All Commentary
Saturday, November 1, 1969

The Value of Money

Most economists are in agree­ment that the inflation in the United States during the past three years has been the worst since the early 1940′s, taking ac­count of both severity and dura­tion. But they cannot agree on the nature of the inflation that is en­gulfing the American economy. To some, inflation denotes a spectac­ular rise in consumer prices; to others, an excessive aggregate de­mand; and to at least one econo­mist, it is the creation of new money by our monetary author­ities.

This disagreement among econ­omists is more than an academic difference on the meaning of a popular term. It reflects profes­sional confusion as to the cause of the inflation problem and the pol­icies that might help to correct it. A review of some basic prin­ciples of economics that are ap­plicable to money may shed light on the problem.

Two basic questions need to be answered: (1) What are the fac­tors that originally afforded value to money, and (2) What are the factors that effect changes in the “objective exchange value of mon­ey” or its purchasing power?

Money is a medium of exchange that facilitates trade in goods and services. Wherever people pro­gressed beyond simple barter, they began to use their most market­able goods as media of exchange. In primitive societies they used cattle, or measures of grain, salt, or fish. In early civilizations where the division of labor extended to larger areas, gold or silver emerged as the most marketable good and finally as the only medi­um of exchange, called money. It is obvious that the chieftains, kings, and heads of state did not invent the use of money. But they frequently usurped control over it whenever they suffered budget deficits and could gain revenue from currency debasement.

When an economic good is sought and wanted, not only for its use in consumption or production but also for purposes of exchange, to be held in reserve for later ex­changes, the demand for it obvi­ously increases. We may then speak of two partial demands which combine to raise its value in exchange—its purchasing pow­er.

The Origin of Money Value

People seek money because it has purchasing power; and part of this purchasing power is gen­erated by the people’s demand for money. But is this not reasoning in a vicious circle?

It is not! According to Ludwig von Mises’ “regression theory,” we must be mindful of the time factor. Our quest for cash hold­ings is conditioned by money pur­chasing power in the immediate past, which in turn was affected by earlier purchasing power, and so on until we arrive at the very inception of the monetary demand. At that particular moment, the purchasing power of a certain quantity of gold or silver was de­termined by its nonmonetary uses only.

This leads to the interesting conclusion that the universal use of paper monies today would be in­conceivable without their prior use as “substitutes” for real money, such as gold and silver, for which there was a nonmonetary demand. Only when man grew ac­customed to these substitutes, and governments deprived him of his freedom to employ gold and silver as media of exchange, did govern­ment tender paper emerge as the legal or “fiat money.” It has value and purchasing power, although it lacks any nonmonetary demand, because the people now direct their monetary demand toward govern­ment tender paper. If for any reason this public demand should cease or be redirected toward real goods as media of exchange, the fiat money would lose its entire value. The Continental Dollar and various foreign currencies over the years illustrate the point.

On Demand and Supply

The purchasing power of money is determined by the demand for and supply of money, like the prices of all other economic goods and services. The particular relation between this demand and supply determines its particular purchasing power. So, let us first look at those factors that exert an influence on individual demand for money.

As money is a medium of ex­change, our demand for it may be influenced by considerations of facts and circumstances either on the goods side of the exchange or on the money side. Therefore, we may speak of goods-induced fac­tors and money-induced factors.

Variation on the Side of Goods

A simple example may illus­trate the former. Let us assume we live in a medieval town that is cut off from all fresh supplies by an enemy army. There is great want and starvation. Although the quantity of money did not change—no gold or silver has left our be­leaguered town—its purchasing power must decline. For everyone seeks to reduce his cash holdings in exchange for some scarce food in order to assure survival.

