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The theory of the value of money

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The theory of the value of money

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Content THE T^ORY OF THE VALUE OF MONEY A Thesis Presented to the Faculty of the Department of Economics University of Southern California In Partial Fulfillment of the Requirements for the Degree Master of Arts (Economics) by Frederick McLeod Kinyon w January 1964 UMI Number: EP44802 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. Dissertation Publishing UMI EP44802 Published by ProQuest LLC (2014). Copyright in the Dissertation held by the Author. Microform Edition © ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code ProQuest LLC. 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml 4 8 1 0 6 - 1346 U N IV E R S IT Y O F S O U T H E R N C A L IF O R N IA THE GRADUATE SCHOOL UNIVERSITY PARK LOS ANGELES 7, CALIFORNIA h c , ( o f y k ' s c ? This thesis, written by Frederick McLeod Kinyon under the direction of hxs....Thesis Committee, and approved by all its members, has been pre sented to and accepted by the Dean of The Graduate School, in partial fulfillm ent of the requirements fo r the degree of MASTER OF ARTS Dean Date.. THESIS COMMITTEE Chairm an ..f 2-63— 2M— G A TABLE OF CONTENTS CHAPTER PAGE I. THE PROBLEM AND DEFINITIONS OF TERMS USED . 1 The Problem.......................... 2 Statement of the problem........... 2 Importance of the s t u d y ........... 3 Limitations of the study........... 3 Terms and Technology................. 4 Organization of the Thesis........... 5 II. MONEY VALUE ................................ 7 Definition of M o n e y ................. 7 Classification of Money Functions .... 10 Money as a medium of exchange......... 11 Money as a standard of value.......... 14 Money as a store of purchasing power . . 18 Money as a standard of deferred payment. 21 Money as a guarantor of solvency .... 24 Definition of the Value of Money.... 25 The general price level and money values 26 Value in exchange................... 31 Price and v a l u e ................... 37 • • li iii CHAPTER PAGE Measurement of the Value of Money........ 41 Definition and purpose of the Index Number 45 Construction of the Index Number .... 52 Inherent limitations of Index Numbers. . 69 Significance of Changes in the Value of Money.................................... 72 Significance of price changes on the distribution of Income and Wealth . . 77 Significance of price changes on the size and distribution of Real Output . . . 85 Summary.................................. 87 III. THEORIES OF THE VALUE OF MONEY............. 89 Introduction......................... 89 Importance of the theory of the Value of of Money.............................. 89 Scope of monetary theory............... 90 Alternative methods of approach to Monetary theory ..................... 92 The Cost of Production Theory of the Value of Money................................ 93 Statement of the Theory............... 93 Evaluation of the theory............... 94 iv CHAPTER PAGE The Bullionist Theory of the Value of Money 97 Statement of the Theory............... 98 Evaluation of the Theory............... 104 The Supply and Demand Theory of the Value of Money................................ 109 Statement of the Theory............... 109 Evaluation of the Theory............... Ill The Quantity Theories of the Value of Money 117 Original statements of the Quantity Theory 118 The modern statement of the Quantity Theory................................ 121 Summary................................... 125 IV. THE QUANTITY THEORIES OF THE VALUE OF MONEY 127 Transaction-Velocity Approach to the Value of Money.............. 128 Statement of the Equation of Exchange . 131 Indirect forces determining the magnitude of the factors in the Equation of Exchange.............................. 138 The Equation of Exchange during the tran sition periods......................... 146 V CHAPTER PAGE Some objections to the Transaction- Velocity Approach 154 The Cash-Balance Approach to the Value of M o n e y .................................. 173 The essentials of the Cash-Balance Approach.............................. 174 The need for Purchasing Power in the form of Money Balances................... 175 Statements of the Cash-Balances Equation 187 Effects of changes in the Supply of Money 204 Effects of changes in the Demand for Money 209 Some objections to the Cash-Balances ! Approach.............................. 212 Summary.............. ................... 219 OF MONEY.................................. 225 Preliminary Summary of the General Theory of Employment............................ 225 The Principle of effective demand . . . 227 The propensity to consume............. 232 The inducement to invest............... 232 V.\ THE INCOME-EXPENDITURE APPROACH TO THE VALUE vi CHAPTER PAGE Basic Terminology of the General Theory of Employment , ............................ 240 Factor costs ............................ 240 User costs.............................. 240 Profits................................ 240 Total Income............................ 241 Aggregate supply and demand price and their significance................... 241 Labor units and wage units............ 245 Savings, Investment, and Income .... 249 The Propensity to Consume and the Multiplier 258 The average propensity to consume . . . 259 The marginal propensity to consume and the multiplier....................... 267 The Marginal Efficiency of Capital and the Rate of Interest....................... 278 The marginal efficiency of Capital . . . 279 The theory of the Rate of Interest . . . 290 The Theory of Price Movements........... 309 Statement of the theory of Prices . . . 309 Evaluation of the theory.......... 315 vii CHAPTER PAGE Evaluation................................ 317 Summary.................................. 322 VI. MONETARY THEORY AND THE QUANTITATIVE INSTRUMENTS OF THE FEDERAL RESERVE SYSTEM 325 Instruments of Monetary Regulation .... 325 The Discount policy and rate........... 325 The Legal Reserve Requirements ........ 330 The Open Market Operations............. 332 Some General Observations on the Influence of Monetary Instruments............... 337 An Evaluation of General Monetary Control. 340 Some limitations to Monetary Policy. . . 340 The effectiveness of Monetary Policy . . 343 The changing significance of Near Monies 345 Summary................................... 351 VII. SUMMARY........................................ 355 BIBLIOGRAPHY...................................... 364 i CHAPTER I THE PROBLEM AND DEFINITION OF TERMS USED Money is an essential and vital entity in the economic system. Functioning in a commercial, industrial, and financial complex which is a wonder of integration and specialization, the role of money has attained a position of pre-eminence. Due to the all-pervading role which money performs in the economic system, each individual is inescapably affected by change in money values. The effect of a change in the value of money may differ appreciably, de pending on the economic station of the individual. The consequences will differ for the debtor and the saver, as opposed to the creditor and the spender. Too, farmers, wage earners, salaried workers, businessmen and stock holders, and fixed income recipients may all be affected differently. A cursory review of history will disclose a dra matic story of the impact of fluctuations in the value of money. Its ability to cause substantial shifts in the distribution of wealth and income, aside from effects on 2 output and employment, can spell financial catastrophe or fortuitous opulence for the individual involved. I. THE PROBLEM Statement of the problem Monetary theory, in its entirety, is but one branch of economics. Its purpose is to explain the functions and impact of money on other segments of the economy. Money value, in turn, is a major problem of monetary theory. The concept of money value is one of the most con troversial in the economic and political sciences. Mil lions upon millions of people, for century upon century, have felt the consequences of changes in value of money. Today, the heat of controversy reigns as torrid as in the past. There is still no single answer or solution to the problem of how to change or control alterations in the value of money. Opinions range from the idea that money is merely a commodity to the theory that money value is a com plex phenomenon of social psychology. This conflict of opinion lies at the root of many political experi ments in the field of business and finance. It largely accounts for the difficulty of solving economic maladjustments by political measures involving credit and monetary innovations which enjoy popular favor but 3 which profoundly disturb the underlying relationship of prices and production.! Importance of the study This study has been undertaken for a number of reasons, of which the following are but a few. The au thor's primary concern was to provide himself with a brief background of monetary theory. Secondly, an evaluation of monetary policies cannot be undertaken prior to the acqui sition of a familiarity with monetary theory. The promi nent and controversial position which the Federal Reserve System occupies in the United States cannot be understood, criticized, or commended without an awareness of the signi ficance of their instruments for affecting the economic machine. Finally, though the study is subject to rather significant limitations, it has proved sufficiently heuris tic to galvanize the author into continuing the study of economics in general, and money and banking in particular. Limitations of the study In the analysis of the various theories of money and its value, it was necessary to impose significant ^Eugene E. Agger, Money and Banking Today (New York: Reynal and Hitchcock, 1941), p. 132. restrictions on the material presented. Since recent con troversies on the relation of money to consumption, invest ment, saving, interest, and income are most commonly stated in terms of the Keynesian approach, the author was forced to emphasize the work by John M. Keynes, his followers and critics. This meant that the works of many other prominent economists had to be excluded, notably the contributions of D. H. Robertson, R. G. Hawtrey, F. A. von Hayek, and the Swedish group. However, it was beyond the intent of this thesis to air the expositions of the entire group of monetary theorists; consequently, a choice as to what was considered to be of greatest present interest was arbitrarily imposed. II. TERMS AND TECHNOLOGY The inclusion of technology and technical terms has been deliberately kept to a minimum. Where the use of strict economic nomenclature is employed, adequate definition and explanation will be found. For instance, an entire section in chapter five on the income-expenditure approach has been devoted to the elucidation of the term inology as employed in Keynes' theory. Nevertheless, an elementary knowledge of general economics will enable the reader to more readily embrace the contents of this thesis. III. ORGANIZATION OF THE THESIS An attempt has been made to construct the thesis so that each subsequent chapter is a sequel of the preceding one. This continuity should facilitate the reading and appraisal of the contents. Chapter two is devoted to setting the ground work for the subsequent chapters. In this chapter, money is defined, as well as described, in terms of the functions it performs. In addition, the relation between value and price is reviewed, along with the significance of changes in the value of money. Finally, index numbers are con sidered in terms of functions and limitations. Chapter three provides a cursory review of several of the more eminent theories which purport to explain the value of money. Each of the approaches is set forth in its traditional form, and is evaluated in the light of today's economic milieu. Chapter four is simply a more intensive presenta tion of the quantity theories outlined in the preceding chapter. Both the cash-balances and the transaction- velocity versions are analyzed in terms of algebraic 6 equations, and their strengths and weaknesses are examined. The cash-balances version is given particular attention, as the interpretations by Pigou, Keynes, and Robertson are separately stated and analyzed. Chapter five is entirely devoted to the general theory of employment as constructed by Keynes. Basic term inology is carefully defined prior to exploring the three prime forces which Keynes held to be of strategic impor-: tance in determining the level of employment of resources in the economy. Chapter six examines the control instruments which are employed with varying efficacy by the Board of Governors of the Federal Reserve System. Too, the instru ments are viewed in terms of the theories which have been previously examined. Chapter seven, while a summary of the foregoing, also includes the conclusions which the author reached. Too, a statement is included in regard to the needs for further study in the area of money value. ] CHAPTER II MONEY VALUE Robertson drew a parallel between the monetary system and one's liver, stating that they attract little attention or thought when operating correctly, but are the subject of much irritation and discussion when they are not.^- Perhaps this explains the continued interest in the subject, for the world has suffered intermittently from currency disturbances since the conception of the monetary mechanism. To more fully understand the relationship between various kinds of money, as well as the relation ship of money to goods and services, a brief survey of what money is, why it is essential to our system, and what functions it performs should be worthwhile. I. DEFINITION OF MONEY Money may be defined in a wide variety of fashions. It is not a vital matter which particular definition one ■ 4). H. Robertson, Money (Chicago: University of Chicago Press, 1959), p. 1. 7 8 decides upon, but it is essential to be consistent in the use of the chosen definition. In this thesis, money will be defined as anything generally acceptable, within a given area and time period, that is primarily used as a medium of exchange and a standard of value, and which, because of such use, performs additional useful functions. It is imperative to note that this definition places emphasis on the economic functions of money, and does not make it possible to identify, once and for all, the media that it subsumes. The definition would be enhanced if a list of the more desirable characteristics of money was presented. Briefly, money is more efficient if, in addition to the functions noted above, the following attributes are present: (1) portability; (2) indestructibility; (3) homo geneity; (4) divisibility; (5) cognizability; and (6) stability of value.^ Since the above are essentially self-explanatory, no further expansion will be made in the thesis. ^Frederick A. Bradford, Money (revised edition; New York: Longmans, Green & Co., 1933), pp. 3-5. 9 Prior to a discussion of the functions of money, it would also clarify the environment if a distinction is sharply drawn between money as an economic medium and money as legal tender. "Legal tender is any kind of money that a government has officially designated as an adequate instrument for the discharge of obligations stated to be payable in domestic money.Governments designate particular types of money in circulation as legal tender as a means of preventing countless disputes and litigation between creditors and debtors as to how outstanding obli gations are to be satisfied. Thus, it is evident that the designation of money as legal tender is a qualification to the acceptability of money, but does not alter the forestated definition. There are a number of reasons why an economic definition is superior to the legalistic one. First, as stated in the above definition, money is largely the result of social and economic evolution, and not merely the product of a government decision. Government may stimulate the process, but in so doing, does not establish general acceptability of the media, but rather sanctions it. -^Raymond P. Kent, Money and Banking (4th edition; New York: Holt, Rinehart & Winston, 1961), p. 17. Secondly, certain types of media have served as money in the economic sense long before they became legal tender. Finally, in times of serious economic disruption, the traditional media may lose their economic suitability regardless of government decree.^ A prime example of this occurred in certain countries during World War II, when cigarettes became more generally acceptable as a medium of exchange than legal money. II. CLASSIFICATION OF MONEY FUNCTIONS In modern economic life, money performs a variety of functions. These functions may be listed as follows: medium of exchange, standard or common measure of value, standard of deferred payment, store of purchasing power, and guarantor of solvency. To these functions might be added legal tender and bearer of options. The consider ation of legal tender was deliberately inserted in preceding discussion so as to facilitate the construction of a more succinct definition. ^S. Korteweg and F. A. G. Keesing, A Textbook of Money (New York: Longmans* Green and Co., Ltd., 1959), pp. xi-xii. In terms of modern analysis, the medium of exchange and standard of value functions may be regarded as primary functions, while the others can be categorized as secondary or incidental functions. Opinions differ over whether the primary functions are merely different views of the identical thing or are two separate functions. The question is whether an item which serves as a medium of exchange automatically serves also as a standard of value. Historically and practically, the distinction is important. Historically, the standard of value function developed prior to the medium of exchange function. Practically, one substance may be utilized as a standard of value, while another substance is being used as a medium of exchange.5 This distinction will be expanded upon in the analysis of money as a standard of value. Money as a Medium of Exchange This function of money is so obvious and familiar that it hardly requires explanation. Were money missing in our system, exchange would be dependent upon barter, a practice which imposes a number of inconveniences. ^Eugene E. Agger, Money and Banking Today (New York: Regnal and Hitchcock, 1941), pp. 32-33. 12 First, the need for some method of dividing and distri- i buting articles of value would be absent. Second , the p' improbability of coincidence between persons possessing and persons desiring would be omnipresent. Third, the complexity of exchanges, which are seldom executed in terms of one single article, would result in the breakdown on substantial segments of our economy.® Therefore, one of the paramount functions which money plays is as a medium of exchange. In any developed economic system in which the production and distribution of commodities are left to the initiative of individuals, the majority are employed in producing items and services which they do not themselves exclusively desire. In these circumstances, where exchange is so essential, a common medium must exist to facilitate the flow of products and services. In its role as a medium of exchange, money confers upon its owners the capacity to command goods and services to pay debts. Rather than exchanging goods for goods, money is exchanged for goods. But the money is not to be ®Ivan Wright, Readings in Money, Credit and Banking Principles (New York: Harper and Brothers, 1926), p. 3. 13 considered an end in itself; it is sought because it is desired for use in the future, eventually exchanging for goods and services.^ Taken in this sense, the result is the exchange of goods for goods, yet the stumbling blocks of barter are eliminated because of this generally accepted medium. In the analysis of this function, it should also be stressed that the value contained by money, its power to serve as a purchase medium, is but a reflection of the value of the goods and services for which it may be exchanged. As long as money circulates, it will have as much value as that for which it is exchanged. This is true whether money is made of paper or gold or any other substance. If money is based on gold, that fact may conceivably influence the willingness of the public to accept it in exchange for goods and services. But its value is derived from that for which it exchanges and not from the gold itself.& ^Lionel D. Edie, Money, Bank Credit and Prices (New York: Harper and Brothers, 1928), p. 19. ^Charles R. Whittlesey, Principles and Practices of Money and Banking (Revised edition; New York: The Macmillan Company, 1954), pp. 158-59. 14 Money as a Standard of Value It is as a standard of value that money can be compared with other units of measurement. This function may be labeled as a measuring stick of prices. When reference is made to money as a standard of value, the implication is that it serves as a device for reducing exchange ratios to a common denominator, thereby permitting the measurement and comparison of values of all other goods and services to be accomplished. However, money should not be taken as an absolute measure of value. The exchange value which a commodity possesses is derived from its ability to satisfy human wants; it is not an actual quality in an article, as is color or durability.^ It facilitates comparison, but is an abstraction and not an identity. It should not be presumed that the article which serves as a standard of value is actually invariable in value; it is merely a medium by which the value of future payments may be expressed. Cognizant that value is simply the ratio of quantities exchanged, it would be unrealistic to presuppose that the medium so chosen would permanently Q ^ Agger, o£. cit., p. 35. 15 bear the exact value relative to other commodities. Nevertheless, it is desirable to have a standard of account of measurement which would continue to exchange for many 10 other commodities in nearly unchanged ratios. The importance of "constancy’ 1 is poignantly articulated in the following: One has only to imagine what would happen to business calculations and plans if the number of ounces in a pound, or of inches in a foot, were . . . variable, and then to remember that, whereas these measures enter only into contracts concerning goods sold by weight or length, the monetary unit enters into every single economic contract of any kind whatever, to get an idea of the extent of the damage to economic efficiency for which a monetary system that is unreliable, or imperfectly understood, may be responsible .H Thus, the manner in which economic values are measured by money differs from the approach used in measuring length or weight in a very critical manner. While it is possible to measure physical units in terms of constant magnitudes, money does not follow suit. It may be assumed that, at a given time, one book might be worth two units of money, and a shirt one unit. If the value lOwright, o£. cit., p. 4. l^George N. Halm, Monetary Theory - A Modern Treatment of the Essentials of Money and Banking (second edition; Philadelphia: Blakiston Go., 1946), p. 17. 16 of the book increases twofold, while that of the shirt remains constant, their relative prices are said to have changed. In the course of economic events, however, it is also possible that as the book is doubling its value in terms of money, the shirt is doing likewise. In this instance, their absolute prices increased, while their relative prices remained the same. In practice, individuals frequently overlook the significance of a change or series of changes in the value of the monetary unit. At certain times, a unit of money may buy more goods than at other times, signifying that the value which it purports to measure cannot be defined in terms of a constant or invariable magnitude. The term "money illusion*1 has been derived from this type of situation, applying to instances when individuals compare money units over time, but fail to notice that equal units of money do not always represent equal units of given 1 o commodities. Prior to the examination of the secondary functions of money, it would be profitable to draw a distinction between money as a standard of value and as 1 o x Korteweg and Keesing, o£. cit., p. 308. 17 a medium of exchange on another plane. Though tradition ally, the functions have been combined into the same article, it is not absolutely necessary that all things which are used as a medium of exchange should themselves be also a standard of value. The only necessity arises in that the former must be expressed in terras of something which is itself a standard of value.13 For example, a Federal Reserve note or a check drawn against a demand deposit are not themselves standards of value, but merely are used to express multiples of the standard. To illustrate further, in the Homeric poems, indications point to the use of cattle as a measure of value, while payments were being made in gold. The Virginians, while using tobacco as a medium of exchange, commonly ’‘thought" in pounds, shillings, and pence.^ With this in mind, Professor Anderson felt that the medium of exchange function may be seen as growing out of the physical difficulties encountered in barter, whereas the standard of value is derived from the intellectual ■^Robertson, o£. cit., p. 3. l^B. M. Anderson, Jr., The Value of Money (New York: The MAcmillan Company, 1922), p. 421. 18 needs of m a n . The latter Is a means of immensely simplifying calculation, bookkeeping, acquiring an under standing of what is happening within the system, etc.; the later making possible many exchanges which could not be made at all if the medium were absent. Money as a Store of Purchasing Power As a store of value or purchasing power, money operates in the diametrically adverse direction than when used as a medium of exchange. In the latter, it is a matter of spending money, while in the former it is a matter of holding money.16 To the extent that a given quantity tends more toward a store of value, the longer it will be so held and not spent. While money is acting as a store of purchasing power, it is carrying value through space and time. The extent of an individual1s use of money in this manner can be measured by his supply of coin and currency plus any demand deposits he owns. This stock of money is maintained 15ibid., pp. 418-23. ^Lawrence S. Ritter, "Money, Income, and Economic Activity,n Money and Economic Activity— Readings in Money and Banking. Lawrence S. Ritter, ed. (second edition; Boston: Houghton Mifflin Company, 1961), p. 13. 19 as a type of revolving fund, since new receipts will be placed into it, while new expenses will be paid from it.^ The rule to be followed in determining the amount a prudent individual will maintain in such a fund is to keep as little as possible, scaling it down to a minimum. This is as applicable to the rich as to the poor. As Professor Edie stated: The danger against which every shrewd seeker of gain will guard himself is the danger of having too much money. He has too much money whenever he has surplus idle funds in pocket or in bank which could profitably be invested or otherwise spent to advantage. . . . in essence the store of value is hoarded money. His strategy as an economic calculator is to dishoard as completely as possible and to place as large a fraction of his resources as possible in forms of property that yield new returns. By keeping too large a holding of money, not only is the individual or business subjected to a loss of earnable interest, but the possibility of value deterioration is also of equal moment. Hence, whoever treats money in any form as a store of value is a speculator in the trend of prices. Therefore, money is an imperfect store of value, ^William Howard Steiner and Eli Shapiro, Money and Banking (revised edition; New York: Henry Holt and Co., 1947). l^Edie, o£. cit., p. 25. 20 ; attributable not only to it being profitless while unspent or uninvested, but also because it is atrophied by every fall in the purchasing power of money.^ Before consideration is given to the other second ary functions of money, attention should be directed to another function, similar to the store of purchasing power function, but carried under another label. Some economists wish to distinguish between the aforementioned function and what is designated as the "bearer of options" function. The distinction is based on the supposition that money is held as a store of value when a definite purpose for its use is in mind, either in the near or distant future. On the other hand, if the holder is not certain as to future developments, desiring to maintain a position which allows him to exercise various options, if and when they present themselves, or until the situation clarifies itself.^0 Basically, the bearer of option function is similar to the speculative motive as distinguished by Keynes in his analysis of liquidity. Keynes defined this 19Ibid.. pp. 25-26. ^Raymond P. Kent, Money and Banking (4th edition; New York: Holt, Rinehart and Winston, 1961), p. 12. 21 motive in terms of its purpose, "the object of securing profit from knowing better than the market what the future will bring forth."21 Anderson felt that the bearer of options is a much more important function than is the role money plays as a store of value, for the former arises from "dynamic change"--from the desire to acquire wealth in commercial transactions. "This is the dynamic function of money par e x c e l l e n c e . " 2 2 Though space and time limit a further analysis of this function at the present time, it should be kept in mind, if only in a heuristic context. Money as a Standard of Deferred Payment In the foregoing, attention was directed to money as a medium of exchange and as a standard of value. As concerns transactions beginning and ending on the moment, little more need be said. But, when employment of con tract obligations is introduced, a new element becomes vitally important. This is the element of time. Whenever a contract is made which extends over a period of time, 21John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt, Brace and Company, 1936), p. 170. 