulation of money differ greatly.[7]