The situation is similar in all cases where the supply of avail­able goods is decreased although the quantity of money in the peo­ple’s cash holdings remains un­changed. In a war, when the chan­nels of supply are cut off by the enemy or economic output is re­duced for lack of labor power, the value of money tends to decline and goods prices rise even though the quantity of money may remain unchanged. A bad harvest in an agricultural economy may visibly weaken the currency. Similarly, a general strike that paralyzes an economy and greatly reduces the supply of goods and services raises goods prices and simultaneously lowers the purchasing power of money. In fact, every strike or sabotage of economic production tends to affect prices and money value even though this may not be visible to many observers.

Some economists also cite the level of taxation as an important factor in the determination of the exchange value of money. Accord­ing to Colin Clark, whenever gov­ernments consume more than 25 per cent of national product, the reduction in productive capacity as a result of such an oppressive tax burden causes goods prices to rise and the purchasing power of mon­ey to fall. According to that view, with which one may disagree, high rates of taxation are the main cause of “inflation.” At any rate, there can be no doubt that the American dollar has suffered se­verely from the burdens of Fed­eral, state, and local government spending and taxing that exceed 35 per cent of American national product.

Yet, this purchasing power loss of the dollar would have been greater by far if a remarkable rise in industrial productivity had not worked in the opposite direction. In spite of the ever-growing bur­den of government and despite the phenomenal increase in the supply of money (to be further discussed below), both of which would reduce the value of the dol­lar, American commerce and in­dustry managed to increase the supply of marketable goods, thus bolstering the dollar’s purchasing power. Under most difficult cir­cumstances, businessmen managed to form more capital and improve production technology, and thus made available more and better economic goods which in turn helped to stabilize the dollar. With­out this remarkable achievement by American entrepreneurs and capitalists, the U.S. dollar surely would have followed the way of many other national currencies to radical depreciation and devalua­tion.

Factors on the Side of Money

There also are a number of fac­tors that affect the demand for money on the money side of an exchange. A growing population, for instance, with millions of ma­turing individuals eager to estab­lish cash holdings, generates new demand, which in turn tends to raise the purchasing power of money and to reduce goods prices.

On the other hand, a declining population would generate the op­posite effect.

Changes in the division of labor bring about changes in the ex­change value of money. Increased specialization and trade raises the demand and exchange value of money. The nineteenth century frontier farmer who tamed the West with plow and gun was largely self-sufficient. His demand for money was small when com­pared with that of his great grandson who raises only corn and buys all his foodstuff in the super­market. Under a modern and a highly advanced division of labor, one needs money for the satisfac­tion of all his wants through ex­change. It is obvious that such de­mand tends to raise the exchange value of money. On the other hand, deterioration of this divi­sion of labor and return to self-sufficient production, which we can observe in many parts of Asia, Africa, and South America, gen­erates the opposite effect.

Development and improvement of a monetary clearing system also exert an influence toward lower money value. Clearing means offsetting payments by banks or brokers. It reduces the demand for money, as only net balances are settled by cash payments.

The American clearing system which gradually developed over more than 130 years from local to regional and national clearing, slowly reduced the need and de­mand for cash and thus its pur­chasing power. Of course, this re­duction of the dollar’s exchange value was negligible when com­pared with that caused by other factors, especially the huge in­crease in money supply.

Business practices, too, may in­fluence the demand for money and therefore its value. It is customary for business to settle its obliga­tions on the first of the month. Tax payments are due on certain dates. The growing popularity of credit cards reduces the need for money holdings throughout the month, but concentrates it at the beginning of the month when pay­ments fall due. All such variations in demand affect the objective ex­change value of money.

The Desires of Individuals for Larger or Smaller Holdings

The most important determi­nant of purchasing power of money under this heading of “money-induced factors” is the very attitude of the people toward money and their possession of cer­tain cash holdings. They may de­cide for one reason or another to increase or reduce their holdings. An increase of cash holdings by many individuals tends to raise the exchange value of money, re­duction of cash holdings tends to lower it.