22Anderson, o£. cit. p. 426. 22 It is possible that serious changes in the economic melieu may occur, giving rise to difficulties as to what is a , f just” satisfaction of the instrument. Various articles might serve with equal ease when the transaction is made at a given moment, or within a short period of time. But, with the introduction of time, inequities may arise be tween the parties involved which are similar to those confronted by money when functioning as a standard of value. For example, John Doe borrowed twenty thousand dollars from the National Bank, agreeing to repay the principal in one lump sum at the end of two years. But, suppose in the interval, the purchasing power of money doubled, so that when the obligation expired, ten thousand dollars would buy as much as twenty thousand dollars did in the beginning. In this case, the lender received a fortuitous bonus which is wholly unmerited. Grave injus tice has been worked between the debtor and the creditor. In order to work with perfection as a standard for deferred payments, the article chosen as that standard' should place both debtors and creditors in exactly the1 same absolute, and the same relative,position to each other at the end of a contract that they occupied at its beginning; this implies that the chosen article should maintain the same exchange value in relation to goods, rents, and the wages of labour at the end as at the beginning of the contract, and it implies that the borrower and lender should preserve the same relative position as regards their fellow producters 23 | and consumers at the later as at the earlier point of time, and that they have not changed this relation, one at the loss of the other.23 Without pursuing a thorough discussion of the problem involved, cursory notice will be granted to two contrasting plans by which the role of money as a standard of deferred payments could theoretically be corrected. One plan conceived of stabilizing the general price level, thereby asserting to guarantee that when the creditor receives back the dollars he loaned out, they will contain purchasing power identical to what it was when the money was loaned out originally. Another method enunciated would be to alter the terms of the original contract so that the creditor would obligate himself to receive, not a fixed number of dollars, but a sum whose purchasing power at the date of maturity would be equal to the pur chasing power of the original number of dollars.2^ The ideas which have been constructed to solve this problem are innumerable, and beyond the scope of this thesis. Nevertheless, it is of interest to note the variety of 22Chester Arthur Phillips, Readings in Money and Banking (New York: The Macmillan Company, 1922), p. 7. 24Edie, op. cit., p. 23. panaceas which fall within these two poles. Money as a Guarantor of Solvency Many individuals and organizations hold substantial quantities of money simply to give assurance that they will be capable of meeting obligations, both known and unexpected. Funds retained on this basis may be labeled as being held for precautionary reasons— "the desire for security as to the future cash equivalent of a certain proportion of total resources."^ The distinct purpose of such a reserve is to provide a means of avoiding any dangers which can follow upon the default of obligations. It is important to note the distinction which separates the service of money as a guarantor of solvency from the role it performs as a store of purchasing power. As stated in the definition of the former, the intention of the holder is to yield these funds to his creditors only if it becomes absolutely essential for him to do so. In the latter capacity, the present intention of the holder is to use the funds to acquire goods sometime in the future. 25 Viewed in terms of efficiency, though money may often be deficient as a standard of deferred payment, it acquits itself commendably as a guarantor of solvency.^6 Obligations to pay in the future usually are stated in terms of a specific amount of money. The individual who incurs a debt of ten thousand dollars, to be paid two years hence, may, or may not, lose purchasing power prior to repayment if the value of money changes during the interval. Nonetheless, he can be absolutely certain of his solvency if, as the maturity of the debt approaches, he holds ten thousand dollars which can be allocated to the satisfaction of the creditor. III. DEFINITION OF THE VALUE OF MONEY The value of money is a social phenomenon, defined in terms of its capacity to command other goods in exchange for itself.^7 This is tantamount to expressing its value as generalized purchasing power. This value is measured Mby what a unit of money will buy in terms of a 26Kent, 0£. cit., p. 13. ^RPy l . Garris, Principles of Money, Credit and Banking (New York: The Macmillan Company, 1934), p. 231. 26 representative assortment of economic goods8 Thus, the value of money is to be considered in terms of the rela tionship of money to other goods, and not of one kind of commodity to another. The General Price Level and Money Values It is in one fundamental respect that the value of money differs from the value of other items. Whereas it is possible to express the value of shoes, books, cars, and other economic goods in terms of monetary units, it obviously is not equally valid to express the value of money in terms of itself. If money were to be used to express its own value, the procedure would be essentially meaningless. For the purpose of this analysis, the ability to command goods and services in exchanges, shall be con sidered to be the value of money. Because money values can be seen only through the value of other goods, it is necessary to reverse the normal role of estimating the value for a commodity. In the assessment of other goods, 2®Rollin G. Thomas, Our Modern Banking and Monetary System (second edition; New York: Prentice-Hall, Inc., 1950), p. 426. 27 money becomes the common denominator by which the total value of an assortment of heterogeneous goods can be computed, simply by adding up the different prices. But, with money, the common denominator is missing. For every item or purpose for which money is used, a separate and distinct value exists.29 Does this mean there is no accurate manner in which to express the value of money, except by enumerating, one by one, all the multifarious types of articles which money will buy? Hawtrey stated; The market assigns a single, determinate price to each thing dealt in; and thereby it establishes a value of the monetary unit in terms of each of the things dealt in. It establishes a multitude of alternative values--values in terms of the several individual things and in terms of all possible collections of them. There is no single value of the unit in terms of things in general, which is theoretically the value of the unit.30 His sentiments were in one sense, in accord with the definition outlined above, that money’s value is derived from its capacity to represent generalized purchasing 29J. l . Hanson, Monetary Theory and Practice (London; MacDonald and Evans, Ltd., 1956), pp. 183-84. 30 R. G. Hawtrey, ’’ Money and Index-Numbers,” Readings in Monetary Theory, The American Economic-Assn. (Homewood, 111.; Richard D. Irwin, Inc., 1951), p. 130. 28 power. Hence, this may be strictly interpreted to mean that changes in its value are indicated only through changes in ability to command goods in general, in exchange not by any capacity to command varying amounts of any 31 particular commodity or service. Many economists, such as Hayek, felt that it is not necessary to conceive of a general value of money or a general price level. The problem is never to explain any "general value of money but only how and when money influences the relative values of goods and under what conditions it leaves these relative values undisturbed . . 32 . " Thus, he felt that the general concept of price levels should be viewed as only a rudimentary instrument in the comprehension of the behavior of money. If real progress is to be made, reliance must be placed in the study of differential price movements. Does this lead to the conclusion that the con ception of a general price level should be ignored, that no economic significance can be attached to such a ^Frederick A. Bradford, Money (revised edition; New York: Longmans, Green and Company, 1933), pp. 187-88. ^Frederick A. Hayek, Prices and Production (London: George Routledge and Sons, Ltd.,. 1932), p. 27. 29 construct? Not necessarily, since one of the pre-eminent problems arises from misuse of the concept. The notion of a general price level follows from the obvious relation ship between goods and money as in the instance of a single commodity. If the price of the item is halved, a given amount of money will buy twice as much of it as previously. However, to extend the analogy to the general price level is to commit the fallacy of composition, that what is true of a part is true of an entire class. The inverse relationship must be qualified in the case of the general price level, since it is the sum of individual prices. The averaging of all prices would result in spacious quantitative accuracy, for it involves the com bining of the similar with the unsimilar, the important with the unimportant.^ A further problem develops when the concept of general price levels is used as a basis for analysis and evaluation of monetary programs. It is imperative, stated Professor Halm, that the dangers of using average prices be continually stressed. If the error is committed, 3%illiam Howard Steiner and Eli Shapiro, Money and Banking (revised edition; New York: Henry Holt and Company, 1947), p. 617. 30 attention is diverted from the vivid realities of the price structure, where consequences of monetary policy are worked out in terms of individual variations.^4 The concept of the general value of money should be considered as an abstraction, a useful construct which is based on a broad consideration of all the different specific values which money possesses.^ The expression has, in reality, no one definitive value, for money has as large a number of different values as there are different people to buy the different qualities and quantities of exchangeable goods and services. Just as it is in error to look for an immediate casual connection between changes in the quantity of money and the economic consequences of such changes, so, too, is it in error to think in terms of average prices as a concise expression of the general O £ L value of money. ° Even when index numbers are employed, it is merely enabling the individual to approach the problem by ■^George N. Halm, Monetary Theory--A Modern Treat ment of the Essentials of Money and Banking (second ed.; Philadelphia: Blakiston Co., 1946), p. 21. 35Richard T. Ely and others, Outlines of Economics (fourth revised edition; New York: The Macmillan Company, 1925), p. 291. 3%alm, loc. cit. 31 considering groups of goods and services instead of an innumerable array. While the commodities can be arbitrar ily limited to those which are homogeneous, either in terms of the goods themselves or by type of user, severe restric tions must be employed if the result is to contain any degree of relevance. Hence, the basic problem remains, in the sense that the value of money is determined through the compilation of individual items of infinite value. Nevertheless, the value of money can be considered, not as a singular item, but as a concept which must be 37 measured in accord with a definitive objective. Granted, severe and arbitrary limitations are omnipresent, the concept does represent a workable alternative to an unruly problem. If cognizantof the above limitations, the use of "average price levels" may be defensible. Those particular problems to be confronted in the construction and interpretation of index numbers will be considered in a subsequent section of this chapter. Value in Exchange In order to supplement the precision of the stated ^R&y L. Garis, Principles of Money, Credit and Banking (New York: The Macmillan Company, 1934), p. 232. 32 definition of the value of money, a review of the signifi cance of "value in exchange" should be beneficial. In the first place, note that value in the sense in which mone tary policy and monetary theory view it, means value in exchange, and the exchange should be market exchange. If it were not for the market, exchange of similar items would not be at the same ratio, and, therefore, the rela tions indicated by value in exchange would be incapable of either determination or measurement. The market should be limited in several respects to be valid or operable. It must be limited in place and in time. Thus, exchange value must be considered in the radlieu of a given market place, at a given time. If either of these two conditions were to differ or vary, the items exchanged might be different, or secondly, their relative importance and value may have changed.^® With this in mind, a preliminary distinction should be drawn between the exchange value and the subjective value of a commodity or service. Exchange value is often identified with market or objective value, as discrete 3®Hawtrey, o£. cit. pp. 129-130. 33 from subjective value. The latter is a personal concep tion of the relative importance attached to a particular unit of a good by an individual. Exchange value is objective andfmeasurable, in the sense that it is an ascertainable fact of the market, being reflected in the form of price. To elucidate, a commodity can, at a given time, have different values for different people, or different values for the same people at different times. This illustration is equally applicable to money. A given dollar may have much greater value when a person earns fifty dollars per week than, ceteris paribus. when he earns three hundred dollars per week. Thus, in this respect, the value of money appears to be similar to the value of all other things.^ Another distinction which should be amplified is centered around the controversies of whether money should have a value in use as well as a value in exchange. A medium of exchange, by the very essence of its capacity to so act, enables individuals to buy what they choose. 39Ely, op. cit.,p. 147. ^Hanson, o£. cit., p. 183. 34 If it could be exchanged only for a certain amount of one item, then its value would be determined by the value of the good in question. But, since the medium of exchange can be exchanged for any other good, the question arises as to what determines the value in exchange of the medium of exchange. To operate effectively, the medium of exchange must possess exchange value, for if it did not have this quality, no one would accept it in exchange for valuable goods. The medium of exchange cannot, therefore, be a free good, such as pebbles. It must contain the essential quality of scarcity, for it must not be available in such large quantities that it is able to satisfy every possible desire. However, this does not mean that it must have a value in use which is distinct from the value it possesses while serving in the role of a medium of exchange. It may have both value in use and value as a medium of exchange. But the critical distinction to be discerned is that the former is not relevant during the time when money is employed as a medium of exchange.^ When money is 43-Halm, op. cit♦, p. 14. 35 fulfilling this function, it does not directly satisfy human wants, nor would it enhance its operation if it were to do so. An additional point can be presented in the expansion of the concept, exchange value. The above definition of the value of money, that is, its general ability to command other goods and services in exchange, can be justified in terms of practicality. In attempting to measure changes in the value of money, it is impossible to accurately discern changes in purchasing power which are due to alterations in the values of goods produced, rather than from real changes in the value of money. Nevertheless, it may be appropriate to distinguish between relative changes in contrast to absolute changes in the value of money.^ Relative changes are those which result from changes in productivity, while those resulting from condi tions which primarily affect money are deemed absolute changes. Granted, it is difficult to distinguish between the two types when considering the economy as an aggregate, particularly since they both express themselves through the same medium, the price level. The dollar, in respect ^Bradford, op. cit. p. 189-90. 36 to individual goods and services, has rarely been stable in value for any extended period, for, while some prices are rising, others are falling or remaining stable. This may be due to changes in the demand for the commodities or because of alterations in the conditions of their supply. However, if on the other hand, all prices are changing in the same direction, though not all at the same magni tude, then the general change in the price level cannot be explained in terms of conditions of supply and demand for the goods and services in the system, but instead in terms of the supply and demand for money itself Therefore, it is necessary to keep two types of change constantly in mind when analyzing the value of money. As Garis stated, because they both express them selves through the price level, it would be at the neglect of productive process, something which is at the very base of our economic system, if the price level is deemed to express only the reciprocal of the value of money. The price level is a reflection of both absolute and relative changes in v a l u e . 4-4 ^Hanson, oj>. cit., p. 185. ^Garis, o£. cit., p. 233. Price and Value Prior to the conclusion of this section, a cursory review of the relationship which exists between price and money value is in order. When the price of a given article rises, its exchange value also rises, while the value of the currency will decline, since more of the monetary units will be required in order to purchase the article. The situation is reversed when the price decreases, for then the value of the monetary unit depre ciates. Thus, it is evident that the relationship between them is not one of cause and effect, but rather expres sions of reciprocal manifestation of identical phenomenon. Therefore, it is always imperative to distinguish between salient manifestations of a change in the value of money, and the cause of such changes. While prices are the measuring stick by which changes in the value of money are made, the price changes are symptoms, not causal factors, of money value changes. A fallacy is popularly committed through the assumption that price fluctuations are due to changes in the volume of money in use. If all prices are moving at the same time and in the same direction, it is tempting 38 to assign to this a general cause instead of to changes which are constantly taking place in demand, techniques of production, and output. It is quite likely that the latter may be exercising an effect on the price of the article in a manner similar to that imposed by changes in the volume of money. The arbitrary identification of changes in price with changes in volume of currency loses much of its appeal when two additional factors are brought to light. First, general price movements, whether upward or down ward, are the result of averaging of a number of individ ual prices. Secondly, the average price level may be unduly influenced by the price changes of a few commodi ties which exercise influence over the other commodities. Hence, it is not possible to draw a prior conclusion from fluctuations on the general price level prior to thorough examination of a multitude of strategic factors.^ Another note-worthy point to consider is that while prices may rise an infinite per cent, the purchasing power of money will never fall by more than one hundred per cent. In Germany, after World War I, though the 45ibid., p. 231-32. 39 wholesale price index rose by trillions per cent, the purchasing power of the mark fell over ninety-nine per cent, but not by the complete one hundred per cent. To fall one hundred per cent, money would have to be abso lutely worthless. To fall more than one hundred per cent, would mean that sellers of commodities would have to both give goods away and also pay the buyer a premium for removing the goods.^ Value differs from price in a monetary economy in yet another fashion. While it is not possible for the value of all goods to rise or to fall simultaneously, it is possible for all prices to move simultaneously in the same direction. This is because value is the purchasing power of a commodity in relation to all other goods, while the price of a good is its purchasing power only in respect to money.^ To regress for a moment, it will be recalled that in the market, goods are bought and sold for money. The amount of money which is used to facilitate the exchange 46i,ionel D. Edie, Money, Bank Credit and Prices New York: Harper Brothers and Company, 1928), p. 185. ^Raymond P. Kent, Money and Banking (fourth ed.; New York: Holt, Rinehart & Winston, 1961), pp. 407-10. 40 of a unit of a particular commodity is price. But, for price to contain relevance, not only must the commodity be identified, but the exchange transaction must also be qualified in terms of a given market, at a given time. From this context, the more abstract and general concept of exchange value has been derived. Exchange values are usually attributed to goods in accordance with their relative strength in exchange, evidenced by their price. In this sense, they may be thought of as economic magnitudes or exchange magnitudes, since it is a consequence of exchange relations with other goods. This is a purely relative or comparative magni tude, there being no other way to express this except in terms of command over other goods. The expression of exchange value can take the form either as a quantity or as a ratio. The value of one book may be expressed as equal to that of two shirts, or by stating that the value of the book is to the value of the shirt as two is to one. Naturally, the value can be expressed in terms of any other commodity. More commonly, price is taken as a statement of exchange value in terms of money. But, by expressing value of goods in terms of money rather than in terms of exchange value, the 41 situation is one of a definitive fact rather than an abstraction. The problem which is always present when dealing in terms of exchange values lies in the fact that the exchange value of a commodity depends not just on its own price, but also upon the prices of all other commodi ties. Thus, when exchange value is used as the equivalent of price, the assumption must be implied that the value of the monetary units as expressed in terms of all goods, other than the particular good being dealt in, is a constant IV. MEASUREMENT OF THE VALUE OF MONEY When the quantity theory was at its zenith, it was used to make a very convenient split in the problems which the economist studied. Money was the factor which deter mined the price level, while relations among prices were explained in terms of the supply and demand analysis of Alfred Marshall or the general equilibrium analysis of the mathematical school.^ 48 Richard T. Ely and others, Outlines of Economics (fourth rev. ed.; New York: The Macmillan Co., 1925, p.144, ^Albert Gailord Hart, Money, Debt and Economic Activity (sec. ed .; New Jersey: Prentice-Hall, Inc., 1948), p. 144. 42 The volume of production and employment was not generally considered a problem by these economists. It was assumed that in the long-run, there was a general tendency for all available productive resources to be put into use. Factors would push themselves into use by bidding down wage rates and raw material prices to the point Where business would find it profitable to employ them. The quantity theorists did, however, recognize short run or transitional periods. Links between changes in relative price and price levels, employment, or general prosperity were noted. Nevertheless, their interest was directed primarily at the long run situation, with full- employment deemed a general tendency. Recent years have witnessed the emphasis placed on the problems involved in the short run. As these problems moved into the fore ground, the price level withdrew as the pre-eminent consideration. In the 1930s, unemployment was the source of prime concern, with the price level all but pushed out of view. Experiences during and since World War II with inflation has brought the price level problem back into eminence, alongside that of unemployment. 43 Due to the separation of problems as briefly- outlined above, the theory and practice of index numbers developed. The natural compliment of the quantity theory of money was the conception of the idea that from time to time there is a pervasive general movement, affecting all prices in the same direction and in the same proportion. This, stated Hawtrey, is a constant concern of monetary policy.'*® The perplexing actuality, however, is that all prices do not necessarily change from timeJto time in the same direction, much less in the same proportion. Today, economists have come to be interested, not so singularly with general price level, but in measuring the effects of price changes on the position of specific groups of individuals. The main reason for this change is simply that "general" changes in prices turn out to be important just because they are not truly general, nor could they be general. "It is the inequality in price changes that brings about the important effects of price fluctuations."51 one of the basic monetary problems 5Or . g . Hawtrey, "Money and Index-Numbers," Read- ings in Monetary Theory. The American Economic Assn. (Home wood, 111.: Richard D. Irwin, Inc., 1951), p. 130. ^Russell Donald Kilborne, Principles of Money and Banking (New York: McGraw-Hill Book Co., 1932), p. 134. 44 arises from this fact: price changes among different goods and services vary in pace and magnitude. If each and every price did double in proportion, then everyone's income would be proportionally increased. The real life situation would be unaffected, for everyone could buy just what he could before, only at a higher price level. The problem, however, is that such an assumption is unrealistic. For instance, since a propor- tion of many persons' property is held in fixed dollar claims, when prices change, the nominal value of these claims does not change in proportion. In this case, to double the general price level would impoverish those whose cash holdings or fixed value claims were significant relative to their income or other assets, as compared to individuals for whom such assets are insignificant. Nor, are these the only reasons why general price changes are not in fact general. Price rigidities, which involve the vast field of monopoly, of collective bargaining and government control, would have to be taken into considera tion. Any price, fixed by legislation, administration, or convention would not be likely to display quick and smooth adjustments to changes in general movements. Hence, the problem which arises when changes in the value of money are measured, is due to the varied responses of prices to changes in this value. Index numbers do not distinguish between a change in prices due to scarcity and one due to changes in the quantity of money in general circulation. If it could be assumed that all prices would be equally affected, it would be possible to choose any price and use it as a measuring stick of changes in the value of money. But, it is evident that the price changes of individual commodities are not related exclusively to changes in money value, but all goods have elements peculiar to their conditions of production and exchange that cause changes in their prices which are not common to other g o o d s . 52 Definition and Purpose of the Index Number It is customary to approach the theory of the value of money by analyzing and explaining price movements. The problem of explaining the behavior of the price level may be deemed the problem of the value of money. The measurement of changes in prices or price levels is the 52 j, Marvin Peterson and D. R. Cawthorne, Money and Banking (New York: The Macmillan Company, 1949), p.389. 46 purpose of index numbers which is germane to the problem j of the value of money. A price index is a device employed with the intent of measuring central tendencies among diverse changes or many individual prices. They are a form of statistical average which facilitates price comparison between dif ferent periods of time.33 Since the usual index number is a striving for accurate depiction, King defined "the perfect index number . . . as some average or combination of sample items which fluctuates relatively in exactly the same manner as does the series of relatives derived from the totals of which the sample is intended to be representative."3^ in actuality, of course, the attain ment of the perfect index number is impossible, and is merely the goal toward which the statistician strives. This should always be kept in mind when working with price levels, for it "is not a given, self-evident fact, but a theoretical abstraction. It is a scientific tool which has to serve for certain scientific and practical 53Edie, op. eft., p. 64. 3^Willford Isbell King, Index Numbers Elucidated (New York: Longmans, Green and Company, 1930), p. 48. 47 55 purposes." The index number is thus a device which facili tates the measurement of average price fluctuations of a selected number of individual commodities. The practical usefulness of index numbers derives from the fact that prices have a tendency to cluster together, thus yielding an indication that the bulk of the particular prices within the index have done likewise. Since it is the relative movement of prices which is so important, an index which is too broad and all-inclusive so that it averages too wide a variety of prices, is of little practi cal use in this respect.It must be continually kept in mind that prices are constantly vacillating upward and downward, downward and upward; that the movement of a particular price is not necessarily in accord with the movement of an abstract average. Prices are determined by a multitude of price-formulating processes. Any influence which changes in the supply of money may have on the ^William Howard Steiner and Eli Shapiro, Money Banking (rev. ed.; New York: Henry Holt and Co., 1947), p. 618. - ^ R o l l i n g. Thomas, Our Modern Banking and Monetary System (second ed.; New York: Prentice-Hal1, Inc., 1950), pp. 403-5. 48 economy are not immediate and direct, but rather come about through single but interrelated price-making forces An immediate obstacle to tackle is the concept of "things in general." People spend their incomes on the flow of goods and services which enter into ordinary con sumption. But, this is only part of the real income or output of the economic system; it is also comprised of various types of new capital goods which are purchased by businessmen. Too, businessmen spend their money on raw materials, the hiring of labor factors, and the exchange of existing capital goods. Therefore, when using this concept, a tripartite must be made between goods and services which enter only into ordinary consumption, goods and services which comprise the gross national product as a whole, and goods and services of whatever kind that are exchanged with the aid of money. In respective order, the value of money can be viewed in terms of its consumption- value, or its income-value, or its transaction-value. A fourth distinction could be made in terms of labor-value, 57ceorge N. Halm, Monetary Theory— A Modern Treat ment of the Essentials of Money and Banking (second ed.; Philadelphia: Blakiston Company, 1946), p. 20. 49 which is the amount of labor of a given quantity which a unit of money can draw forth.^ These are all situations which must be met when using a term as highly imprecise as the general value of money or purchasing power. Hence, when comparing values, there is an infinite variety of situations and variables to consider. "A bus ride during which you sit down is not the same thing as a bus ride during which you have to keep on giving up your seat."^ An economically relevant definition of a price level cannot be divorced from the purpose in mind, and because each purpose delimits usefulness, a separate index number must be calculated for each such purpose.60 Since index numbers are used for a variety of purposes, the choice depends upon the object in mind. It is only after determination of this objective that it is possible to proceed intelligently in selecting the materials to use as data. 5%). H. Robertson, Money (Chicago: University of Illinois Press, 1959), p. 15. . ^Ibid., p. 16. ^Russell Donald Kilborne, Principles of Money and Banking (New York: McGraw-Hill Book Company, 1932), p. 115. 50 Consequently, when constructing an index number, the first question to answer concerns the use for which it is intended. The statistician must be clear as to whose cost of living he wants to measure, and at what location, geographically. Once these problems have been solved, the figures cannot be accurate for persons of different tastes, 61 even if working at the same job in the same locality. For example, when the ordinary individual thinks of prices, he does not consider all prices, but is interested only in the amounts of the things he himself buys, or antici pates purchasing. Too, there are no two people to whom money has the same value when they start out to spend it. Moreover, attention must not only be confined to spending. All are interested in what can be obtained for what one s e l l s . 62 Thus, at best, the person to whom the index number applies is an abstraction. The statistician can only hope to make him as representative as possible. Nonetheless, any conclusion based on the above should not categorically denounce the use of any type of 61 Robertson, loc. cit. ^Geoffrey Crowther, An Outline of Money (New York; Thomas Nelson and Sons, Ltd., 1948), p. 84. 51 general price level index. King felt it was useful to attempt to compute an index which approximates the general level of prices. But, he warned that proper qualification must be made, since so many of the important commodities are not standardized and because different people feel that different classes of the standardized goods should be included.^ Hence, it is unlikely any;one index would satisfy or represent all individuals. To conclude this examination of the purposes and qualifications to the use of an index number, the follow ing statement by Mills epitomized the preceding: Though . . . interest in the "general level of prices" has been dominant, other aspects of the behavior of price-relatives have received attention .... There has been . . . a growing appreciation of the economic importance of the price relations between different commodities and services. The con ception of prices as a system has been introduced, and the internal structure of this system has become an object of scientific inquiry. Once the significance of this conception is appreciated, it is clear that no single index number of commodity prices can yield the information concerning the behavior of prices and the shifts in price relations which economists and busi ness men require. For many important aspects of price behavior quite elude measurement by such an index. 64 6%illford Isbell King, Index Numbers Elucidated (New York: Longmans, Green and Company, 1930), p. 208. 64pxetlerick C. Mills, The Behavior of Prices (New YorJj^National Bureau of Economic Research, Inc., 1927), 52 Construction of the Index Number An index number is constructed by combining individual items, each of which is a ratio between the price of the article at one date relative to the price of 65 the same article at another date. The ratios can be computed on the basis of daily, weekly, monthly, or yearly statistics. They may be expressed as an average of several periods or computed at regular intervals. Index numbers are not based upon complete coverage of every price, but on a sampling of data and hence the samples must be representative of the universe or population described.66 The purpose or intent of the index number is to be indicative, to represent fairly, so far as one number can, the general trend of the various divergent ratios from which it is derived. When prices are compared between two different dates, it is evident that while some prices were constant, others were rising or falling. Nevertheless, within these diverse movements of individual goods and services, there 65R0y L. Garis, Principles of Money, Credit and Banking (New York: The Macmillan Company, 1934), p. 243. 66steiner and Shapiro, loc. cit. 53 may be a general trend which is susceptible to measurement. This possibility arises from the fact that large fluctua tions are not as frequent as are small price changes; that the majority of prices are somewhat adhesive, clustering toward a central tendency. If a larger percentage of all prices are rising, the central tendency may be considered to be rising; or if it is falling, a larger proportion of all prices are likely to be in the declining group. But, whether the central tendency is upward or downward, this concentration of individual prices above or below the tendency is what is considered to be amenable to statistical measurement.^7 In the construction of the actual index number, five principal problems are involved: (1) number and kinds of commodities to include in the sample; (2) source of the data; (3) weighing of the data; (4) selection of a proper base period; and (5) mathematical method of calculating the index number. Number and kind of commodities. Among the tens of thousands of commodities and services which enter into 67i,ionel D. Edie, Money, Bank Credit and Prices (New York: Harper Brothers and Company, 1928), pp. 64-5. 54 exchange, it is essential to select a limited number of representative samples for inclusion in the index number. One of the primary difficulties in the construction of the index number is that of arriving at a proper distribution of samples so that all the classes and types of commodi ties which may be strategic are included. The more repre sentative is the selection of the samples, the smaller is the number of individual commodities required. The number of items to include may be gauged by the type of prices one is trying to measure. Whereas a general purpose index of wholesale prices will include a relatively large number of commodities, a much smaller number can be used as a barometer of general business conditions. Studies by W. C. Mitchell have shown that the number of commodities makes little difference if the desired end is to indicate broad price movements. Never theless, it is essential that a large enough group be chosen to provide a representative picture of all sectors of the economy.^8 The number of commodities included is related to the problem of accuracy. If the chosen goods are truly 68steiner and Shapiro, ojd. cit., p. 619. 55 representative, and precise price quotations are readily available, a highly accurate index number can be obtained from a relatively small group of commodities. On the other hand, if the accuracy of the data is questionable, a much larger selection will tend to conceal any errors of individual quotations. But, as Fisher stated, there are limits which should be imposed on the size of the sample: An index number, really valuable, has been com puted for as few as ten commodities .... Seldom, however, are index numbers of much value unless they consist of twenty commodities; and fifty is a much better number. After fifty, the improvement obtained from increasing the number of commodities is gradual and it is doubtful if the gain from increasing the number beyond two hundred is ordinarily worth the extra trouble and expense.®" In the selection of the commodities, one criterion is uniformity in the commodities over a period of time. A commodity may undergo an improvement or deterioration in quality, resulting in a unit that is nominally constant, yet with a variable content. Difficulties of this type are more acute with finished products than with raw materials. A problem such as this is of particular moment today, due to the large quantities of labor embodied in 6 ^ I r v i n g Fisher, The Making of Index Numbers (second edition, revised; New York: Houghton Mifflin and Company, 1922), p. 340. 56 finished goods. With rising wage costs, the goods nearest the consumer reflect the labor cost, introducing a mislead ing element into the index number. Solving the selection problem also requires the need to recognize different classes of commodities and prices. Caution must be exer cised to restrict duplication of certain commodities at successive stages of m a n u f a c t u r i n g . 70 por example, an index which includes iron ore, pig iron, steel billets, steel rails, and automobiles involves considerable duplica tion, since the same commodity is included in the calcula tion at successive levels of manufacture. In the decision of which particular group of prices to select for measurement, the use to be made of the index number should be the governing factor. Thus, if the requirement is to measure the changes in the cost of living of workingmen, the index must draw from such sources as retail food prices, and the prices of clothing, fuel, shelter, etc.71 Not only will this particular list 7®Edie, op. cit., p. 68. 7lRollin G. Thomas, Our Modern Banking and Mone tary System (second edition; New York: Prentice-Hall, Inc., 1950), p. 404 57 differ from one compiled for business and professional groups, but it will also vary for workingmen in different geographical areas. Mills concurred with this, stating that regional variations in price behavior must be taken into account, particularly in a country which is as economically diverse as is the United States. Too, these differences are more acute when measured in terms of consumer goods than in wholesale goods.^ Even with the above problems solved, there are still remaining problems as to which price groups should be selected for the construction of indexes which depict the value of money. One view is that the most significant are those prices which represent the sale of commodities and services to the consumers. The alternative viewpoint is derived from the theory that the flow of money takes place through a number of more or less distinct channels and that consequently, an analysis of money should take cognizance of a plurality of price levels. The distinc tion is primarily one of emphasis, not one of seclusion of the alternative. One defense of the use of the prices of consumer ^Mills, o£. cit., p. 188. 58 goods and services is based on the concept that, under stationary equilibrium, the prices of these goods will be equal to the total of the prices of the factors of produc tion which went into their production.As Keynes statedj the compilation of secondary indexes might be used to 74 build up to the measurement of the general value of money. Such a measure has, therefore, much to recommend itself when the analysis of prices is to be launched from a theoretical position rather than a statistical analysis. Another defense proceeds from the idea that consumer spending is the central factor in business cycle analysis, and, therefore, variations in this price level must be a prime area of analysis. Keynes espoused the use of an index number which measures all the items which enter in final consumption as the proper implement for measurement of the general value of money.7- * A rejoinder to this proposition would be that while consumer spending and 73 J. Marvin Peterson and A. R. Cawthorne, Money and Banking (New York: The Macmillan Company, 1949),p.391. 7^John Maynard Keynes, A Treatise on Money, Vol. I (New York: Hareourt, Brace and Company, 1930), p. 66. 75Ibid., p. 57. 59 price fluctuations are of paramount importance, this should not be a substitute for more comprehensive analysis of other price levels whose variations are of equal significance, particularly in the search for causal factors.76 The calling for construction and analysis of plural price indexes is a product of the fact that all prices are not affected equally by changes in the demand for and the supply of money. Not only does such an analysis arise from this manifestation, but also from the realization that an injection of new money into the system is not diffused throughout all segments of the economy immediately or evenly. New money comes into existence in the form of specific balances owned by an individual, a firm, or a governmental unit, and is henceforth injected in such a manner as to affect, initially, some particular component of the price system. Thus, this theory is based on the concept that the economic edifice is not one homo geneous unit, evincing a need to study relative prices as a basis for inductive analysis. Schumpeter adhered to 76peterson and Cawthorne, o£. cit., p. 392. 60 this line of thought, as he levied greatest importance on particular price indexes. He wished to concentrate analysis on the . . . flow of expenditure runs . . . through several basins or economic spheres .... And there is no meaning to a combination of items from different spheres, or the whole of all the items of different spheres or phases, of the monetary stream. A varia tion in one direction of a price in the market of consumers' goods is not compensated by an equivalent variation in the other direction of a price in the market of producers' goods. There is, to be sure, plenty of interdependence between the different spheres, and units of potential expenditure can be shifted from one to the other. But this is irrelevant for the arithmetic of the thing. The relevant criterion is substitutability in the technical sense; we must combine, in order to get the proper price- level figure, the prices and quantities of all goods which compete for the sum that actually buys in a given sphere and in a suitable time interval, and nothing e l s e . 77 It is only fair to point out that Keynes was also aware of the need to use plural indexes, regarding them as a neces sary instrument in the study of monetary theory.As noted above, the distinction lay in area of emphasis. Source of the data. In the construction of index ^Joseph A. Schumpeter, Business Cycles, Vol. I and II, (first edition; New York: McGraw-Hill Book Co., 1939), p. 457. 78Keynes, oj>. cit., p. 54. 61 numbers, two types of data are required— weight and prices. Weights can be handled in terms of either money values of goods, or as physical quantities. Prices are normally a more readily available form of data than quantity data. Information on values or quantities has to be obtained from such sources as government reports, census records, trade association reports, which are not usually available in frequent intervals. Because of these and other problems, prices in the form of market quotations or contract prices are more often utilized; in the price indexes. Contract prices are based on actual sales by dealers and representative manufac turers. Market quotations, usually in the form of bid and ask prices, can usually be obtained by surveying newspapers, trade journals, produce exchanges, etc. Care must be exercised in this area as well, partly because such quotations are subject to rapid change, and partly because the bid and ask as transcribed in the newspapers may not be the actual prices at which executions are m a d e . Too, it is important that any quoted prices be 7Lionel D. Edie, Money, Bank Credit and Prices (New York: Harper Brothers and Company, 1928), p. 69. 62 obtained from a relatively broad market, for if they are not representative of a large number of transactions, bias O f ) may enter into the calculations. w Therefore, as with the other segments involved in construction of index numbers, the assembling of price and quantity data requires skill and judgment on the part of the investigator. If the work is done satisfactorily at this state, a main portion of the battle is won. The number of commodities may thus be relatively small if the collection of data is accurate, with no loss in the accuracy of the finished index number. Weighting of the data. Weighting is defined as the degree of relative importance attached to each of the selected commodities. Price indexes can be distin guished by the process of weighting, either simple formula or weighted formula. The former is often deemed to be unweighted, for no assigned weight is stated. However, this is actually a haphazard and unconscious weighting,for ®%illiam Howard Steiner and Eli Shapiro, Money and Banking (revised edition; New York: Henry Holt and Company, 1947), p. 620. 81 Eugene E. Agger, Money and Banking Today (New York: Reynal and Hitchcock, 1941), p. 103. 63 there is no such thing as a truly unweighted index number. The contrast is between those indexes which are weighted inadvertently and illogically, and those which are weighted by a deliberately conceived p r o g r a m . Thus, if a simple average is calculated from the sample data, the statistician may consciously or uncon sciously give the data haphazard rather than equal weight. For the price changes to approach accuracy, each item must be deliberately weighted in accordance with its relative importance. This relative importance is determined on the basis of either money value in relation to the money value of all items to be included, or on the basis of physical quantity produced, distributed, or consumed of the one item in relation to the other.83 Much skill and judgment is demanded from the statistician, for weights are altered only at long intervals, so that price variations may exercise the primary influence on the index. Selection of a proper base period. The use of index numbers enables comparisons to be made of the trend of a series over a period of time, reference being made to S^Edie, o£. cit., p. 70. 83Steiner and Shapiro, loc. cit. 64 a selected year which serves as a base. In this manner, conditions which prevail at one moment are expressed as a percentage of those prevailing at an earlier base period. In the selection of the base period, primary emphasis must be directed to the comparisons which are desired. Oftentimes an average of a number of consecutive years is used, on the assumption that a multiple base serves to offset cyclical oscillations to a greater extent. In other cases, year-to-year comparisons are made by using a chain base. This consists of taking each preceding year as the base for the current one. There are also indexes which have no base at all, such as the Dun and Bradstreet compilation. It is stated in aggregate terms for a selected number of items.84 There are several reasons why a recent base is more desirable than one which is remote. First, it is simpler to visualize price fluctuations as percentages of a recent base. Secondly, as the base becomes more remote, it is increasingly difficult to include important new commodities that may not have existed when the base period 84Ibid. 65 was selected and weights were assigned. A third reason is the tendency for errors and biases, which are omnipresent in even the most carefully constructed index number, to become exaggerated as the base becomes increasingly Or remote. J Fourth, the dispersion of price relatives is not as great when a recent base is employed. In general, the index is of greater significance the less the dispersion?^ Thus, the obtaining of an index number representative for the total price movement becomes increasingly difficult as the remoteness of the base period from which the price relatives are computed increases. Mathematical methods of calculating the index number. With a review of the four steps outlined above completed, it remains to conclude with the final step of calculating the index number by the use of a mathematical formula. Even though it is felt to be outside the perim eter of this thesis to present a thorough analysis of the ^^Rollin G. Thomas, Our Modern Banking and Mone tary System (second edition; New York: Prentice-Hall, Inc., 1950), p. 408. ^^William Leonard Crum and others, Introduction to Economic Statistics (New York: McGraw-Hill Company, Inc., 1938), p. 275. 66 mathematical complexities of index numbers, a brief acquaintance with Fisher's "ideal" formula may be profitable. Fisher commenced with a discussion of the six basic approaches to the computation of the index number; namely, the arithmetic, harmonic, geometric, median, mode, and the aggregative. The arithmetic is arrived at by adding the price relatives together and dividing by their number; the harmonic involves adding their reciprocals together and dividing into their number; the geometric is computed by multiplying the price relatives together and extracting the root indicated by their number; the median is selected by arranging the price relatives in order of size and selecting the middlemost; the mode is obtained by arranging the price relatives in order of size and select ing the commonest; and the aggregative is computed by add ing together the actual prices of each year and taking the ratio of these sums.®^ Fisher discussed 134 possible formulas, believing that fully thirty of the total yield results that are 87 Irving Fisher, The Making of Index Numbers (second edition, revised; New York: Houghton Mifflin and Company, 1922), p. 41. 67 accurate within a fraction of one per cent. The ultimate is commissioned the "ideal" formula, which he purported is capable of eliminating, as an instrument of measurement, the purely mathematical error to one-tenth or even one- hundredth of one per cent. "That is, the error probably seldom reaches one part in eight hundred, or a hand's breadth on the top of Washington Monument, or less than three ounces on a man's weight . . .”88 The equation took, the following form: where: = price of the item at the base period = quantity of the item at the base period = price of the item in the given year = quantity of the item in the given year = sum of all the items89 Fisher felt that arguments calling for use of different formulas for different purposes are negated by the use of his "ideal" formula. Once differences about formulas are banished, the true problems of accuracy are shifted to the other features of index numbers, such as assortment of goods and services, data, and number of 88Ibid., p. 228. 89Ibid., p. 482. 68 samples needed. In this respect, he was not as dogmatic in his appraisal of index numbers as is sometimes assumed. Errors which are due to insufficiency of number are reasonably slight, while those accredited to inaccuracy of the data are not significant, even though they may be great when viewed individually. Henceforth, the effort to improve the accuracy of index numbers must center chiefly on the assortment of the items to be included. This will differ for the different purposes to which the proposed index number is to be p u t . 9 ® As noted previously, the notion that the "ideal” formula is indeed ideal is a much challenged allegation. King, for one, did not feel that the tests of factor- reversal, circular-reversal, commodity-reversal, and time- 91 reversal are necessarily valid or germane. He was particularly opposed to theories which purport to estab lish the index number as a definitive reflection of a generally representative situation. As long as the questions asked differ, the formulas employed must also vary if satisfactory results are to be attained. 90Ibid., p. 365. 9^Willford Isbell King, Index Numbers Elucidated (New York: Longmans, Green and Company, 1930), p. 55. 69 Because of the complex nature of the data involved, it does not seem feasible to do any experimental work in determining the best formula to use in computing an index number of the general price level. One is there fore forced to depend upon deductive reasoning for the solution. The data involved are so heterogeneous in their nature that it would be dangerous to rely upon a small sample . . . ,92 Some economists feel that the core of the disagree ment between these two men was due to the different features which they stressed. King concentrated upon the purpose of the index, viewed in terms of its logical validity. Fisher, on the other hand, was concerned with the defects which were incorporated in the mathematical QO processes of calculation. J Inherent Limitations of Index Numbers Because of the vast array of statistical informa tion available to economists in the United States, "... where life is conducted from cradle to grave as a statis tical experiment, and where man’s works and all God’s creations are made the material for statistical exercises . . . ," cursory examination of the more conspicuous 92Ibid., p. 201. 9^Steiner and Shapiro, o|>. cit. , p. 622. 70 QA limitations of index numbers should be beneficial. The difficulties of statistical computation are of no greater importance than such fundamental problems as choosing representative commodities or choosing a proper base period. These theoretical difficulties cannot be obviated merely by the improvement of statistical tech niques. Even though a theory is strictly logical, it may still fail to explain every variation which occurs in the value of money as that value is reflected in a series of index numbers. These limitations vitiate any attempt to explain completely the behavior of money as it affects the level of prices.95 A prime limitation arises from the fact that price measurements take place in a dynamic world, one in which the relative importance of goods and services is subject to constant change. As Keynes explained, . . . the composite commodities representative of the actual expenditure of money incomes are not stable in their constitutions as between different places, times or groups. They are unstable for three reasons-- y^Ivan Wright, Readings in Money, Credit and Bank ing Principles (New York: Harper anda.Brothers, 1926), p. 1055. ^^George N. Halm, Monetary Theory— A Modern Treat ment of the Essentials of Money and Banking (second edition Philadelphia: Blakiston Company, 1946), pp. 100-1. 71 either (1) because the need which the object of expenditure is intended to satisfy, i.e. the purpose of the expenditure varies, or (2) because the effi ciency of the object of expenditure to attain its purpose varies, or (3) because there is a change in what distribution of expenditures between different objects is the most economical means of attaining the purpose. . . . For these reasons every change in the distribution of real incomes or in habits and educa tion, every change in climate and national customs, and every change in relative prices and in thedchar- acter and qualities of the goods offered for purchase, will affect in some degree the character of average expenditure. For example, if the price of an article falls, then the possibility arises of a bias in the weighing, for as price falls, new uses become feasible, while more of the product can be afforded. The conclusion to be derived, if solely on the above points, is that neither in theory nor in application is definitive accuracy or representa tiveness attainable. Index numbers, while worthy of use as a tool for economic analysis and policy formulation, will always remain abstractions from reality which must be properly qualified.