This is so well understood that even the mathematical economists emphasize the money “velocity” in their equations and calculations of money value. Velocity of circu­lation is defined as the average number of times in a year which a dollar serves as income (the in­come velocity) or as an expendi­ture (the transaction’s velocity). Of course, this economic use of a term borrowed from physics ig­nores acting man who increases or reduces his cash holdings. Even when it is in transport, money is under the control of its owners who choose to spend it or hold it, make or delay payment, lend or borrow. The mathematical econo­mist who weighs and measures, and thereby ignores the choices and preferences of acting individ­uals, is tempted to control and manipulate this “velocity” in or­der to influence the value of mon­ey. He may even blame individ­uals (who refuse to act in accord­ance with his model) for mone­tary depreciation or appreciation. And governments are only too eager to echo this blame; while they are creating ever new quan­tities of printing press money, they will restrain individuals in order to control money velocity.

It is true, the propensity to in­crease or reduce cash holdings by many people exerts an important influence on the purchasing power of money. But in order to radically change their holdings, individuals must have cogent reasons. They endeavor to raise their holdings whenever they foresee depressions ahead. And they usually lower their holdings whenever they an­ticipate more inflation and declin­ing money value. In short, they tend to react rationally and nat­urally to certain trends and poli­cies. Government cannot change or prevent this reaction; it can mere­ly change its own policies that brought forth the reaction.

The Supply of Money

No determinant of demand, whether it affects the goods side of an exchange or the money side, is subject to such wide variations as is the supply of money. During the age of the gold coin standard when gold coins were circulating freely, the supply of money was narrowly circumscribed by the supply of gold. But today when governments have complete con­trol over money and banking, when central banks can create or withdraw money at will, the quan­tity of money changes significant­ly from year to year, even from week to week. The student of money and banking now must care­fully watch the official statistics of money supply in order to under­stand current economic trends. Of course, the ever-changing supply of money must not be viewed as a factor that evenly and uniformly changes the level of goods prices. The total supply of money in a given economy does not confront the total supply of goods. Changes in money supply always act through the cash holdings of individuals, who react to changes in their personal incomes and to changing interest rates in the loan market. It is through acting indi­viduals that supply changes exert their influences on various goods prices.

In the United States, we have two monetary authorities that con­tinually change the money supply: the U.S. Treasury and the Federal Reserve System. As of February 28, 1969, the U.S. Treasury had issued some $6.7 billion of money, of which $5.1 billion were frac­tional coins. The Federal Reserve System had issued $46.3 billion in notes and, in addition, was hold­ing some $22 billion of bank re­serves. Commercial banks were holding approximately $150 billion in demand deposits and some $201 billion in time deposits, all of which are payable on demand in “legal money,” which is Federal Reserve and Treasury money.

The vast power of money crea­tion held by the Federal Reserve System, which is our central bank and monetary arm of the U.S. Gov­ernment, becomes visible only when we compare today’s supply of money with that in the past. Let us, therefore, look at the vol­ume of Federal Reserve Bank credit on various dates since 1929:

Date Total in Billions

1929 Jun. 1.5

1939 Dec. 2.6

1949 Dec. 22.5

1959 Dec. 29.4

1969 Aug. 20 58.2
Source: Federal Reserve Bulletins

These figures clearly reveal the nature and extent of the inflation that has engulfed us since the early 1930′s. The 1940′s and again the 1960′s stand out as the periods of most rapid inflation and credit expansion.

How Government Creates Money

Why and how do our “monetary authorities” create such massive quantities of money that inevit­ably lead to lower money value? During the 1940′s, the emergency argument was cited to justify the printing of any quantity the gov­ernment wanted for the war effort. During the 1960′s, the Federal government through its Federal Reserve System was printing fe­verishly in order to achieve full employment and a more desirable rate of economic growth. Further­more, the ever-growing public de­mand for economic redistribution inflicted budgetary deficits, the financing of which was facilitated by money creation.