^7 96john Maynard Keynes, A Treatise on Money, Vol.I (New York: Harcourt, Brace and Company, 1930), pp. 95-6. ^D. H. Robertson, Money (Chicago: University of Chicago Press, 1959), p. 20. 72 V. SIGNIFICANCE OF CHANGES IN THE VALUE OF MONEY Changes in the value of money manifest themselves through changes in prices. The economic disturbances which these price changes provoke, arises mainly from the failure of incomes, debts, and commodity prices to change proportionally. This price dispersion, that is, the tendency of individual prices to scatter, can be examined by distinguishing between the effects which it has on the distribution of income, the distribution of wealth, and on real output. Prior to discussing the significance of price movements, a brief explanation of the type of price move ments which the economics system experiences, is in order. Economists are in general agreement that the economic system creates at least four types of price movements: (1) long-run or secular movements; (2) cyclical fluctua tions; (3) seasonal variations; and (4) random or sporadic changes. To speak intelligently about price changes, the distinction between these four classes must be kept in mind. Secular changes refer to the slow upward or down ward movements of a price level which is sustained for a 73 relatively long period of time, such as ten, twenty, or thirty years. The forces which influence and determine the secular trend must be reasonably powerful, as well as broad in scope. While the causes for the trend may change at any time, they do influence the economic system in some uniform, or regularly changing manner through periods of time long in comparison with business cycles. The secular trend is entirely empirical, for it merely signifies a sustained process of change. It does not yield any information as to cause, for the trend is a particular combination of a group of interrelated forces.^® The cyclical type of price movements follow the business cycle. It consists of recurring alternations of rising and falling levels of activity and normality, or prices. It should be noted that while these cycles generally last from two to eleven years, they are to be regarded as recurring but not necessarily periodic.^9 The price movements normally vary in magnitude, depending upon the intensity of the cyclical swing, while also 98Ray B. Westerfield, Money, Credit and Banking (rev. ed.; New York: Ronald Press Company, 1947), p. 441. 99Robert Aaron Gordon, Business Fluctuations (New York: Harper and&Brothers, 1952), p. 214. 74 contributing to the fluctuation through their influence on business profits and expectations. Mills stated that this type of price movement has . . . something in common, in respect to sequence of change, amplitude and duration. These changes in different periods are far from showing perfect uniformity, but there is unmistakable evidence that the observed resemblances would not be found if the cyclical movements of individual prices represented random fluctuations alone. The seasonal movement of prices, unlike the cyclical and the secular, repeats itself in a more or less regular fashion each year. Though the precise pattern is susceptible to change with the pattern of time, it does tend to revolve around the changing seasonals of the year. Basically, they can be attributed to the following situations: (1) there are a number of conventional seasons which arise due to situations such as religious observances, statute law, fashions, customs, etc.; and (2) in the temperate zones, the changes in the weather control the growth, production, transportation, and use of 1 01 many commodities.- Even though the seasonal changes lOOprederick C. Mills, The Behavior of Prices (New York: National Bureau of Economic Research,Inc., 1927), p. 159. 101-Westerfield, o£. cit., pp. 441-42. 75 offset one another to a considerable degree, enough of them remain uncancelled as to make their influence felt on the level of some prices. Normally, for many commod ities, these changes are reasonably regular in time, amount, and direction, while for other goods, the changes may vary more or less in these respects. Random price movements are simply all those price movements not included in the secular, the cyclical, and the seasonal categories. While it is generally conceded that this type of movement cancels itself out due to one acting against another, if they are grouped together and related in some manner, they can move a price level in one direction or another. These types of movements may be divided into two categories. There are, first, the minor random movements which occur so frequently that they give a ’’saw-tooth” effect to a price series. They can arise for an infinite number of reasons, and fre quently the causes are not known. The second category of random fluctuations is of greater significance. This includes the sharper variations, the sporadic changes, which can normally be traced to specific causes. Examples would include war or the threat of it, Strikes, or ’’acts of God.” These variations can be distinguished by the 76 fact that they are not cumulative, as are the cyclical variations. Once the situation clarifies itself, such as the settling of a strike, the result is an immediate reversal type of movement back toward the previous level. This is not to say, however, that these irregular move ments are not cumulative, but merely that the period of time they cover does not reach the minimum needed to 102 classify it as a cyclical variation. An additional point to consider is the shifting interrelations among these elements over a period of time. Hence, the aforementioned types of time variables must be evaluated in the context of varying lengths of time, particularly the seasonal, cyclical, and the secular. Their consequences will vary, not only in proportion to their amplitude, but also in proportion to the rapidity 103 of their movements. A secular trend of the price level in the form of a seventy per cent rise spread over a thirty-five year period is far different in its economic and social consequences than an equal spread over a three lO^Gordon, o£. cit., pp. 212-13. lO^Lionel D. Edie, Money, Bank Credit and Prices (New York: Harper Brothers and Company, 1928), p. 75. 77 year period. The identical analogy applies to the cyclical and the seasonal in terms of impact and signifi cance. With the importance of time variation established, an examination of several of the groups which are affected by swings in the price levels will be commenced. Significance of Price Changes on the Distribution of Income and Wealth Price movements would work small injustice to the various social classes and economic interests if all price movements affected each of them uniformly. The critical problem, however, arises from the inequality of gain and loss between the various economic groups. Some prices rise earlier than others, some at a faster pace, or to a higher level. While one class of income is declining, another is advancing. One segment of industry is able to adjust itself quickly to price changes, whereas, another adjusts itself very slowly. It is the varying periods of lag, shifting sequences, and uneven amplitudes, which characterize the major price fluctuations and create serious economic problems. Business enterprise. Due to the manner in which corporations are constructed, the proprietary interests benefit at the expense of bondholders and other creditors when prices are rising. On the other hand, when prices are falling, the proprietors lose while the creditors reap the benefits of increased purchasing power. Anything which increases or decreases business costs, without a corresponding adjustment in selling prices, will expand or contract, whichever the case may be, the residual income which the businessman receives. A prime factor in the capriciousness of the businessman's share may be attributed to the "stickiness" of certain factor prices. When prices are rising, lagging costs enable the businessman to enjoy "windfall" profits, in the sense that "they are the result of the fortuitous circumstance of a rising price level instead of a reward for efficient management and meritorious anticipation of economic trends."'*'^ However, this halcyon period of profit taking may develop into an opprobrium for the businessman when viewed over a period of time. In the eyes of the consumer, these exceptional windfall profits lO^Rollin g . Thomas, Our Modern Banking and Monetary System (second edition; New York: Prentice-Hall, Inc., 1950), pp. 417-18. , . . 79 appear as a cause rather than as an effect or consequence of rising price levels. As Keynes remarked, To convert the business man into the profiteer is to strike a blow at capitalism, because it destroys the psychological equilibrium which permits the perpetuance of unequal rewards. The economic doctrine of normal profits, vaguely apprehended by every one, is a necessary condition for the justifica tion of capitalism. The business man is only tolerable so long as his gains can be held to bear some relation to what, roughly, and in some sense, his activities have contributed to s o c i e t y . 10.5 Conversely, sticky costs and falling prices produce "windfall” losses. Wages and interest costs are particularly difficult to bring down, and this results in a pinching of the residuum share of the businessman. It is true, of course, that if technological advances result in cost saving techniques, a fall in money prices may not precipitate a drought in business profits. Expectations aside, in weighing the effects of a deflation, it is the relation between the prices of products and marginal and 106 average unit costs of production that is so critical. j0hn Maynard Keynes, Monetary Reform (New York: Harcourt, Brace and Company, 1924). 106(jeorge jj. Halm, Monetary Theory--A Modern Treatment of the Essentials of Money and Banking (second edition; Philadelphia: Blakiston Company, 1946), p. 99. 80 Nevertheless, as a practical matter, the ability of prices to meet such exacting requirements is most unlikely. Debtors and creditors. The "progressive deteriora tion in the value of money throughout history is not an accident, and has had behind it two great driving forces— the impecuniosity of governments and the superior political influence of the debtor class."^^ Due to the vast importance of borrowing and lend ing in our economy, any disturbances to the relationship between these two parties is of grave significance. If a creditor made- a loan of one thousand dollars and the price level doubled in the interim prior to maturity, the proceeds received will be the same, but their purchasing power will be fifty per cent less. Thus, the debtor has gained, while the creditor has sustained a loss in real terms. Conversely, when the price level is falling, the impact of the two parties is reversed,with the creditor gaining and the debtor losing. Thus, in general, the position of the creditor is antithetical to that of the debtor. Nevertheless, they ■^^Keynes, oj>. cit., p. 12. 81 do have common interests at stake as the price rise or decline increases in magnitude, for both are better off in the long-run when the economic system is operating under stable conditions. As an example, a rapid rise in prices may temporarily favor the debtor class, but if the rise generates maladjustments which later bring on a depression, losses through default of obligations may well exceed any specious gains originally acquired. Individuals who conceive of society only in terms of aggregate analysis and interpretation, are presented with an interesting thought by Fisher when appraising debtor and creditor relationships. He stated that upon first viewing the disturbance between these two parties, it seems that one's loss is the other's gain, to an exact degree, and hence, the aggregate wealth of the two has not changed. But one might as well reason that when a bank vault is robbed . . . society is none the poorer. If you, the victim of the robbery, should be told, "What you have lost the burglar has gained, and therefore society as a whole is just as well off!" that would 108(;eorge Walter Woodworth, The Monetary and Banking System (New York: McGraw-Hill Book Company, 1950), pp. 44-45. 82 be cold comfort to you. In somewhat the same sense, this burglarizing dollar is defrauding people, it does so impersonally. . . . The evil is not (primarily at least) general impoverishment; it is social injustice. Unlike burglary and personal fraud, there is no viola tion of the letter of the law as to debts, but there is a defeat of its spirit and i n t e n t . This certainly raises many interesting questions when compared with the statement by Keynes at the commencement of this section. Wages. During the period of price fluctuations, the various segments of labor fare differently. Unorgan ized laborers, white collar workers, and the professional classes may find their money wages lag behind a rise in the cost of living, so that they live under a condition of declining real incomes during the dynamic phase of the period. The aggressive policies of organized labor, on the other hand, have enabled them to eliminate any sub stantial lags in wage rates, and in many instances have kept on a par with or exceeded any declines in purchasing power. Because rising prices are generally associated with increasing business activity, employers will normally prefer to meet any demands for higher wages rather than lO^irving Fisher, The Money Illusion (New York: Adelphia Company, 1928), pp. 60-1. 83 have production halted by a union strike. Usually, price rises preceed wage hikes, so that a short lag does exist between the two events. During a price decline, however, labor as a group has suffered a decline in real wages, not primarily through a cut in wage rates, but because of a decline in total employment. The unionized workers and the salaried class suffer less than the unorganized laborers, particu larly those who are employed in the durable goods 111 sectors. Farmers. Price fluctuations are more acute for the farmers than for many other lines of business. This industry is unable to adjust its production rapidly to changes in price conditions. The production period is relatively long and the rate of turnover is so slow as to prevent current adjustments in physical volume of output. It is this inelasticity of supply for agricultural products which prevents them from escaping the ills of falling prices as easily as other groups. ■^^J. L. Hanson, Monetary Theory and Practice (London: MacDonald and Evans, Ltd., 1956), p. 207. l^Woodworth, o£. cit. , p. 41. H2gdie, o£. cit. ,pp. 84-5. 84 The farmer has traditionally favored inflationary tendencies, for not only are the prices of farm products increasing, but in addition, there is a price lag in the cost structure which they face. As a group, farmers are large debtors, and can be disencumbered from the burden of mortgages, at the expense of mortgagees, by paying interest, amortization, and other fixed charges in a depre ciated medium. Thus, they share doubly in the specious benefits which inflation engenders. Nevertheless, while the farmer has little cause to fear inflation immediately, long-run considerations may label such a conclusion as myopic. When the inflationary bubble has exploded, the farmer must readjust his cost structure to the new price structure, an experience which has proved to be most painful and difficult. The problems which the farmer faced in the 1920s and 1930s were in large measure the product of an inability to adjust pro duction to the proper levels subsequent to the demise of the wild boom epoch of the World War I years. 113Kenneth K. Kurihara, Monetary Theory and Public Policy (New York: W. W. Norton and Company, Inc., 1950), p. 57. H^Steiner and Shapiro, o£. cit. p. 633. 85 Significance of Price Changes on the Size and Distribution of Real Output Monetary theory does not delimit itself to a study of price levels and variations thereof. It is also con cerned with the interrelations between price, value, and employment. For instance, the relationship between prices and output may be considered to be a theory of output alone during a slump, then passing into a theory of prices and output as the recovery progresses, and finally ending up as a theory of prices as the boom reaches its zenith’ ! ' 15 This emphasizes, not that one factor is paramount at a given time, but merely that the relationship between the factors is constantly shifting, necessitating a study of the whole system if an adequate understanding is to be acquired. Changes in the general levels of prices exert a significant effect on production. The extent of economic activity is largely dependent on the expectation of profit yields. When prospective profits are large, business is ^■^D. H. Robertson, Money (Chicago: University of Chicago Press, 1959), p. 172. generally active, and production is likely to be at a high level. When prospective profits are small, or disappear altogether for a large segment of the business community, unemployment is likely to increase and the volume of pro duction to decrease. When price levels are rising, business profits are usually on the increase. This is a result of selling prices moving upward at a faster pace than costs of pro duction. As explained above, many of the expenses of the businessman, such as wages, interest costs, and rents, increase either very slowly or with a time lag. So long as costs lag behind the increase in prices, the profits of the enterprise are increased. Therefore, as a general statement, an upward movement of prices is favorable to an increase in the volume of production in the short-run. When the price level is decreasing, production and employment also tend to decline. Just as interest costs and wages lag behind commodity prices during an inflation, they also lag behind in a deflation. The fall in commod ity prices in relation to costs results in a profit squeeze and causes many enterprisers to curtail production or to shut down their plants completely. VI. SUMMARY 87 i The influence of money in our economy has been briefly explained in terms of function and significance. Too, the problems of measurement have been outlined. The importance of price changes was considered to play a vital role in the economy, the impact depending on (1) the extent to which the price level fluctuates; (2) the rapid ity with which prices rise or fall; (3) the degree to which prices of all kinds of goods, wages, rents, interest rates, and other forms of income move together; (4) the consistency and steadiness with which prices rise or fall; and (5) the length of the period of general increase or decrease in prices. A final qualification which was noted in this chapter must be continually kept in mind, which concerned the sanctity of the price level. A particular price level is not a sacred thing, except that its existence for a significant period of time makes it the cornerstone for a myriad of money contracts and other economic relationships. H^Ray b . Westerfield, Money, Credit and Banking (revised edition; New York: Ronald Press Company, 1947), pp. 446-47 88 The public has a real interest in preventing any marked variations from the ’’traditional™ level. For such a vari ation necessarily involves a transgression of varying degree among existing contracts and arrangements. Revi sions and readjustments to a new plateau require a decade or more, while in the interim, the economic edifice may be severely shaken in its foundation. H^George Walter Woodworth, The Monetary and Banking.System (New York:. McGraw-Hill Book Company, 1950), p. 39. CHAPTER III THEORIES OF THE VALUE OF MONEY I. INTRODUCTION To solve the vast number of modern economic problems, it is necessary to possess a knowledge of the causal forces which determine the value of money. Money is seen as performing a peculiar and vital role in the determination of the volume of output, the distribution of output among the factors of production, and the level of consumption. The Importance of the Theory of the Value of Money Today, the problem of a stable price level is con sidered to be a goal of the government, thereby requiring a thorough knowledge and understanding of the principles of monetary theory by the general public as well as the central banker. Too, there is a growing belief on the part of the public that the duty of the government should encompass the areas of wealth and income distribution which result from changes in money value, much as it now 89 90 tries to prevent redistributions which arise from fraud or theft. A third reason for garnering an understanding of monetary theory arises from the effects which the business cycle has on price movements as well as employment and output. In this latter respect, it is felt that ameliora tive action should be placed along side preventive action. As John Stuart Mill noted, money "exerts a distinct and independent influence of its own when it gets out of order," and today it is widely recognized that money is often "out of order.Therefore, monetary theory is assigned the duel task of (1) identifying the various types and degrees of monetary disorders, as well as per iods of monetary order; while, (2) analyzing and attempt ing to mitigate the effects of the various types of monetary disorder. Scope of Monetary Theory As previously noted, the context within which the influence of monetary theory operates, is not necessarily restricted to analysis of the effect of factors 3-Lester V. Chandler, The Economics of Money and Banking (third edition; New York: Harper and Brothers, 1959), p. 196. 91 originating on the side of money, or even to just monetary policy. It is equally cognizant of the influence money exerts on nonmonetary factors, for these factors may have an equal, if not greater, impact on the behavior of the economy. A well trained policy-maker must understand the relationships within and between monetary and nonmonetary components if the policies designed and employed are to be efficacious as well as appropriate. Monetary theory has been employed in attempting to analyze many different types of interrelationships, with the primary emphasis shifting from time to time. Prior to the Great Depression of the 1930s, monetary theorists devoted primary concern to the measurement of changes in the value of money, to describing the significance of such changes, and to the factors deemed to be causal determi nants . The traditional supply and demand analysis was applied to the value of money, and attempts to explain it were derived from these studies. The central interest was directed to the long-run equilibrium situation, where full employment of resources was reached after all adjustments had been made. Only secondary attention was paid to the length of time required for this adjustment to occur, or to the effects which must take place during the 92 adjustment. While interest in the relationship of money to the long-run equilibrium and to the long-run conduct of price levels remains as zealous as in the past, over the years, theorists became dissatisfied with the restricted context of dealing primarily with value of money concepts. Brought forth was a desire to study the flow of money as well as its supply or stock. Variations in the rate and direction of money are now seen as capable of influencing changes in economic activity and development sizeably out of propor tion to concomitant changes in the value of money. Emphasis on employment and unemployment, disequilibrium and business fluctuations are manifestations of this narked shift in analysis. Alternative Methods of Approach to Monetary Theory Money is examined in a number of different, but related manners, including the quantity approaches and the income-expenditure approach. The quantity theory is divided into two subgroups— the transaction-velocity approach, and the cash balances approach. The transaction-velocity approach views the money supply as a stock which has a measurable velocity or turnover each period as it circulates. The transaction 93 aspect of the theory refers to the payments made, while the velocity component is the number of times a unit of money turns over within the period. The cash balances approach, or, by its alternative label, the Cambridge theory, starts from the premise that every dollar must have an owner at any given time. In asking the owner why he chooses to hold it, the theory is particularly applicable when analyzing the investment segment of the economy. The income-expenditure theory which is analyzed in chapter five, focuses attention on the act of spending. While similar to the transaction-velocity approach in the sense that both are spending theories, its difference lies in the emphasis on spending out of receipts rather than out of balance. It is of especial aid when a study of the relationship between spending and saving is to be made. II. THE COST OF PRODUCTION THEORY OF THE VALUE OF MONEY Statement of the Theory It is asserted by some economists that the value of money is determined in the same manner as the value of all commodities and services produced in the economic system. Assuming that a commodity is reproducible and is 94 sold under reasonably competitive conditions, its normal value will proximate the cost of producing it in quanti ties which are in accord with demand. Holding that the value of money was equal to that of the material from which it came, the only step needed, therefore, was to explain the value of the precious metal. Value was held to be determined by the cost of production, with the demand side of the picture held as a constant. As cost of production increased, so, likewise, did the value of the commodity. Relative to other goods, money value could change if its cost of production were to change appreci ably more or less than that of other manufactured goods.^ Evaluation of the Theory The application of the concept that identical forces determine both the value of economic goods and the value of money is subject to a number of difficulties. A first difficulty is that money is not always a commodity which is produced by labor and capital. In many cases, the government and the banks completely control the supply of money in the monetary system, making it impossible to ^S. Korteweg and F. A. G. Keesing, A Textbook of Money (New York: Longmans, Green and Co., Ltd., 1959), p. 280. 95 equate the cost of producing goods with the cost of producing money. Secondly, international restrictions act as a deterrent to fulfillment of this theory. Interfer ences with the free flow of goods and of the money commodity between different countries diminishes any tendency for the value of money to be the equivalent of its cost of production. A third criticism which also arises from the statement that the normal value of commodity money is determined by its cost of production, is that the theory does not indicate what causal relation exists between the value of money and its cost of production. Granted that the normal value of commodity money is equivalent to its cost of production. But, the cost of producing commodity money is determined in part by the costs of remuneration to the factors of production, and the amount of the remun erations are themselves significantly determined by the value of money. The sequel of this is simply that the value of money as determined by its cost of production is not as correct an assertion as that the cost of producing money is determined by its value.^ ^E. M. Bernstein, Money and the Economic System (Chapel Hill, N.C.: The University of North Carolina Press, 1935), p. 182. 96 A fourth reason for refecting this theory of money value is that at any given time, there is no one cost of producing gold. The cost of producing gold, similar to many other commodities, is composed of many different cost schedules. The height of the schedules depends upon the efficiency of the individual producers, as well as the inherent tendency for costs to increase in the mining and refining of the product as output expands. If an adequate explanation is to be found, it must be at the margin, where value and expenses of production tend to be equal. Even in this instance, however, the position of the margin varies with the magnitude of the demand for gold.^- Another criticism of the cost of production theory is evident when examination of the mining industry is under taken. Often, gold production is a joint endeavor with the production of other metals, such as silver, zinc, and copper. In this instance, allocation of the proper share of total costs to each product is very arbitrary. As a final criticism, Edie pointed out that any change in the long-run trend of prices will normally lag several years behind the corresponding change in the production of gold. ^Lester V. Chandler, An Introduction to Monetary Theory (New York: Harper & Brothers, 1940), pp. 94-95. 97 After new rock formations are discovered, from five to eight years elapse before modern mining equipment can be installed and the salable product put on the market. After the gold has entered bank reserves, further time elapses before banks can expand their credit and note issue. Not until this stage has been reached does the price level effectively respond to the influence of the new money supply. Hence, prices lag considerably behind the discovery of new sources of supply. In the long run they respond, but the intervening lag is of great importance in estima ting the correlation between gold and prices. This lag is ordinarily from five to seven years. III. THE BULLION1ST THEORY OF THE VALUE OF MONEY The adherents of the Bullionist theory believe that money derives its value from either its value as a commodity, or from a commodity in which redemption is possible or anticipated.^ It does not arise from use as a medium of exchange or from the sanction of the State. Money is just another commodity and its value is a product of utility and cost of production. It differs from other commodities primarily because it is quite well supplied with the qualities which make it acceptable. It follows that to the bullionists, money is ^Lionel D. Edie, Money„ Bank Credit and Prices (New York: Harper Brothers and Co., 1928), p. 245. %. M. Anderson, Jr., The Value of Money (New York: The Macmillan Co., 1922), pp. 152-53. 98 limited to those items which have a full intrinsic value of their own. Any medium which also serves in this capac ity is labeled a money substitute and derives its value from the possibility of redemption into the standard money. Money is either essentially gold or the "ghost of gold." The value of gold is set by the market for gold, which is then transmitted to money. The money prices at which goods and services are exchanged are merely translations of the true gold price.? Statement of the Theory The bullionist theory can be labeled an extreme interpretation of the cost of production theory. They hold that the value of any standard monetary unit is based upon the amount of the commodity contained in the unit. This is tantamount to saying that a dollar, which contains 5/21 grains of nine-tenths fine gold, has avvalue equal to the gold contained therein, and no more or less. The laws of supply and demand, operating upon gold bullion, determine the value that sets the value of the monetary ^ Albert Garlord Hart, Money, Debt and Economic Activity (second edition; New Jersey: Prentice-Hall, Inc., 1948), p. 152. 99 unit. With this as a launching point, the commodity theorists proceed to the following propositions: (1) All bank credit and paper money derive their value directly from redemptive rights in the standard money commodity. (2) Since money derives its value from the redemption rights in the commodity money, it follows that credit money retains its value only so long as it is redeemable, either presently or anticipated in the future. If redemption is no longer anticipated, credit money becomes valueless, since money can have no value apart from its commodity value. (3) Money is not dependent upon quantity for its value. The value of monetary gold, admit the bullionists, would be decreased by an increase in the supply of gold if this lowered the value of gold bullion. However, the price level is not affected by the quantity of gold money itself. The value of gold is affected by monetary demands only when it absorbs a portion of the supply, thereby augmenting its commodity value. (4) Money is employed merely to effect the exchange between goods, for price is fixed prior to the 100 exchange. The pricing process itself is simply a compari son of the value contained by a unit of gold with the value of a unit of goods. (5) The volume of bank credit can not directly affect prices. Bank credit derives its value from the bullion in which it is redeemable. Only after prices are determined, is bank credit created for use as a medium of exchange. It is after prices have been arrived at that bank credit springs into existence, with its volume determined by the rate of business activity and the level of prices. The causal relationship is conceived by the bullionists as moving from prices to bank credit. The value of gold is, however, less than it would be if bank credit were not in existence. Due to the creation of bank credit as a medium of exchange by the banking system, the monetary demands for gold are diminished. This leaves more gold for use as bullion, with the consequent effect that its value is less than it would be sans bank credit. (6) Price movements and business activity draw forth a response from both credit and standard money. Additional reserves will come forth whenever a shortage of bank reserves develop, because of the effect which higher interest rates have on attracting specie from other areas and countries. The cost of production of goods, rather than changes that affect gold, is the force which causes change in price levels.® The bullionists feel that in instances where the monetary system of every country is at one time or another based upon a commodity such as gold, or is convertible into such a commodity, the value of the monetary unit is fixed by the supply of and demand for the money commodity in industrial uses. This holds true even if monetary uses of the particular commodity in the form of coin and bank reserves leads to a reduction in the supply available for non-monetary uses, while increasing the value of the mone tary commodity. "The value of the precious metals, as money, must depend ultimately on their value as materials of jewelery and plate; since, if they were not used as commodities, they could not circulate as money."^ According to this theory, the value of commodity money, in the long-run, is determined by its cost of SRollin G. Thomas, Our Modern Banking and Monetary System (second ed.; New York: Prentice-Hall, Inc., 1950), pp. 521-22. ^E. M. Bernstein, oj>. cit. p. 184. 102 production; in the short-run, this value is relatively fixed. The latter condition is considered accurate, both because the stock of commodity money is large relative to its annual output, and because the demand for gold changes slowly. Any changes in the value of money are regarded as the result of changes in the real expenses of producing the goods and services purchased with money. It is the value of gold bullion which determines what the value of money, for the purpose of purchasing goods and services, will be. Any changes in the value of money can be traced to causes operating on either the side of gold or on the side of goods. The stock of gold being so immense, short-run fluctuations in the purchasing power of money must originate from the goods side of the picture. These fluctuations are the product of changes in the cost of producing goods and services. The price of any one article, wrote Laughlin, . . . is the quantity of the standard for which it will exchange. We are studying a case of exchange value; and the price obviously can be modified by anything which raises or lowers the exchange ratio of goods to the standard. If the standard were supposed to be constant, any one knows that changes of price could be brought about by changes in the expenses of production of goods. Put a tax on goods and it is expected in general that their prices will rise; introduce wonderful new inventions which save labor, and without question the price of the goods thus affected will fall. In neither case is it possible to refer the change in prices to changes in the demand and supply of ’’ money” (however it may be defined). In reality . . . any sudden or extreme fluctuations in prices, in any few years, could not be assigned to causes operating on the money standard, but to those operating on goods themselves.10 In summary, this theory, while it does not assert that the demand for gold is equivalent in form to that of any other commodity, does insist that money is either gold, or the ’’ghost of gold.” The entire superstructure of paper money, bank credit is merely an incidental reflec tion of the real phenomenon.H Commodities are thought of as having gold prices and these, in turn, are translated into money prices. From the bullionist viewpoint, the less gold a dollar contained, the higher was the money price of a commodity that corresponded to a given gold price. Warren stated that during the depression, When the country changes the price of gold, the effect on prices of most basic commodities is practi cally instantaneous. In fact, the anticipation of a change in the price of gold may cause commodity prices to change in advance of the fact.12 iUj. Laurence Laughlin, Money and Prices (New York: Charles Scribner's Sons, 1924), pp. 6-7. H-Hart, loc. cit. l^George F. Warren and Frank A. Pearson, Gold and Prices (New York: John Wiley and Sons, Inc.,1935), p. 191. 104 This statement is of particular economic significance since it was Warren who advised President Franklin D. Roosevelt when the devaluation of the dollar was under taken in 1933-1934. Roosevelt manifested great confidence in the efficacy of this deflation theory, remarking on October 22, 1933, "When we have restored the price level, we shall seek to establish and maintain a dollar which will not change in purchasing and debt-paying power during the succeeding g e n e r a t i o n . " ^ The velocity of money was apparently not considered.^ Evaluation of the Theory On the positive side of the bullionist theory, a number of comments should be made. Because of the lineage which exists between our domestic monetary system and the commodity gold, the theory cannot be entirely cast aside when studying the monetary system. The impact of inter national payments must include a consideration of gold, both in terms of its international and domestic signifi cance. The current problems involving interest rates, 13Louis A. Rufner, Money and Banking in the United States (New York: Houghton Mifflin Co., 1938), p. 727. ^Bernstein, oj>. cit., p. 297. 105 the balance of payments, and the size and flow of gold stocks, are examples of the continued importance of gold in the economic system.1J The argument of the bullionist that cyclical price increases spring from an increase in the value of goods and result in the swelling of bank credit in quantities adequate to make the price increases possible, is of some merit. It is true that at times such as this, the holding of goods is increasingly profitable. In the short-run, the bullionists' view may be considered preferable to the shallow view at times advanced by the quantity theorists, that bank credit is created in proportion to the supply of bank reserves and is the strategic factor in pushing 16 prices upward. ° The bullionist theory is subject to severe criti cism in many quarters. There is some truth in their statement that the value of money is always equal to the value of the monetary metal for which it is given or received. Nevertheless, their line of causation is con sidered to be upside down. It is not the value of gold ^Hart, oj>. eft., p. 153. ■^Thomas, loc. cit. 106 determining the value of money, but rather the value of money determining the value of gold. The industrial demand for gold is not as important in this context as is the demand for gold for monetary purposes. Bullionists may also be challenged on their assertion that the gold side of the supply picture is free from influences which can affect its value. Although the supply aspect of gold may be constant in the short-run, the demand side is not equally situated. The changing pros perity of a community, with concomitant changes in incomes, varies the industrial demand for gold. The demand for gold for monetary uses is subject to significant fluctuations, as, for instance, in the situation where the threat of a drain on bank reserves increases the demand for gold. Furthermore, the demand for gold for hoarding may vary, increasing or decreasing with the anticipated value of gold. In summarizing this point, so long as the demand for gold is susceptible to significant changes, the stability of the supply of gold does not insure stability of its value.^ l^Bernstein, o£. cit., p. 188. 107 The contention that paper money can have no value save that derived from the possibilities of redemption has not been sufficiently established by the bullionists. Too, the thesis that the pricing process is merely one of comparing the value of goods with the value of gold money has not shown itself to be amenable to verification. The experiences of currency devaluation in the 1930s by the United States failed to bear out their assertions. For example, the strict application of this concept during the devaluation of the gold content of the dollar by over forty per cent would have necessitated a proportionate increase in commodity prices in terms of gold dollars by approximately seventy-five per cent. The problem, however, was that it never occurred to businessmen that they should revise their cost figures, for they fixed their prices on a cost-plus basis.Insofar as the effect which the devaluation had on prices, it was manifest in increases in the dollar price of foreign currency units tied to gold, and thereby altering the markets for commodities entering into foreign transactions. The advocates of this theory felt that the ^Thomas, loc. cit. 108 nonmonetary uses of gold overshadowed the monetary uses. But, the facts of the situation repudiated this contention for several reasons. First, nonmonetary stocks have long been much smaller than the stock held for monetary purposes. Secondly, monetary stocks are the product of many years of accumulation, so that if monetary demands for gold declined sharply, the market for gold in indus trial and artistic uses could not absorb the supply for many years. Hence, it is erroneous to assert that the total value of gold is dominated by the nonmonetary uses. Gold is demanded for reasons which differ from the demand for other goods because gold is linked with money.^ Equally inadequate is their explanation of short- run price changes. They felt that these were due to identical changes in the real cost of producing the goods and services which are bought with money. Due to the vast bulk of goods which are produced by existing tech niques, it is inadequate to explain short-run price fluctuations in terms of changes in production methods. Even in times when revolutionary changes in techniques are ■^Hart, o£. cit., p. 152. 109 taking place, the decline in the cost structure is slow and gradual. The bullionist explanation in this respect is not sufficient for grasping the large and sudden price movements which take place in our society. Causal implication is also missing, for in the short-run, it is the price of an article which determines how much of it will be produced, and how far expenses will be incurred in producing it. A further complication arises since the expenses of production are themselves a product of the value of money, for they depend upon the monetary outlays to the factors of production. But, in turn, these rates depend upon the value of m o n e y . 20 i n conclusion, the bullionist theory of the value of money is not adequate to the task. Insufficient explanation is given for explaining the manner in which the value of money is determined, as well as for the causal relations which produce changes in money value. IV. THE SUPPLY AND DEMAND THEORY OF THE VALUE OF MONEY" Statement of the Theory The attempt has been made by many economists, ^Bernstein, o£. cit., pp. 189-90. 110 including the Austrian school, to integrate an explanation of the value of money and of changes in this value, with the general theory of economic value.it is held that the equilibrium of the demand for and the supply of the good, determines the market value of the goods as expressed in money prices. For every good sold in the market, there is one price at which the demand for and the supply of are equal, with market forces continually working toward this equilibrium price. The explanation is also extended to the value of money in the short-run, asserting that since it is both useful and scarce, money is capable of providing services similar to those of any other commodity, with its value amenable to determination by the normal supply and demand analysis.^2 In analyzing this approach to money value, a preview of the assumptions which support it will clarify, as well as simplify, the examination. Inherent in this theory is the definition that money is considered to be an Korteweg and F. A. G. Keesing, A Textbook of Money (New York: Longmans, Green and Company, Ltd., 1959), p. 279. oo ^Bernstein, loc. cit. Ill economic commodity, but only in terms of its nature, not in terms of its physical qualities. It must, therefore, possess utility and scarcity, and be influenced by the traditional forces of the supply and demand schedules. If this theory is to be substantiated, the aforementioned terms must be comprehended in the context in which they are normally employed in economics. Were this not to be so, the parallel constructed between the determination of the value of economic goods and the value of money would be invalidated. Evaluation of the Theory The usefulness of money arises from the fact that it commands an exchange value; whereas, with all other goods, exchange value is assumed to be the effect rather than the cause of its usefulness.^ While it is most common to consider utility in terms of what it grants to the individual, it may also be construed in terms of the convenience it yields to the community by facilitating both specialization, and the system of production, distri bution, and consumption of the national income. Regarded in this sense, the utility of money is a derived utility, 2%.orteweg, op. cit., pp. 280-81. 112 dependent upon those satisfactions secured from the goods purchased with money. Since this utility of money is a derived utility, its value is dependent upon the satisfactions secured from the goods and services purchased by money. Any change in the value of money must change its utility; an increase in prices decreasing the utility, a decrease in prices increasing the utility of money. In this respect, no analogy can be drawn between money and goods, for the utility of money is determined by its value; whereas, the value of a commodity is determined by its utility.24 It is true that up to a certain stage, money may behave for the individual, much like any other commodity. But, what is true of the part is not necessarily true of the whole. While most goods, as they become available in increased quantities, yield greater total satisfaction, such is not the case with money. Whereas, any one indi vidual would like to have more money for spending or saving, for the economic system as a whole, an entirely different impact and significance sets in. Commodities ^Bernstein, op. cit., p. 191. 113 retain their usefulness even if they become so plentiful that the process of selection and rejection is discontinued; a profuse supply of money would all but destroy money's usefulness. As previously noted, money is useful only because it commands goods in exchange, while commodities 25 may have an exchange value if they are useful. Perhaps the peculiar characteristics of the util ity of money can be depicted more lucidly if a distinction is drawn between marginal utility and total utility when the quantity of money is increased. If the quantity of a given good is increased, its marginal utility is de creased, but its total utility is increased. On the other hand, if prices rise proportionately when the quantity of money is increased, the marginal utility of money is diminished, but the total utility of money remains constant This signifies what is meant when it is stated that the quantity of money in a community, except during a period 26 of transition, is a matter of indifference. To conclude the discussion on the similarities between goods and money ^Korteweg, o£. cit., p. 282. 26gernstein, o£. cit., pp. 191-92. 114 in terms of utility, it can be stated that money cannot be relied upon to perform in accordance with laws which are constructed to handle economic entities from which it differs in essential qualities. A distinction must also be drawn between the scarcity of money and the scarcity of economic goods. The well-being of a community cannot be advanced by decreasing the scarcity of money, a conclusion which should follow if money were similar to economic goods. The problem arose when attempting to equate the scarcity of former with that of latter. In terms of economic goods, scarcity is a result of the limited resources of nature, and/or the real sacrifices which must be undertaken in production. But, when analyzing money, other than commodity money, its scarcity is an artifi cially imposed phenomenon created by the monetary authori ties of the State, with the intended purpose of regulating the value of money.. The question then presents itself as to whether or not the total prosperity of the community can be advanced if the scarcity of money is decreased. Such a conclusion should be in line with that drawn from economic goods if this theory is to demonstrate the 115 validity of its precepts. It is generally accepted that the well-being of the community is not augmented by dimin ishing the scarcity of money, and that it is advanced if the proper degree of scarcity is maintained. Therefore, the parallel drawn between money and economic goods in 27 this respect is of doubtful soundness. The concept of demand for money also poses serious questions. It is true that the community needs money if it is to transact its economic affairs. However, in this sense, is it a demand for a given number of units of money, or is it a demand for the means to command real resources? Bernstein stated that the community does not demand a quantity of money, but a quantity of purchasing power. If the latter proposition is correct, then there should be a tendency for the demand for money to increase when the value of money decreases, and conversely, to decrease when the value of money increases. But, in fact, there is no such a tendency by the community. The quantity of pur chasing power in the community, tending to be constant under ordinary conditions, is independent of the value of money, although not of changes in this value. In terms of ^Bernstein, loc. cit. 116 what would be expected with a normal demand schedule, the variations in the quantity of purchasing power which the community demands with changes in the value of money react in opposite directions. This is not to say, however, that the quantity of purchasing power the community would like to hold does not rise, at least temporarily, with increases in the value of money, nor that it fails to decrease, temporarily, with a decline in the value of money. In attempting to construct a supply schedule for money, difficulties similar to those evident in the demand analysis are confronted. First, regardless of how it is defined, as the quantity multiplied by the velocity, or merely as a quantity, the supply schedule for money does not have the characteristics of a similar schedule for economic goods. Bernstein noted, If the supply of money constituted a true supply schedule, the tendency would be for the quantity of money to vary directly with changes in its value, or in extreme instances, to remain fixed regardless of the value of money. In fact, a rise in the value of money— lower prices--tends to bring about a decrease in the quantity of money; and a fall in the value of money--higher prices--tends to bring about an increase in the quantity of money. ® 28Bernstein, o£. cit., p. 193. 117 One explanation for this takes cognizance of the amount of deposit money within the money supply, as determined by the banking system in response to the demand for credit. For instance, during a period of rising prosperity, with the banking system willing to create credit for business men, and the latter willing to accept it, an increase in prices tends to bring about an increase in the quantity of money. Conversely, a fall in prices, with a concomitant contraction of credit, tends to bring about a decline in the quantity of money.^9 jn summary, the supply schedule for money seems to travel in a direction opposite from a similar schedule for economic goods. V. THE QUANTITY THEORIES OF THE VALUE OF MONEY The question of changes in the value of money has already been indirectly touched upon in previous analysis of the inadequacies of certain explanations of the source of money value. For example, those theories which explain the value of money in terms of the quality of the money material implied that the value of money would change as the quantity is changed through the changing of the ^Bernstein, loc. cit. 118 content of the monetary unit. Now, however, attention is concentrated on explaining why changes occur in the value of money, in contrast with those that regard such changes as incidental to the question of why it is that money possesses value in the first instance. Original Statements of the Quantity Theory In comparison with all of the theories which have purported to explain the manner in which the value of money is determined, at any one time, and why this value varies over time, the quantity theory is probably the oldest and the most influential. Roman writings contained evidence of crude statements of the theory; with the aid of men such as Bodin, it became somewhat more sophisti cated during the sixteenth century, and by the latter part of the eighteenth century it had received further develop- ment, notably by Hume and Cantillon. u For instance, Jean Bodin engaged in controversy with Malestroit over the effect which the discovery of new American mines was hav ing on prices in the sixteenth century. Bodin*s tract, ^Lester V. Chandler, An Introduction to Monetary Theory (New York: Harper and Brothers, 1940), p. 21. 119 "Response aux paradoxes de Malestroit touchant 11encher- issement de toutes Choses et le Moyen d'y remedier," recognized the problems of money value, and with one phenomenon being related to another, came forth with his version of a quantity theory. The English Classical school of economists, and J. S. Mill in particular, consecrated much thought to the development of this theory. It was Mill who brought together the thoughts of the earlier writers and enunci ated the first statement of the quantity theory in its modern form. His point of view and doctrines have continued . to dominate American thought on the problem. If there were less money in the hands of the com munity, and the same amount of goods to be sold, less money altogether would be given for them, and they would be sold at lower prices; lower, too, in the precise ration in which money was diminished. So that the value of money,other things being the same, varies inversely as its quantity; every increase of quantity lowering the value, and every diminution raising it, in a ration exactly equivalent.31 Nor did the classical formulation by Mill fail to recog nize the importance of the velocity of money. •^John Stuart Mill, Principles of Political Economy— with some of Their Applications to Social Philosophy, ed. W. J. Ashley (London: Longmans, Green and Company, 1920), p. 493. 120 If we assume the quantity of goods on sale, and the number of times those goods are resold, to be fixed quantities, the value of money will depend upon its quantity, together with the average number of times that each piece changes hands in the process. The whole of the goods sold (counting each resale of the same good as so much added to the goods) have been exchanged for the whole of the money, multiplied by the number of purchases made on the average by each piece. Consequently, the amount of goods and of transactions being the same, the value of money is inversely as its quantity is multiplied by what is called the rapidity of circulation. And the quantity of money in circulation is equal to the money value of all the goods soldi; , divided by the number which expresses the rapidity of circulation.32 The original or crude construction of the quantity theory rested on the assumption that the amount of money spent during a period of time is proportionate to the quan tity of money. The experience of the business cycle, how ever, shows this assumption to be unrealistic, if not false. In the first state of a recovery from the trough of a bus iness depression, an addition to the quantity of money may have little, if any, effect on prices, and even when prices have begun to rise, it is unlikely they will rise propor tionately to the increment in the quantity of money. Furthermore, when the boom has reached its pinnacle, any additions to the quantity of money may result in a more 32Mill, op. cit., p. 494. 121 than proportionate rise in prices. The connection between the quantity of money and the price level, however, is of importance. Even though it is impossible to accurately gauge the effect of a small increase in the money supply, it cannot be doubted that a very large increase will precipitate a fall in the value of money, though not proportionately. The effect which the increase will have depends upon what the recipient of 33 the increment does with it. The Modern Statement of the Quantity Theory Although in agreement that the value of money is directly related to its quantity, the various modern quantity theories of money differ as to the means by which this relationship is reached. Shortly before the commence ment of the First World War, Irving Fisher, while distin guishing between legal tender and bank deposits, arrived at his mechanical version. E. W. Kemmerer was also of great influence in the development of this approach to the theory of money. This interpretation, commonly labeled the "transaction-velocity" theory, enjoyed its greatest •^J. L. Hanson, Monetary Theory and Practice (London: MacDonald & Evans, Ltd., 1956), pp. 191-92. 122 popularity in the United States, particularly as an t i ostensible explanation for the inflations which occurred in the decade prior to the Great Depression of the 1930s. Fisher's statement of the quantity theory assumed that the three immediate factors which determined the general level of prices were: (1) the physical volume of trade to be effected with money; (2) the quantity of money; and (3) the velocity of circulation of money. Price variations were traced to changes in one or more of these factors, as evinced in the statement that "the price level varies (1) directly as the quantity of money in circulation (M), (2) directly as the velocity of its circulation (V), (3) inversely as the volume of trade done by it (T)."