How was it done? The Federal Reserve has at its disposal three different instruments of control which can be used singly or joint­ly to change the money supply. It may conduct “open-market pur­chases,” i.e., it buys U.S. Treasury obligations in the capital market and pays for them with newly-created cash or credit. Nearly all the money issued since 1929 was created by this method. Or, the Federal Reserve may lower its dis­count rate, which is the rate it charges commercial banks for ac­commodation. If it lowers its rate below that of the market, demand will exceed supply, which the Fed­eral Reserve then stands ready to provide. Or finally, the Federal Reserve may reduce the reserve requirements of commercial banks. Such a reduction will set Federal Reserve money free for loans or investments by commercial banks.

It does not matter how the new money supply is created. The es­sential fact is the creation by the monetary authorities. You and I cannot print money, for this would be counterfeiting and punishable by law. But our monetary authori­ties are creating new quantities every day of the week at the dis­cretion of our government leaders.

This fact alone explains why ours is an age of inflation and mone­tary destruction.

Variable Responses

The Quantity Theory, which of­fers one of the oldest explanations in economic literature, demon­strates the connection between variations in the value of money and the supply of money. Of course, it is erroneous to assume, as some earlier economists have done, that changes in the value of money must be proportionate to changes in the quantity of money, so that doubling the money supply would double goods prices and re­duce by one-half the value of money.

As was pointed out above, changes in supply always work through the cash holdings of the people. When the government re­sorts to a policy of inflation, some people may react by delaying their purchases of certain goods and services in the hope that prices will soon decline again. In other words, they may increase their cash holdings and thereby counter­act the price-raising effect of the government policy. From the in­flators’ point of view, this reac­tion is ideal, for they may con­tinue to inflate while these people through their reaction may pre­vent the worst effects of inflation. This is probably the reason why the U.S. Government, through post office posters, billboards, and other propaganda, endeavors to persuade the American people to save more money whenever the government itself resorts to inflation.

When more and more individ­uals begin to realize that the in­flation is a willful policy and that it will not end very soon, they may react by reducing their cash hold­ings. Why should they hold cash that depreciates, and why should they not purchase more goods and services right now before prices rise again? This reaction intensi­fies the price-raising effects of the inflation. While government in­flates and people reduce their mon­ey demand, goods prices will rise rapidly and the purchasing power of money decline accordingly.

Passing the Buck

It may happen that the govern­ment may temporarily halt its in­flation, and yet the people continue to reduce their cash demand. The central bank inflators may then point to the stability of the money supply, and blame the people for “irrational” behavior and reac­tion. The government thus excul­pates itself and condemns the spending habits of the people for the inflation. But in reality, the people merely react to past experi­ences and therefore anticipate an early return of inflationary policies. The monetary development during most of 1969 reflected this situation.

Finally, the people may totally and irrevocably distrust the offi­cial fiat money. When in despera­tion they finally conclude that the inflation will not end before their money is essentially destroyed, they may rush to liquidate their remaining cash holdings. When any purchase of goods and services is more advantageous than holding rapidly depreciating cash, the value of money approaches zero. The money then ceases to be mon­ey, the sole medium of exchange.

When government takes control over money, it not only takes pos­session of an important command post over the economic lives of the people but also acquires a lucra­tive source of revenue. Under the ever-growing pressures for gov­ernment services and functions, this source of revenue—which can be made to flow quietly without much notice by the public—consti­tutes a great temptation for weak administrators who like to spend money without raising it through unpopular taxation. The supply of money not only is the best indi­cator as to the value of money, but reflects the state of the nation and the thinking of the people.



Debauch the Currency

Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a con­tinuing process of inflation, governments can confiscate, se­cretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some…. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

JOHN MAYNARD KEYNES, The Economic Consequences of the Peace

  • Hans F. Sennholz (1922-2007) was Ludwig von Mises' first PhD student in the United States. He taught economics at Grove City College, 1956–1992, having been hired as department chair upon arrival. After he retired, he became president of the Foundation for Economic Education, 1992–1997.