^ Obviously, it is the inclusion of the second and third factors which distinguishes this modern interpretation from the original statements of the quantity theory. Another important interpretation of the quantity theory of money places primary emphasis upon the ^Irving Fisher, The Purchasing Power of Money— Its Determination and Relation to Credit Interest and Prices (new and revised edition; New York: The Macmillan Company* 1925), p. 29. 123 community's desire to hold a particular quantity of money to carry on its economic affairs, and the fashion in which this determines the value of money. Designated as the "cash-balances" theory, it was developed by the Cambridge economists, headed by Alfred Marshall. It was widely employed in England, and achieved much the same popularity there as did the ’’transaction-velocity" version in this country.35 Emphasizing the holding of money as a liquid reserve, advocates of this approach feel that their scheme is superior to the former on two counts. First, since it is stated in terms of supply and demand, the integration of monetary theory with the general value theory of economics is facilitated. Secondly, because it is claimed that the motivating force behind every economic decision is dependent upon the subjective valuations of individuals, the process of determining the value of money is more clearly related to these individual valuations.36 Ellis stated that the modern quantity theories are ^Charles R. Whittlesey, Principles and Practices of Money and Banking (revised edition; New York: The Macmillan Company, 1954), p. 90. 3 6 Chandler, o£. cit., p. 74. 124 | built around the following central doctrines: (1) The circulation of money is due to its ability to command real resources and discharge obligations; (2) The value of money is affected by all forms of money, whether commodity money, representative money, or managed money; (3) The quantity of money, directly or indirectly, determines the value of money; and (4) The value of irredeemable paper money does not require a special explanation.37 In conclusion, a definition of the quantity theory will further facilitate the forecoming expositions. According to this theory, prices are determined by the relation between the demand for, and the supply of, money. The demand consists in the offering of goods for money; the more goods are offered, the greater the demand. The supply consists of the money- pieces, whatever their material or form, available for the purchase of goods. The goods to be exchanged through the instrumentality of money remaining the same, an increase in the supply of money will, accord ing to this theory, raise prices; conversely, a decrease in the supply of money will lower prices.38 ■^Howard s. Ellis, German Monetary Theory, 1905- 1933 (Cambridge, Mass.: Harvard University Press, 1934), p. 5. ^®Henry Higgs (ed.), Palgrave1s Dictionary of Political Economy (London: Macmillan and Company, 1926), III, N-Z, p. 244. VI. SUMMARY 125 This chapter has provided a brief, but necessary, background of the role which monetary theory has played in our economy prior to World War I. The cursory perusal of the historical development of the cost of production and the bullionist theories, as well as the supply and demand approach, will facilitate the proper development and evaluation of two versions of the quantity theory, the "transaction-velocity” and the ”cash-balances." The subsequent development of the quantity theory has been undertaken for several reasons. The quantity theories are in harmony in that both agree that the normal effect of a change in the quantity of money is a propor tional change in the value of money, assuming that ade quate time has elapsed for the change in the money supply to permeate the economic system. A point of disagreement arises, however, over the emphasis given by one or the other to the means by which the effect of changes in the quantity of money work themselves out. Further controversy can develop over the meaning of the value of money and its measurement, and the assign ment of causal relationships between the various forces 126 involved. These differences are of sufficient magnitude to require a distinction to be drawn between the approaches to the quantity theory. Chapter four will analyze the transaction-velocity theory as developed by Fisher and Kemmerer, as well as the cash-balance approach taken by the Cambridge School. CHAPTER IV THE QUANTITY THEORIES OF THE VALUE OF MONEY While every variant of the quantity theory agrees that the value of money is specifically related to its quantity, there are differences of opinion as to the means by which this relationship is constructed. As mentioned in the preceding chapter, the approach to the problem can be viewed from either the "transaction-velocity*’ angle, or the ’’cash-balances” angle. The former has achieved greater popularity in the United States, and is best represented by the writings of Irving Fisher. The latter version has been predominant in England, where it is associated particularly with the Cambridge School. Note should be made that the quantity theory and the quantity equations of exchange are not identical expressions; and, in strict parlance and logic, it is not correct to assert that such an equation is an algebraic expression of the quantity theory of money. Quantity equations simply declare that of the factors which 127 128 influence prices, the quantity of money should be included. On the other hand, the quantity theory is a statement of the paramount importance of the role performed by the quantity of money, relative to the other factors which affect the level of prices.^- It is logically consistent to accept the exchange equations and still deny the quantity theory. To illus trate, it is possible to contend that in actuality, price changes cause proportional changes in money, without making any reservations at all concerning the equation of exchange. The equation does not necessarily present any particular theory of price-level determination, even though it is most commonly associated with the quantity theory of the value of money. The equation is equally applicable as a device for presenting a theory which puts little or no emphasis on the quantity of money.2 I. THE TRANSACTION-VELOCITY APPROACH TO THE VALUE OF MONEY Analysis of the theory of the value of money from ■hlay B. Westerfield, Money, Credit and Banking (rev. ed.; New York: Ronald Press Company, 1947), p. 431. ^George Walter Woodworth, The Monetary and Banking System (New York: McGraw-Hill Book Company, 1950), p. 298. 129 the standpoint of transactions begins with a presentation of a formula showing the relation of prices, money, and 1 the volume of output. As a preliminary to the introduc tion of the equation of exchange,a number of qualifications and distinctions must be noted and kept in mind as the exposition proceeds. In the form of MV = PT, the equation of exchange is an identity, and does not yield causal relations. On the other hand, the assertion that one or more factors in the equation are independent, or that one or more factors are dependent is not an identity. An identity is a state ment of the same facts in two different forms; its func tionality depends on whether the alternative presentations yield further insight into the situation. In a form, such as P 53 MV/T, the equation is a theory. In this instance, a hypothesis has been formulated, and deductions can be made and subjected to statistical verification. In terms of itself, the equation of exchange is merely a mathe matical identity which expresses the volume of business in two ways--by money spent and by the value of goods exchanged. It is useful because it systematically reduces the vast array of complex factors in the economy into two basic groups. The demand for money, which is equivalent to all the goods and services offered against money, is offset from the supply of money, which is equivalent to the demand for all goods and services.3 Therefore, as Fisher emphasized, there is both a money-side and a commodity-side to the equation. The total money paid is the money-side, and is a product of the supply of money multiplied by its rapidity of circulation. The commodity- side is composed of the products of the amount of goods exchanged multiplied by their respective prices.^ Beyond the acceptance of the equation of exchange, those who accept the quantity theory of money must also assert the following:^ (1) That differences in the veloc ity of money or in the volume of trade do not overshadow differences in the quantity of money as causes of differ ences in prices; (2) that nonmonetary forces do not bring ^W.H.Steiner, Eli Shapiro, and Ezra Solomon, Money and Banking— An Introduction to the Financial System fourth ed.; New York: Henry Holt and Company, 1958), p.440. ^Irving Fisher, The Purchasing Power of Money-- Its Determination and Relation to Credit Interest and Prices (new rev.ed.; New York: The Macmillan Co. ,1925) ,p.l7. 5 Albert G. Hart, Money, Debt and Economic Activity (sec. ed.; New Jersey: Prentice-Hall, Inc.,1948), p. 159. about differences in prices in a manner that will induce inverse differences in the volume of trade or parallel differences in the quantity of money or its velocity; (3) that differences in the quantity of money will not initiate inverse differences in its velocity, since if this were to occur, the money supply, multiplied by its velocity, might not change or might change in the opposite direction; and (4) that differences in the volume of trade will not be induced by parallel differences in the quantity of money. Statement of the Equation of Exchange Fisher defined the equation of exchange as "a statement, in mathematical form, of the total transactions effected in a certain period in a given community Stated algebraically, Fisher's equation of exchange is as follows: MV - M'V' - PT, where: M is the amount of money; that is, coin and paper currency, which is in circulation, outside of the Treasury and the banks. V is the velocity of circulation of money; the rate of turnover of money. M 1 is the volume of bank deposits, exclusive of ^Fisher, o£. cit., pp. 15-16. 132 i i interbank deposits, which are subject to demand. It includes deposits which are the result of cash deposits by customers of the bank, as well as those created by the banking system through the making of loans and investments. V' is the velocity of circulation of bank deposits. P is the general price level which prevails during the given period. T is the aggregate total of all transactions for which money payments are made. Money flow is represented by the symbols on the left side of the equation, and the money value of the flow of goods is represented on the right side. The equation, although it is logically sound, sheds no light on the causal relationships which exist between changes in the volume of transactions and prices (PT), and changes on the money side (MV). Since the quantity of goods sold multi plied by their prices is equal to the amount of money spent for such goods, it follows, reasoned Fisher, that the price level will fluctuate in accord with changes in the quantity of money, provided that the velocity of circu lation of money or the volume of goods exchanged remain in a given state. For, if changes in the quantity of money affect prices, then changes in the velocity of cir culation and the quantities of goods must also produce effects on prices. With this before him, Fisher built 133 his theory of causation, purporting to explain how altera tions in price-levels are brought about. He considered the price level to be a passive factor, determined by the other five components in the equation. Before presenting an analysis of the forces which act upon the five determining factors in the equation, it will be beneficial to further define these factors in the equation. In defining money, no distinction is drawn between money in circulation and money not in circulation. There is held to be no difference in kind between money which is in circulation and money which is not; the distinction is rather that some money circulates at a faster rate than other money does.^ In recognizing the importance of both types of money, that is, lawful money (M) and bank deposits (M1), Fisher maintained that the latter is not independent in quantity, but is in fact a function of the supply of legal tender. Deposits normally remain a rela tively constant ratio to money for two primary reasons. First, bank reserves are maintained in a more or less fixed ratio to bank deposits. Secondly, individuals, firms ^Westerfield, loc. cit. 134 and corporations keep a more or less fixed ratio between their cash dealings and their check dealings, as well as between their deposit balances and their money. These ratios are a product of habit and individual convenience.^ The inclusion of deposit currency in the equation ■ of exchange does not, under normal circumstances, derange the quantitative relationship between money and prices. Fisher did admit, however, that in periods of transition, the relationship between M and M* is by no means strictly proportionalBank deposits are held to merely magnify the effects which the quantity of money has on the level of prices and does not in the least distort this effect. Furthermore, whether bank deposits are included or not, the effect which changes in velocity or trade will have on prices remains the same. Therefore, It . . . follows that any change in M, the quantity of money in circulation, requiring as it normally does a proportional change in M*, the volume of bank deposits subject to check, will result in an exactly proportional change in the general level of prices except, of course, so far as this effect be interfered with by concomitant changes in the V's or the Q's that is, T's.10 Fisher proceeded to define V, the velocity of %isher, oj>. cit., p. 50. ^Fisher, Ibid., p. 55. lOpisher, Ibid., p. 52. 135 circulation of money. Its value is comprised of the total amount of money payments in a given period, divided by the number of pieces of money in circulation. This quotient depicts the average number of times each unit of money is employed in purchasing goods during the period. It’s the "average number of coins which pass through one man's hands, divided by the average amount held by him."■*-!• It is neces sary to distinguish between the gross and the net circula tion of the medium of exchange, for V is not the average number of times money changes hands from one individual to another. It is . . . the rate at which money is used for purchas ing goods, not for "making change." The result is the difference between the number of times each piece changes hands against goods. If a $10 bill is trans ferred in purchase of goods and $2 is given back "in change," the actual money expended for goods is measured, not by $12, the gross transfer of money, nor yet by $10, the gross amount transferred against goods, but by $8, the net amount paid for goods.12 The velocity of circulation of bank deposits is symbolized as V’. It is arrived at by dividing the aggre gate volume of bank debits in a given period, by the average dollar amount of deposits during the same period. l^Fisher, o£. cit. , pp. 352-53. ^ Ibid. 13William Howard Steiner and Eli Shapiro, Money and Banking (rev.ed.; New York: Henry Holt and Co., 1947),p.638. 136 Represented in one magnitude is T, the volume of trade. It is the sum of the physical volume of goods, services, and securities sold for money in a given com munity during a particular period of time. All articles are included, and every article is counted each time it is sold. 1-4 The symbol P in the equation represents the average price at which the physical quantities of things are sold during the period, and is commonly called the ’’general price-level." Because it is a summary term, P does not indicate what relationships exist within the price struc ture. Consumer's final products are not distinguished from wages and other costs, nor are producers' goods, securities, farm products, and so forth. Thus, since it is so all- encompassing, P is held to be a very abstract and heterogeneous construct. As an additional note, it should be recognized that the prices embraced in the equation of exchange are prices which have been actually realized on the things paid for with money during the period. P does not include l-^Lester V. Chandler, An Introduction to Monetary Theory (New York: Harper and Brothers, 1940), p. 41. : ___________________ 137 '’quoted'1 prices for articles which are tendered for sale, but that are not sold and paid for. Nor does it include "anticipated" prices. Naturally, realized prices both influence and are influenced by anticipations, but antici pated prices are never in fact realized.15 In summary, the equation of exchange shows that the four magnitudes, M, V, T, and P are mutually related. Since exchanges, whether individually or collectively always involve a "quid pro quo," the two sides of the equation must be equal. Thus fulfilled, it is imperative that prices bear a relation to the other three sets of magnitudes; consequently, "these prices must, as a whole, vary proportionally with the quantity of money and with its velocity of circulation, and inversely with the quan tities of goods exchanged."16 A simultaneous change in two or all three of the factors of influence, will result in a price level which is a compound or resultant of these various influences. It is possible that one may offset the influence of the others, so that it is not categori cally correct to assert that a doubling of the quantity of l^Woodworth, oja. cit., p. 297. l^Fisher, o£. cit., p. 18. 138 money will result in a doubling of the price level. Prices will vary directly as M and V, and inversely with T, pro viding that only one of these three magnitudes vary in each case, with the others remaining s t a t i c . ^ Indirect Forces Determining the Magnitude of the Factors in the Equation of Exchange Within the equation, M, V, and T are included as direct or immediate determinants of the price level, the level varying inversely with T, and directly with M and V. Even though these three are granted the status of direct determinates, this is not tantamount to according them the rank of ultimate determinates of the price level. Rather, they are themselves the product of a multitude of under lying objective facts and human decisions. It is neces sary to search behind the equation of exchange, not within it, to discover the ultimate determinants of the value of money. The discussion will proceed on the premise that all of the terms are of substantial significance, for any one of them can be of prime importance in a given context. •^Fisher, o£. cit., p. 21. 139 Determinants of the quantity of money (M and M*). The primary determinants which affect the total money ID supply are: I. The size of the monetary base, that is the supply of funds available for use either as cash or as reserves behind check deposits. A. The size of the monetary gold stock. 1. The amount of gold assimilated in earlier periods. 2. Additions to the monetary gold stock from current gold production. a) The real cost of producing the gold. b) The consumption of gold for nonmone tary purposes. B. The amount of other types of money issued by the government. 1. Coins, except those made on gold. 2. Paper money, except gold certificates. C. The amount of central bank credit outstanding. II. The community's choice as to the relative amounts of cash and of checking deposits that it wishes to hold. III. The height of the ratio between bank reserves and checking deposits. A. The legal or customary reserve requirements. B. The policy of banks as to permitting reserves to be deficient or excessive, relative to requirements. The quantitative relationship between bank depos its and money, in a given community, is regulated by such considerations as the state of development of the business wealth. Fisher held that there is: . . . a relation of convenience and custom between check and cash circulation, and a more or less stable •^Chandler, o£. cit., p. 30. 140 ratio between the deposit balance of the average man or corporation and the stock of money kept in pocket or till.19 In explaining this relationship, he felt that in normal periods, a community tends to retain a fairly constant amount of lawful money; if this amount becomes too large it is deposited in a bank and hence, into deposit money. Conversely, if the amount of lawful money is deemed to be inadequate, deposit money is withdrawn and converted into lawful money. In order to be sure that they can convert deposit money into lawful money, the banks maintain a reserve of lawful money. Therefore, the quantity of deposit money is dependent on the volume of lawful money, even though "during periods of transition this relation 20 between money (M) and deposits (M') is by no means rigid." Substantiating these assertions on the basis of both theoretical grounds and on evidence drawn from statistical studies, Kemmerer agreed with Fisher's conclu sion on the relationship between deposit money and lawful money. In referring to the percentage of deposits to reserves which a banker attempts to maintain, Kemmerer stated that: 19]?isher, o£. cit., pp. 51-52. ^Ibid., p. 55. 141 In the absence of changes in the banking laws of the country, or of banking practices, or in the rela tive use of checks and cash as media of exchange, or of business confidence, this normal percentage, with due allowance for seasonal changes, would tend to persist, regardless of changes from year to year in the amount of money in the country or changes in the physical volume of trade.21 In concluding, Fisher deducted that in a static or given situation, the volume of demand deposits (M1) bears a more or less definite relationship to the volume of legal tender money (M).^ This is attributed to the fact that people generally maintain a fairly steady ratio between the amount of legal tender they hold and their bank deposits. Therefore, the volume of credit (M') can be ignored as an independent factor in the determination of the value of money, since it will generally vary in direct proportion to fluctuations in the quantity of legal tender coin and paper money. Determinants of the velocity of money (V and Vf). Fisher held that the size of the money supply affects 2lEdwin Walter Kemmerer, Money--The Principles of Money and Their Exemplification in Outstanding Chapters of Monetary History (New York: The Macmillan Company, 1935), p. 56. 22Fisher, o£. cit., pp. 151, 54. 142 prices only through its impact on the volume of money expenditures, or on the demand for things for which money is spent, and that the correlation between these expendi tures and the money supply was far from perfect. This led him to the presumption that the rapidity of circulation of money is one of the direct determinants of the amount of expenditure, and consequently, the value of money. This led to an attempt to answer the question, ”what is it that determines the value of money?” In a previous chapter, it was noted that the functions of money included those of acting as a medium of exchange and as a store of value. If every individual, as he received a given sum of money, were to immediately spend it, the velocity of money would be infinitely great. In fact, however, this rarely occurs. A person will normally hold at least a portion of his money for some period of time, if only for a few hours, a day, or a month. When this occurs, the individual is holding the funds as a store of value. The longer the ’’average interval or rest” between the receipt and the expenditure of the money, the lower must be its velocity of circulation.^ ^^Chandler, oj>. cit., p. 34. 143 The determinants of the velocity of money can be 9 A enumerated as follows: I. The stage of development of the credit and finan cial system and the extent to which the community uses it. A. The ease of lending and investing. B. The ease of borrowing. II. The habits of the community as to saving and consumption. III. The systems of payment in the community. A. The frequency of receipts and disbursements. B. The regularity of receipts and disbursements. C. The correspondence between times and amounts of receipts and disbursements. IV. The rapidity of transportation of money. V. The state of expectations or anticipations of the community. A. The amounts of future income and prices of goods and services. B. The movements of the prices of income- yielding assets. The first four of the determinants of velocity described in the above outline may be collectively con sidered to regulate the normal state of velocity at any period, with changes in these factors taking the complex ion of long-term adjustments. Collectively, this group may be addressed as the ’'platform” of economic and finan cial development and commercial patterns of the society. It can be concluded that the velocity of circula tion is affected by any decision which alters the length 2^jbid., p. 36. 144 of time that money will be held before it is again spent. As indicated in the above outline, any changes in individ ual evaluation, as well as in the surrounding circum stances, may cause alterations in the rate at which money is spent. The "norm” may undergo wide variations in short periods, particularly during the various phases of the business cycle. Although this phase has been analyzed more intensively in a subsequent section, note should be made that changes in the state of anticipations and expectation, can exert significant influence on the rate of money velocity. Determinants of the physical volume of trade (T). It was previously stated that the aggregate of money expenditures in any given period varies with the size of money and deposits (M and M 1) and the ratio of velocity (V and V"). However, the price level varies with the relationship between these expenditures and the physical volume of things bought with money, not with just the absolute volume of money expenditures. Hence, the third determinant of the value of money is the actual volume of trade to be executed with money. Prices will be lower, with a given quantity of money, as the trade volume 145 increases, and conversely, prices will be higher, with a given supply of money, as the trade volume decreases. The determinants of the physical volume of trade 25 are summarized as follows: I. Factors determining the potential volume of current production of goods and services. A. The size of the population, its health, energy, and philosophy. B. The extent of territory, location, and rich- nessoof the natural resources. G. The supply of capital equipment. D. The state of knowledge as to techniques of production and administration. E. The variety and extent of human desires. F. The extent of free trade. G. The state of business conditions. II. The level of employment of the factors of production. III. The number of times that currently produced goods and services are exchanged for money. A. The manner in which business is strueted; the extent of business integration. B. The degree of specialization. IV. The volume of new security issues, and the number of times they are sold for money. V. The volume of goods and securities carried over from earlier periods and the frequency with which they are sold. VI. The extent to which barter is practiced. The state of business confidence excepted, the above forces are not susceptible to rapid change in the short-run, and like the velocity of circulation, is declared to be independent of the quantity of money in the ^^Chandler, ojj . cit., p. 42 . 146 equation of exchange. The stream of business depends on natural resources and technical conditions, not on the quantity of money. The whole machinery of production, transportation, and sale is a matter of physical capacities and te none of which depend on the quantity of money. In those rare instances where T is affected by P, Fisher regards them as abnormal. It should also be noted that the ratios of M to M' and that of V to V 1, are somewhat susceptible to the effect of T.^7 In concluding the review of the indirect influences which make themselves felt through the five direct deter minants, Fisher asserted that it is now possible to . . . restate . . . in what causal sense the quantity theory is true. It is true in the sense that one of the normal effects of an increase in the quantity of money is an exactly proportional increase in the general level of prices.28 It is, therefore, possible, Fisher maintained, to assert that the equation of exchange 1 1 stands forth . . . as the great determinant of the purchasing power of money.^9 The Equation of Exchange during the Transition Periods The transaction-velocity version of the quantity ^Fisher, ©£. cit., p. 155. ^Steiner and Shapiro, oj>. cit., p. 639. ^^Fisher, o£. cit., p. 157. ^ ibid., p. 150. :hni.que, 147 theory is inextricably wrapped in a veil of "normalcy." Fisher, in making innumerable qualifications to his deduc tions, emphasized the necessity of maintaining a vigilance, since any tendency;to "drop the assumptions would lead to spurious conclusions. We have emphasized the fact that the strictly proportional effect on prices of an increase in M is only the normal or ultimate effect after transition periods are over. The proposition that prices vary with money hold true only in comparing two imaginary periods of each of which prices are stationary or are moving alike upward or downward and at the same rate. As to the periods of transition, we have seen that an increase in M produces effects not only on the P's but on all magnitudes in the equation of e x c h a n g e . 30 Drawing a parallel between the business cycle and a pendulum, Fisher admitted that the pendulum is always seeking the equilibrium situation, but some occurrence of one type or another, continually prevents the attainment of this position. He then went on to state that periods of transition are the rule; periods of equilibrium, the exception, so that the exchange mechanism is continually in a dynamic rather than a stable condition.31 Attention is first directed to lawful money (M) 30Ibid., p. 159. 31lbid., pp. 70-71. 148 and deposit money (M') during the transition period. Fisher readily conceded that during periods when the aggre gate quantity of money is either increasing or decreasing, it is statistically evident that M and M' will be moving in a similar direction, but M' at a more rapid rate, and thereby disturbing the normal ratio which sexists between the two types of money. In periods of declining prices, such as during a recession, the quantity of M may be increasing while the quantity of M' is decreasing; con versely, the ratio of M' to M may increase during a period of prosperity. In fact, the relationship of M* to M is constantly varying during transitions, so that any "func tional1 1 ratio between M and M' is at best vulnerable to every cyclical oscillation.^ The transition period also distorts the equili brium performance of the velocities of lawful and deposit money. The major forces which determine the level of V and V 1, as well as lead to changes in their level, may be grouped into short-run and long-run categories. The long- run forces which have been discussed by Fisher in his 32e # Bernstein, Money and the Economic System Chapel Hill: The University of North Carolina Press, 1935), p. 205. 149 analysis of the indirect determinates of velocity, include the height of development of the credit and financial institutions, and the paying habits of the economy, etc. Closely related to the short-run changes in velocity are the state of business milieu and the general public's expectations about the future level of prices including interest rates and incomes. The exchange velocity of money often accompanies a general rise in business activity. This relation may be explained on several grounds. First, some components of the aggregate money supply whose velocity during the previous depression had been quite low or zero, will be called upon to purchase consumption goods and investments; hence, the velocity of exchange of the total money supply is increased by a greater velocity in segments of the total which has pre viously been inactive. Secondly, the rate of price changes may cause short-run changes in velocity. During times when prices are rising or declining with more than average speed, balances are turned over more rapidly than usual as businessmen anticipate further changes.^3 ^J. Marvin Peterson and D. R. Cawthorne, Money and Banking (New York: The Macmillan Company, 1949), pp.409-11. 150 In summarizing the role of velocity during periods of price inflation or deflation, it can be safely asserted that this factor performs a very important role. Under conditions of other than “normal" circumstances, it tends to propel inflation, people attempt to spend money with ever-increasing rapidity; in the opposite situation of a price deflation, expenditures are reduced and people at tempt to hold on to their money as long as possible.34- Fisher stated that the volume of trade (T), like the velocity of circulation, is independent of the quantity of money, except during periods of transition. Any fluctua tion in the quantity of money will not, in a "normal" state, appreciably affect the volume of trade.35 However, in any given period, and especially if the period is less than a complete business cycle, the total output of the economy will not necessarily be offered for sale. Inven tory liquidation and accumulation can affect the actual sales made for money so that final output must be adjusted for inventory changes to approach a practical concept of the volume of trade. Secondly, the degree of industrial ^George N. Halm, Economics of Money and Banking (Homewood, Illinois: Richard D. Irwin Company, 1956),p.88. ^Fisher, o£. cit., pp. 155-56. 151 integration in the economy affects the volume of trade. The transaction-velocity approach, in considering each exchange of money or balances, must include in the volume of trade the transfers between trades as well as those transfers of final output.36 In summary, the business cycle probably exerts the greatest influence on the volume of trade in the short- run. While controversy reigns over the efficacy of monetary forces in this sphere, equal or paramount signi ficance must be granted to such dynamic elements as inventions and technological improvements, the flows of income, shifts in the demand for products, and so forth. Passing note should be made of the role Fisher assigned to price (P) during the transition period. He felt that the price level is a dependent factor in the equation of exchange, and except for limited periods of transition, it is incorrect to regard the price level as an independent cause of fluctuation in any of the other magnitudes V, V* , T, M, or M 1.^? The price level is normally the one absolutely passive element in the equation of exchange. It is 36peterson, o£. cit., pp. 411-12. 37 Fisher, o£. cit., p. 169. 152 controlled solely by the other elements and the causes antecedent to them, but exerts no control over them. In this review of the transition period and its effects on the transaction-velocity approach to the quantity theory of value of money, it is readily evident that the proviso, "other things being equal" must be strongly emphasized. Of the factors which demand special emphasis, business confidence in general, and the public's confidence in the value of the country's money, must be considered as particularly important.^9 Nonetheless, Fisher continued to assert that after the equilibrium is established, the permanent or ultimate effects come into play, providing an equilibrium situation ever exists. In general, then, our conclusion as to causes and effects is that normally the price level (the P's) is the effect of all the other factors in the equation of exchange (M, M', V, V', and the Q's); that among these other factors, deposits (M') are chiefly the effect of money, given the normal ra.tio of M' to M; that this ratio is partly the effect of trade (the Q's); that V and V' are also partly the effects of the Q's; and that all of the magnitudes, M, M', V, V', and the Q's are the effects of antecedent causes outside the equation of exchange ad infinitum. •^Fisher, Ibid., p. 172. 39K,emmerer, o£. cit., p. 57. 153 The main conclusion is that we find nothing to interfere with the truth of the quantity theory that variations in money (M) produce normally proportional changes in prices. To conclude, the transaction-velocity approach to the problem of how the value of money is determined is depicted by Fisher as a matter of recognizing M, V, and T as the three immediate determinants of the general price level. Changes in P may originate from one or more of these factors, or from any combination of them at any time. Each of the determinants is affected by a large number of underlying factors, so that the general price level is influenced by the vast array of forces which work through M, V, and T. Too, it should be noted what the transaction-velocity approach does not state. No inference is made that every change in P must spring from a change in M, or that P will always vary directly with M or even with M/T. Nor, should the theory be construed to suggest that each of the factors, M, V, and T has its own distinct and peculiar determinants and is arrived at independently of the other two. While variations in the price level may originate entirely from M, or entirely from V, or entirely ^Fisher, ©£. cit. , p. 183. 154 from T, the most frequent result is a concomitant change in all three. The sequence is not invariable.^ Some Obi ections to the Transaction-Velocity Approach When employing the equation of exchange as a means for explaining the value of money, it is assumed that the velocity of money and the volume of transactions are not affected by the quantity of money or the level of prices and the changes in the quantity of money are the cause of changes in the price level. The customs of the commun ity are assumed to be the factors which determine the velocity of money, and are regarded as constants for long periods. The supply and efficiency of the factors of production are assumed to determine the volume of trans actions, and except for intervals during the business cycle, are not supposedly subject to substantial changes in the shocrt-run. Only the quantity of money and the price level are considered to be subject to comparatively signi ficant fluctuations in the short-run; and of these changes, that in the quantity of money is felt to be independent and the source of change in the price level. Upon the ^Chandler, oj>. cit., p. 45. validity of these assumptions depends the usefulness of the equation of exchange as an explanation of the factors which determine the value of m o n e y . ^ A majority of the critics of this theory accept the general principles that the value of money is determined by the working of the forces of supply and demand, but ' disagree with the specific form in which demand and supply are held to function by the quantity theorists. It can be said that the quantity theory is simply one version of the supply and demand theory of money; one that emphasizes the importance of supply as the main causal factor in the determination of money value.^3 Fisher’s approach is confronted with certain logi cal difficulties. First, Fisher ignored cyclical changes, thereby depreciating the usefulness of his theory of the value of money. Too, it is well established that the value of money and the volume of production are mutually affected. Therefore, Fisher's theory has a serious logi cal difficulty to surmount. If it is correct that the volume of trade is independent of the level of prices only ^Bernstein, o£. cit., pp. 211-12. ^Lionel D. Edie, Money, Bank Credit and Prices New York: Harper Brothers and Company, 1928), p. 195. 156 in those instances where the price level is stable, . . . then Fisher, who assumes that the volume of production and prices are mutually independent, has yet to explain the changes that do in fact occur in the general level of p r i c e s . 44 Anderson extended a criticism along much the same line in questioning the logical consistency of Fisher’s handling of the volume of trade (T) in the equation. Exclaiming that if Fisher considered T to be a "dollar's worth" of a particular commodity, and if this is his general solution to the problem of compiling T, and if it is used in the equation when the question of causation, as distinguished from mensuration, is embraced, then a vicious circle is created. "If T involves the price-level in its definition, then T cannot be used as a causal factor to explain the price-level.45 The understanding of this approach will be improved if the principal criticisms are organized into a number of categories. The following paragraphs will present them in such a manner. ^William Howard Steiner and Eli Shapiro, Money and Banking (revised edition; New York: Henry Holt and Company, 1947), p. 640. 45b . M. Anderson, Jr., The Value of Money (New York: The Macmillan Company, 1922), p. 160. 157 The theory is too static. The term static can refer to either of two things in this context: that the quantity theory is concerned with just a particular point of time; or, that it is concerned with some normal long- run tendency under hypothetical circumstances of equili brium. The first explanation of the term relates to the assumption by the quantity theorists that, if at a given moment money in circulation were to be doubled, prices would double. In such a "ceteris paribus" situation, the quantity theorists insist that the supply of money and the price level will move in like proportion. In reality, however, the element of time must be injected during the period when the volume of money is being doubled.^ The business cycle may accelerate in one direction or another, the President of the United States may instigate a "de facto" expropriation of the control of a primary industry, and so forth. Any such development would mean that a "ceteris paribus” situation was not prevailing, with con sequent damage to the validity of the hypothetical situation. This type of criticism appears to be valid; the equation of exchange is a purely conceptive device. ^Edie, ojj>. cit., pp. 195-96. 158 The term '’static** may also be interpreted in the context of the long-run situation. "An increase of M normally causes a proportional increase in M'. An increase of M does not normally affect V, V 1, or the Q's.'4^ "The price level is normally the one absolutely passive A O element in the equation of exchange4-0 The key to this doctrine, obviously, is the word "normally.” It is admit ted that during the transition period, prices may be an active rather than a passive factor. However, once the transition period has passed and the new price level has established itself, prices again revert to a passive nature, and are purely effect, not cause. "We have emphasized the fact that the strictly proportional effect on prices of an increase in M is only the normal or ultimate effect after transition periods are over."4^ Critics of the theory strongly challenge the asser tion that normal periods are "normally normal." In real ity, economics is immersed in long-run movements of both supply and demand, in fortuitous fluctuations, in busi ness cycles, etc. It is true that the tendencies as ^Fisher, op. cit., p. 158. 48lbid., p. 172. 49ibid., p. 159. 159 propounded by Fisher are logically valid in their hypo thetical context. But even so, we are laboring with the unreal assump tion that if prices were not what they are, something else would be true. Surely this approach will never satisfy those who are concerned with the unrelenting, incessant time series of the real world, with secular trends, business cycles, seasonal adjustments, and irregular disturbances. A static theory is highly inadequate to explain these ever-present fluctuations. They are not mere transition periods between static calms, nor mere perturbations upon some imaginary sea of equilibrium; but they are the fundamental continu ous stuff of everyday experience and reality. Some thing more than the static, normal concept is necessary to an understanding of these highly dynamic aspects of price behavior. It is not so much that the static theory is untrue, if construed strictly and properly, but that it is insufficient as a guide through the mysteries of price fluctuations.^ Too, Mitchell points out that in the wholesale as compared with the retail trades, payments often lag behind delivery (T), which in turn lagp behind price agreements. Of the payments (MV^'V1) made to-day, the bulk are payments for goods transferred (T) some time ago, at prices (P) most of which were agreed upon still earlier; a considerable fraction are payments for goods transferred to-day at prices now agreed upon; a minute fraction are payments for goods which will be trans ferred later. Similarly, of the goods transferred (T) today, a few have been paid for in advance, more are paid for now, but the bulk will be paid for in 50gdie, o|>. cit., p. 197. 160 the future.*^ This objection becomes increasingly significant as the period which the equation measures is shortened. The introduction of this qualification may restrict the use of the equation of exchange to long periods of time, while also accounting for some of the statistical discrepancies which arise when calculation of the factors within the equation is tackled.^2 in the present state of business procedures, the payments made on any particular day are not likely to equal the prices quoted on that day multi plied by the volume of goods transferred to buyers. Over short periods of time, it becomes obvious that the equa tion is not applicable to the task of measuring price fluctuations. In the long-run, when the extent of overlap at each end is relatively small in comparison with the total of business operations during the period, it is possible to a.ssume that these factors are somewhat related to one another.-*^ SJ-Wesley C. Mitchell, Business Cycles - The Prob lem and Its Setting (New York: National Bureau of Economic Research, Inc., 1928), pp. 130-31. f^Bernstein, cit., p. 220. 5%. Cyril James, The Economics of Money, Credit and Banking (second edition: New York: The Ronald Press Company, 1935), p. 536. 161 In summary, the conclusions that are logically drawn from the equation of exchange when qualified by an assumption has no applicability in actual, short-run, business conditions. In this case, it may be possible to state that the price level never varies proportionately with the quantity of money, or directly with the velocity of money, or change in inverse proportion with changes in the volume of goods transferred by money. The theory is unrealistic♦ The equation of exchange yields an inaccurate picture of the process by which prices are constructed, for they are not determined by a mere addition of all the money spent and then comparing them with all the goods exchanged. But price making is a continuous phenomenon; the price of one article is influ enced by the price obtained in the previous sale, and itself conditions that price quoted in the succeeding transaction.^5 Prices are established prior to the exchange of ^^William Trufant Foster and Waddill Catchings, Money (third edition, revised; New York: Houghton Mifflin Company, 1927), pp. 162-63. ^Steiner and Shapiro, o£. cit., p. 648. 162 money for goods in the prevalent context of the market. Mitchell, relating the process of price determination to the course of the business cycle, stated that "most of the time, P and T are active factors in the equation of exchange; they bring about changes in M 1, V and V* ; to a less extent they affect even This conclusion he based upon the interests of the credit man in the current and anticipated money value of merchandise, and he continued: During a period of depression, the quantity of coin and paper money which was in hand-to-hand use toward the close of the preceding period of prosperity, exceeds current requirements. The velocity of circu lation declines; "idle money" accumulates in the banks, swelling their cash reserves; if the bank-note cur rency is elastic, it is contracted; if business remains more active in other countries, gold is likely to be exported. What happens to coin and paper money happens also to deposit currency and to commercial credits. Business men turn over their funds less repidly, require less working capital, repay part of their bank loans (despite the lower discount rates), and reduce their accounts payable. The reduction of bank loans commonly exceeds the net flow of idle cash to the banks, so that deposits subject to check decline somewhat. Accordingly, the limit upon coin and paper money in circulation is fixed, not by the monetary stock and bank-note policy, but by the current demands of trade. Similarly, the limit upon deposit currency is fixed, not by what the banks can provide, but by what business men care to use. In ^Mitchell, o£. cit., p. 137 163 Professor Fisher's terms, the fall of prices and the concomitant shrinkage in the physical volume of trade are, for the time being, the "active” factors in the equation of exchange. To the conditions which they produce, the monetary and banking factors adjust them selves in whatever way the organization of the mone tary and banking systems permit. These banking and monetary adjustments to business depression are among the developments which facilitate a revival of activity. The low discount rates, the reserve lending-power of the banks, the redundant quantity of coin and paper money, the low velocities of circulation mean that an increase in business transactions will encounter no check from the inade quacy of the circulating medium. Business men who see a prospect of profit in enlarging their purchases have no difficulty in securing means of payment if their bankers share their confidence. The physical volume of trade and prices can enter an ascending spiral, every increase in the one promoting an increase in the other. As the dollar volume of business expands, a new series of adjustments is worked out in the distri bution of coin and paper money between the banks and the public,in the issue of bank notes, perhaps in the international distribution of gold, certainly in the volume of deposits subject to check, and in the veloc- itus of circulation. Monetary and banking conditions may be said to "permit" these developments, and even to "favor" them; but the "active" role is still played by prices and the physical volume of trade. Not until the dollar volume of business has grown so large that it taxes the elasticity of the monetary and banking system, do the monetary factors in the equation of exchange begin to diminate business transactions. . . . It then becomes true that both prices and the physical volume of trade are "passive" factors, controlled for the time being by monetary and banking conditions. And this dimination becomes more absolute if the stringency develops into a financial panic, and many business men fear lest they cannot 164 obtain funds to meet their maturing obligations.5? Hawtrey also tendered an objection, attacking the fundamental employment of the equation of exchange as a method for determining the forces which establish the purchasing power of money. He disagreed with Fisher’s and Kemmerer's contentions as to the nature of the transac tions and money payments to include in the equation. The ’’transactions" in which money passes include not only sales of goods and services, which contribute to form the price level, but dealings in credit instruments and rights to receive money. When a purely pecuniary right, such as a bill of exchange, or a bond or debenture, is sold for money, the trans action throws no light on the purchasing power of money. . . .58 Even though some economists feel that purely financial transactions should not be omitted, others feel that this type of transaction has been assigned undue weight in the equation of exchange.59 The theory of causation is too rigid. It is often said that the quantity theory is too mechanical. 5^lbid. pp. 133-35. CO R. G. Hawtrey, Currency and Credit (New York: Longmans, Green and Company, 1934), p. 37. S^Bernstein, o£. cit., p. 221. 165 Greidanus even went so far as to group the formulations of Fisher, Casses, Schumpeter, Kemmerer, and Wichsell under the common heading of "the mechanic money theories," the reason being that they proportedly fail to delve into the area of human volition. The dispute that M is not the cause of P has long been waged. As Edie pointed out, it is the "interconnec tions, the reciprocal relations, the mutual influences," that are of prime significance. Prices and the money supply are simply two variables in a very complex group of variables. A disturbance which is initiated at one point or place in the group will make itself felt all along the line, and in turn, these will react upon the initial dis turbance. Prices should be viewed, not as being affected by only the variable money, but as a function of a group fil of variables, including itself. For example, an increase in the level of prices may cause people to spend their money more rapidly for fear that its purchasing power may ^Tjardus Greidanus, The Value of Money - A Dis cussion of various Monetary Theories and an Exposition of the Yield Theory of the Value of Money (New York: Staples Press Incorporated, 1950), pp. 56-83. 63-Edie, o£. cit., p. 198. 166 diminish even further, with the result that the velocity of money is increased. Furthermore, conditions such as these justify efforts to hold on to commodities as long as possible. Hence, it is claimed that increasing prices tends to diminish transactions as well as increase velocity, both of these tendencies contributing to the f % 2 acceleration of the rise in prices. Consider Fisher's assumption that an increase in the quantity of money has the effect of a proportional increase in bank deposits. But an increase in bank depos its is not solely the consequence of more cash being brought to the banks; instead they originate from the desire of the banks to employ their excess cash reserves in additional loans and investments. However, neither a bank nor anyone else desires to invest when there is good cause to believe that the investment will entail the sus taining of a loss. Businessmen and investors/will not be desirous of seeking loans from the banks in order to pur chase, nor will the banks be willing to invest in securities, when the prices of commodities and securities ^Charles R. Whittlesey, Principles and Practices of Money and Banking (revised edition; New York: The Macmillan Company, 1954), p. 93. 167 are declining, and the decline is anticipated to continue further downward. In circumstances such as these, addi tions to the cash reserves of banks will not and cannot cause a proportional increase in loans and investments, and consequently, in bank deposits. When bankers are eager to invest, and businessmen and investors are enthu siastic about borrowing, only then will an increase in bank reserves be likely to result in a proportional increase in bank deposits. This points out one of the most serious defects of the quantity theory of money, for while it is possible to assert that an increase in bank reserves will allow for an expansion of bank investments and loans and therefore, deposits, it is not equally correct to assert that such an increase in bank reserves necessarily and immediately causes such an expansion to occur.^3 Furthermore, not only is there a plethora of idle bank reserves during stages of a depression, with disconcerting consequences on the traditional ratio between the volume of money in the banks, and bank deposits, but if the depression is of 63james W. Angell, The Behavior of Money— Exploratory Studies (New York: McGraw-Hill Book Company, Inc., 1936), p. 157. 168 severe moment, and there is a rife of bank failures, people will upset the customary ratio between money in circulation and the cash reserves of the banks. Too, so long as the prices of securities, real estate, and com modities, and wages are under a deflationary pressure and declining slowly, individuals invest and spend less readily, so that the velocity of money and bank deposits is appreciably diminished; and this tendency cannot be forestalled by the ejaculation of additional money.^ Other objections to the theory. Due to the difficulties of statistical analysis, it is very difficult to segregate either M or P in such a manner as to deter mine the relationship for any particular class of commodi ties or services. The price level is a heterogeneous conglomeration of all commodities and services which are exchanged for money, a mixture of wage rates, security prices, real estate prices, and a myriad of other ingredients.^5 ^Louis A. Rufner, Money and Banking in the United States (New York: Houghton Mifflin Company, 1938), pp. 99- 100. 6^James, oj>. cit♦, p. 534. There are critics that dwell upon the inadequacies of purely monetary theories of economic relations, but not to the complete disregard of the profound reactions of the economy to fluctuations in the monetary factors. An increase in the quantity of money pervades the economic organ in an uneven manner; it affects the distribution of incomes among the populace, and hence production must adjust itself to compensate for changes in the relative demands for commodities. Too, the money factor may spend itself in the reconversion of technology; entrepreneurs may receive the major portion of the new money with the result being an increase in the production of capital goods. The decline in the price level brought about by the employment of technological advances may be offset by the introduction of new money. Fisher's answer, of course, to such assertions was that any non-monetary factors exert their influence through one or more of the variables in the equation.66 Other economists maintain that the cash-balances approach is preferable to the transaction-velocity approach since the former places greater emphasis on the human ^^Westerfield, o£. cit., p. 434. 170 factor. Fluctuations in the psychology of the public, particularly their desire to retain or to spend money balances of purchasing power, are designated as being more important than the supplyi:of money. However, this dis tinction was more significant in former times than at present, since advocates of the transaction-velocity versions are now inclined to direct more emphasis to changes in velocity, which also revolve on shifts in the psychology of the public. During a meeting of the American Economic Associa tion in 1910, the causes for the price increase during the period between 1896 and 1909 were discussed, with analysis of Fisher's then up-coming book, The Purchasing Power of Money, the center of much of the controversy. Of the references made to Fisher's book, a number of remarks by fLQ prominent economists are note-worthy. T. N. Carver stated, ”1 believe that to a certain l !extent P is actually the cause of M." ^Whittlesey, o£. cit., p. 96. ^Chester Arthur Phillips (selected and adapted by) Readings in Money and Banking (New York: The Macmillan Company, 1922), pp. 159-212. 171 Murrary S. Wildman commented that: Granting that Professor Fisher's analysis shows a perfect correspondence between the course of prices on the one hand and the quantity of money and credit instruments on the other hand, I am still unable to see which magnitudes are properly to be regarded as causes and which as effects. . . . May it not be possible that variations in M*, or credit, and V and V', the velocity of circulation of both money and credit, be simply in consequence of the variation in M and P? Why is P the only passive term or why is it passive at all? F. E. Taussig observed that: It deserves to be said, perhaps, that the term M1 (deposits) in his equation is not entirely independent, but is in some degree a function of T. I say to some degree; it is dependent on T in part only, and not for very long periods. J. Laurence Laughlin declared that: Professor Fisher's equation of MV, M'V' PT is to my mind not a solution, but only a statement, of the problem of price levels. It can be read backward as well as forward. Professor Fisher . . . seeks to establish a causal relation between the amount of money in circulation (M) and the amount of deposits (M*) which, in my judgment, is wholly unfounded. , . . The error con sists in supposing that a man's deposit account at any time varies with the amount of money in his possession. Rather, the deposit account varies with a man's wealth. The rich man does not carry much more money to pass from hand to hand than the man of moderate means. E. W. Kemmerer exclaimed that: Professor Fisher's formula expressing the rela tionship between the circulating media and prices is 172 essentially the same as my own, but he pays little attention to the factor of business confidence, which is a most important consideration in the interpreta tion of the formula. The ratio of deposit currency to bank reserves is a function of business confidence. The above objections point to a number of conclu sions. First, the transaction-velocity version of the quantity theory of money value is essentially a long-run interpretation, accentuating mechanics rather than psychology. It is not designed to produce a realistic short-run theory of the manner in which prices are actually determined. Nor is there a general acceptance of the con tention that the price level is dependent upon the quantity of money, or that changes in prices must originate with changes in the latter or that price changes are a result of a proportional change in the quantity of money,69 The opinion expressed by the Board of Governors of the Federal Reserve System is an appropriate conclusion of this survey of objections to this approach: There have been times when the amount of money and prices have changed together; but usually they have not. When they have moved together this may have been due to the fact that it takes more money to do the fact that it takes more money to do the same amount of business when prices are high than when they are low. ^Steiner, o£. cit., p. 650. 173 Whether prices and the volume of money do or do not move together depends on many other conditions, such as weather and the size of harvests, inventions, foreign trade, Government spending, taxes, wages, and the general attitude of business. When people are venturesome and expect good times, they lay in sup plies and this tends to raise prices. When people are discouraged and expect things to go badly, they tighten their belts and buy as little as possible. The demand for goods declines and prices fall. Usu ally other things have a greater influence on prices than has the amount of money. II. THE CASH-BALANCE APPROACH TO THE VALUE OF MONEY The cash-balances version of the quantity theory of money achieved its greatest popularity in the European countries, and particularly in England. In choosing to employ the cash-balances rather than the transaction- velocity approach, it is not a question of fundamental conflict, but one of alternatives. Proponents of each have insisted that both the theories and the equations used to illustrate them are interchangeable. The differ ences of opinion are rather a product of disagreement over ; the fruitfulness of the two types of presentation. The I 7®Board of Governors of the Federal Reserve System "Proposals to Maintain Prices at Fixed Levels Through Monetary Action," Money and Economic Activity--Readings in Money and Banking. Lawrence S. Ritter, editor (1st ed.; Boston: Houghton Mifflin Company, 1952), pp. 242-243. cash-balances advocates preach of the superiority of their analysis on two counts: (1) they believe that since the i motivating force behind all economic activity is the sub- | ! jective valuations of individuals, it more lucidly relates t ; to the process of value determination; and (2) because it i ■ is stated in terms of supply and demand, it facilitates ! the integration of monetary theory with the general theory of value.^ There is also a very important shift in emphasis i 1 between the two versions. The cash-balances version shies I away from the predominant concern with the forces behind 1 changes in the supply of money, toward an equally con- , centrated concern with the forces behind changes in the demand for money. The analysis will also differ in the respect that, whereas the transaction-velocity equations ! cover a period of time, the cash-balances equations depict I - j n \ a situation at a given moment. 1 The Essentials of the Cash-Balances Approach ] The analysis is based on the conviction that the j 7^Lester V. Chandler, An Introduction to Monetary Theory (New York: Harper and Brothers, 1940), p. 74. 1 72 ! A . C. L . Day, Outline of Monetary Economics ; (London: Oxford University Press, 1957), p. 250. 175 interaction between the supply of, and the demand for, money determines the value of money. At any given moment, the value of money is set at the point where the supply of, and the demand for, money are equal, with variations in the value as occur through time, the result of oscillations in either its supply or its demand, or both. In terms of the familiar propositions of the general theory of value, the value of money is held to fall and prices to rise if supply is increased without an off-setting increase in demand, or if the demand is increased without an equiva lent offsetting decrease in supply. If the tendencies of supply and demand to increase are the opposites of the above example, the result would be reversed; that is, the value of money would rise and prices would fall. Since this represents but the barest outline of the cash- balances approach, it is necessary to analyze the nature of the supply of, and the demand for money, and to deter mine the forces behind their behavior if the theory is to I achieve a meaningful and useful station in explaining real phenomena. The Need for Purchasing Power in the Form of Money Balances Due to the previous examination of the forces which influence the money supply, it will not be reviewed again. It shall suffice to state that the supply of money is the sum of all the bank deposits subject to check, plus the total of coin and currency in the hands of the public. The remainder of this section will concentrate on the demand side of the picture. In a number of ways, the ability to command real resources makes a given amount of money more desirable than an equivalent amount of actual resources for which it will be later exchanged. For instance, having a quantity of money on hand or at call enables the individual to delay the decision of what goods and services to purchase until the most opportune moment is presented. In a specialized society, every individual considers it both convenient and necessary to retain on hand or at call a certain quantity of purchasing power in the form of money to tide him over until his money holdings can be replenished. It is imperative to note that the individual is endeavoring to hold a particular quantity of purchasing power and not a chosen number of 177 7 % monetary units. J He is attempting to retain purchasing power which is sufficient to pay for these items that he anticipates buying during a given period of time. It is evident that once the individual has decided upon the amount of purchasing power he desires to hold in the form of money, the amount will fluctuate with the level of prices. If the prices of those items which he desires to purchase are low, the amount of money he must retain is less than if the prices were high. To illustrate, if the community wishes to hold at any given time enough purchas ing power in the form of money to buy twenty units of goods and services, it must retain one hundred dollars if the average price per unit is five dollars, or forty dollars if the average price per unit is two . dollars.74- In so adjusting their money holdings of purchasing power, the community determines the velocity of money. "It will appear . . . that changes in the rapidity of circulation of money are themselves incidental to changes in the amount of ready purchasing power which the people . . . find it 73e . m . Bernstein, Money and the Economic System (Chapel Hill, North Carolina: The University of North Carolina Press, 1935), p. 222. ^Chandler, o£. cit., p. 76. advantageous to keep in their own holding At any given time, the demand for money can be expressed as the amount of goods, securities, and services that will be bought with money during a particular period of time. It fluctuates, therefore with (1) the length of time over whose transactions, purchasing power in the form of money is held; and (2) the amount of trade in goods, 7 f . securities, and services per unit of time. The demand for money is likely to increase as the physical volume of trade to be effected with money increases. As pointed out in analyzing trade volume (T) in the previous section, the larger the amount of trade in a community, the more likely it is to demand a larger balance of purchasing power in the form of money. But, the trade volume is not the sole determinant of the demand for money; it also depends on the length of the time over whose trade the community decides to hold purchasing power in the form of money. Given the amount of trade, the demand for balances is smaller if the community elects to hold enough money to ^Alfred Marshall, Money, Credit and Commerce (London: Macmillan and Company, Ltd., 1924), p. 43. ^chandler, oj>. cit. , p. 77. 179 cover its purchases for a one month period than if for a two month period. The period of time may be expressed as a fraction of a year, so that if the period is one month, the fraction is 1/12; if half of a month, 1/24. Hereafter, this fractional period will be designated by the symbol , , k.n The symbol ”kM is obviously a close relation to the velocity of circulation (V) as depicted in the transaction- velocity approach to the quantity theory. Upon closer examination, it is evident that ’ ’ k” is the algebraic recip rocal of "V", so that k = 1/V, and V = l/k.^ To illus trate, if the community desires to hold purchasing power equivalent to its expenditures for one month, k = 1/12 and total expenditures are at the rate of twelve times the money supply each year; V will turn over at the rate of twelve times per year. Since T , k" and "V** are algebraic reciprocals, it follows that they are the product of the same phenomena. These forces were outlined in the preceding section, and need be but briefly outlined here. The individuals within the community will strive to maintain their purchasing ^Frederick A. Bradford, Money and Banking (sixth edition; New York: Longmans, Green and Company, 1949),p.578 -80. 180 power in the form of money at that level relative to their expenditures, which offers the maximum net advantage. The i ! height of this particular level depends upon a host of surrounding circumstances. K will be relatively large if j (1) the individuals of the community are apprehensive over | the possible instability of their incomes, in particular, I f j and of prices, in general; (2) the credit and financial • system is inadequately developed, so that the processes of lending and borrowing are subject to considerable difficulty and expense, and investments may be liquidated i j only at a slow and costly pace; and (3) the payments system in use is such that income payments are infrequent and irregular in amount and disbursements and receipts are ! ! highly uncoordinated. K will be small if (1) the individ- i uals of the community can rely on their incomes accruing j - - ■ J regularly and in rising amounts, and that prices are likely to rise; (2) the credit and financial system is highly developed and extensively used, allowing the extension and acquisition of credit to coincide with a minimum of problems, and investments can be readily liqui- I dated and at a nominal expense; under conditions such as ' this, people are willing to acquire and retain investments 181 rather than hold money as a store of value; and (3) the payments system in use is such that income is received frequently and regularly, and the intervals between receipt and disbursement are well c o o r d i n a t e d . 78 After the community has deliberated upon all relevant conditions, including existing and anticipated factors, the individuals within decide on the amount of purchasing power that they will demand to retain in the form of money, thereby arriving at the aggregate purchas ing power of the money supply. For instance, if the community tries to retain enough money to cover all the transactions they expect to execute during a twelfth of I the coming year, the aggregate purchasing power of the J money supply will be just adequate to command these resources. The equality is effected through appropriate price adjustments. There is only one price level which'is appropriate for any particular set of conditions relative to the demand for and supply of money. If the price level is lower than this level, the purchasing power of the money i 78chandler, oj>. cit., pp. 77-78. | supply is in excess of the quantity demanded, so that on j balance, the community feels that their money balances are j i ! superfluous. They will then attempt to decrease their ; I j I money holdings by either withholding some goods and i ..................... • ! services from the market, or by increasing their purchases.! This will continue until prices have increased to the point where the purchasing power of the money supply is forced down to the desired level. Alternatively, if * prices are stationed above the appropriate level, the I | purchasing power of the money supply is then insufficient ! j to cover the amount demanded by the community, so that on 1 i "....... ; balance, people will feel that their holdings are too I , . .. i small. They will then attempt to supplement their money , | ' ! I balances by either offering additional goods and services for sale, or by cutting back on their spending. Similar to the previous situation, this will continue until prices have fallen enough to increase the purchasing power of thej money supply to the appropriate l e v e l . ^9 1 Since the aggregate purchasing power of the money supply is determined by the demand for money, regardless ! ^^Lester V. Chandler, The Economics of Money and Banking (third edition; New York: Harper and Brothers, 1959), pp. 312-16. of the quantity of money, it follows that with a given j ! demand, the price level varies directly and the purchasing j I ' 1 ! power of each monetary unit inversely with the quantity of j ! t money. For example, if the community demands to retain ! in the form of monetary purchasing power command over one I thousand units of economic goods and services, and if the I j quantity of money is equal to one thousand dollars, then | the average price per unit of article purchased will be j i one dollar; conversely, if the money supply were doubled, i i the average price per unit would be two dollars. It is i I i i imperative to emphasize that the proportionality between j ! the money supply and the price level is maintained only l j if the demand for money remains constant, and except in ^ instances of extreme inflation, the demand for money is I as much a variable as the supply of money. It is evident that the task of explaining the behavior of the aggregate demand for real money balances j now becomes a matter of explaining why individual demands behave as they do. Every recipient of income attempts to | i maintain a balance of purchasing power in the form of i i money which is sufficient to cover the period separating i i his income receipts. An individual's decision to retain ; i so much of a money balance indicates a desire to hold I that quantity of money, rather than either more or less. | I i I What then, are the precise contents of these displaced i i ialternatives? Holding can be reduced by the individual in j . ! !three ways: (1) by lending money to someone else; (2) by | -! satisfying debts which are owed to someone else; or (3) by j j i ! spending money on anything. Alternatively, holdings can [ I : be increased in three corresponding ways: (1) by borrowing! I from someone else; (2) by demanding the satisfaction of a j I ' | loan made to someone else; or (3) by selling anything | i " ! | which the individual owns. All manners of changing one's j holding of money can be executed in this manner, through 1 AO I a combination of one or more of the alternatives.O K J Thus, ; when holdings of purchasing power are deemed to be in i | excess of needs, money may be spent, for instance, on j consumer's goods from which is derived an income of grati- | fication, or invested in capital goods or securities from ! j which is derived a money income.81 ! j There are real inconveniences attached to the ! ! j situation whereby the individuals' holdings of purchasing j I ! j - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - .- - - - - - - - - - - - ■ R. Hicks, "A Suggestion for Simplifying the Theory of Money," Readings in Money and Banking, The Amer- i ican Economic Assn. (Homewood, Illinois: Richard D. Irwin, I Inc., 1951). ! i ! | ^Bernstein, qj>, cit., p. 223. . power in the form of money has fallen too low— he may not i i - i I :be able to satisfy his debtors quickly; bargains in the , ^purchasing of goods and securities may have to be foregone;; ! ! i purchases may have to be confined to sellers who extend j |credit with the consequence of having to accept lower j j quality or higher prices for equal quality; or due to a j 1 i i I failure to receive money at expected times, or in expected J amounts, having to forego expenditures for necessities. j i Thus, even though the possession of a large reserve of j I money purchasing power offers undoubted advantages, it ; I ! i ! likewise entails a number of disadvantages. By weighing i . ! the alternatives, though granted it is in a rough and ; i I crude manner, each individual arrives at the size of the | QO : money balance that he shall demand. j I i The businessman is guided by similar considerations! I i in determining what portion of his total business assets | i or income he wishes to retain in the form of money pur- [ chasing power. He attempts to hold on hand or at call, a - j quantity of money adequate to provide for the variable ! j rate at which income and expenditures flow. He ! j 0 0 j 0 Lester V. Chandler, An Introduction to Monetary ; Theory (New York: Harper and Brothers, 1940), p. 76. 186 anticipates satisfying any temporary requirements by borrowing from banks and from other sources, and thus affecting the size of his money balances. By instinct and experience he balances the benefit against the loss of a large holding: he knows that, if he keeps too little purchasing power at his command, he will be frequently brought into straits; and that if he keeps an inordinate quantity, he will diminish the material sources of his income, and yet may find but few occasions on which he can turn the whole of his ready purchasing power to any great advantage.88 Similar motives direct a bank in determining what proportion of its assets to retain in the form of lawful money and reserve deposits with the Federal Reserve. It desires to hold just that amount of lawful money and reserves deposits which allows it to meet cash withdrawals and adverse clearings; but it does not desire to unneces sarily forego any opportunity to utilize its holding of income earning assets. Therefore, among individuals and businessmen, there are forces which tend to determine the most economical balances of money holdings to be main tained on hand or at call in the light of surrounding circumstances, tradition, and anticipations. By weighing the advantages of using money in this 83narshall, o£. cit., pp. 46-47. way, the community arrives at the amount of real resources j I i they wish to have a command over in the form of money j 1 ! holdings. I i Every person tends to adjust his balances of money > to that point where the net advantage of holding j additional money to be spent at a more convenient or [ more valuable time, is equal to the disadvantage of i being deprived of the psychic or money income that 1 additional money spent on consumers* goods or invested | in capital goods or securities would yield.&4 Every change in the holding of money balances brings with I ......... I it disadvantages of one form or another, and these disad- I vantages are of more consequence for large than for small i j ' changes in the holding of money balances by the community. i This applies not just to the holding of money balances, ! i j but also to the ownership of claims expressed in terms of I • ' i I money, such as mortgages, bonds, and fixed contracts of I I ! ~ i all types. Therefore, the quantity of money that the community attempts to hold is elastic and never rigid, and I will vary with the net advantages the community associates | 85 i with the holding of purchasing power in the form of money. 1 Statements of the Cash-Balances Equation i The relationship between the total supply of money i S^Bernstein, o£. cit., p. 224. ^ Ibid. , p. 225. 188 in a community, and the desire of the people to retain a command over real resources in the form of money balances, can be expressed by algebraic equations. Like the advo cates of the transaction-velocity approach, those who espouse the cash-balances interpretation utilize an alge braic identity to facilitate the exposition of their examination. General statement of the equation. Of the several variants of the formula, the following is a typical exposition: M = KTP, where M is the supply of money; T is the physical volume of trade to be transacted with the use of money during the period, commonly a year; K is the length of the period over whose transac tions purchasing power is retained in the capacity of money; P is the level of prices of the items included in T.86 The equation is a truism in the sense that the money supply (M) is equivalent to the value of those items over which purchasing power is retained in the form of money (KTP). KT represents the physical volume of those commodities and services over which purchasing power is held in the form of money, while P represents the average ^Chandler, qjd. cit., p. 80. 189 price of every unit of these things. Changes in any one of the factors M, K, or T can initiate a compensating change in P. Stated in another manner, P may vary with a shift in the supply of money (M), or by a shift in the demand for the purchasing power in the form of money, which fluctuates with K and T. It is interesting to note that the cash-balances equation can be easily translated into the equation which expresses the transaction-velocity version of the quantity theory of money. Since K * 1/V, the equation M = KTP may be written M = 1/VTP, or MV = PT, which is obviously the latter version of the quantity theory. The symbol K describes what might be purchased with the money balances being held at a given moment, whereas V describes the amount of goods and services that have been purchased during any one turnover of total balances during a period.®^ Seldon has differentiated between K and V by describing the situation as one involv ing a distinction between a function (K) and a particular value of the function (V), rather than a matter of &?Edward S. Shaw, Money, Income, and Monetary Pol icy (Chicago: Richard D. Irwin, Inc., 1950), p. 348. 190 alternative modes of expressing the same idea.**® Never theless, it is true that arithmetically, K is the recip rocal of V. However, it does not follow that the Cambridge analysis is in fact the same thing as the Fisher analysis. The difference may be stated in the following manner: In terms of the Cambridge version, sudden and quick shifts in the desire of the community to hold purchasing power in the form of money balances may exert a profound effect on prices and incomes even though the monetary authorities successfully maintained stability in the money supply. The desires of the community to retain money balances is a powerful factor, and must be taken into account no less than the money supply. It is not M, but K, that holds the 89 stage in this type of analysis. The symbol K may also be viewed in terms of the i - ' length of the period over whose transactions the community actually holds purchasing power in the form of money balances; it is not the length of the period over whose **®Richard T. Selden, "Monetary Velocity in the United States," Studies in the Quantity Theory of Money, Milton Friedman, editor (Chicago: University of Chicago Press, 1956), p. 181. QQ °7Alvin H. Hansen, Monetary Theory and Fiscal Pol icy (New York: McGraw-Hill Book Company, 1949), pp. 49-50. 191 transactions the community "elects" or even attempts to hold purchasing power in the form of money balances. The community has no choice in the matter, for a paradox is at work. To elucidate, if the community is collectively desirous of increasing their money balances, that is, the length of the period over whose transactions money pur chasing power is held, an effort to do so will initiate a sequence of events which will lead to a net decrease in their aggregate holdings of money balances. The price level will continue to fluctuate until a situation of equilibrium is achieved in which the four factors in the 90 equation are once again in a position of equilibrium. u A community-wide increase in the demand for money would result in a decrease in prices, a decline in profit expec tations, a decline in bank credit, and, therefore, a diminished volume of money balances. Money is truly a paradox; by wanting more the community ends up with less, and by wanting less it ends up with more. Within the discretionary limits to which everyone is subject, what the community really "elects" is to spend or not to spend their 90 W. H. Steiner and others, Money and Banking--An Introduction to the Financial System (fourth edition; New York: Henry Holt and Company, 1958), p. 440. 192 money balances. The purchasing power of these balances is not, therefore, a matter of alternatives, but rather a 91 spontaneous by-product of these "elections.” The "length of the period over whose transactions the community actually hold purchasing power in the form of money balances” is a function of the amount of cash held and the level of prices. Neither the community nor the individual possesses the capacity to choose both. Because paradoxical consequences are created when such attempts are undertaken, it may be preferable to state the demand for money in terms of the forces which affect the retention of cash balances vis-lt-vis nonmonetary assets, while omitting any implications that individuals or a 9 community can actually exercise a choice in these matters. Pigou1s interpretation.of the equation. Of the Cambridge economists, Pigou was probably one of the first to give the cash-balances concept an algebraic construc tion. Let: ^Leland J. Pritchard, Money and Banking (Boston: Houghton Mifflin Company, 1958) pp. 638-39. 92Ibid. 193 R be the total resources, expressed in terms of wheat, that are enjoyed by the community (other than its bankers) whose position is being investigated; k the proportion of these resources that it chooses to keep in the form of titles to legal tender; M the number of units of legal tender; and P the value, or price, per unit of these titles in terms of wheat; Then the demand schedule just described is repre sented by the equation P = kR/M.^3 Provision can be made in the equation to allow for that proportion of the community's money holdings which are in the form of bank deposits. In his interpretation of the equation, rather than showing the price of a unit of real resources, Pigou described the value of a unit of money, that is, the total units of real resources that a unit of money will buy. This is equivalent to stating the equation as a reciprocal of the price level. He assumed that the amount of real resources over which the community holds command in the form of money balances is a uniform proportion of the amount of real resources it utilizes in a given period of c . Pigou, "The Value of Money," Readings in Monetary Theory, The American Economic Association (Home wood, Illinois: Richard D. Irwin, Inc., 1951), p. 165. 194 time, that is, its real income. In fact, however, the amount of real resources that a community controls with its money balances is related to neither income nor wealth alone, but to a com bination of income, wealth, and business habits of the community, while also remaining somewhat independent of these influences. In this sense, perhaps it is just as well to regard the relationship as an independent variable. Nevertheless, Pigou's contention is valid in normal times, in the sense that the amount of real resources that the community controls with its money balances is a reasonably 95 constant proportion of its real income. Keynes interpretation of the equation. In his Monetary Reform, Keynes approached the quantity theory in much the same manner as Pigou. He asserted that the aggregate value of a community's supply of money is tied in with its desire to retain command over real resources in the form of money balances. The number of notes which the public ordinarily have on hand is determined by the amount of purchasing ^Bernstein, o£. cit., p. 227. 95Ibid., p. 228. 195 power which it suits them to hold or to carry about, and by nothing else. The amount of this purchasing power depends partly on their wealth, partly on their habits.9° The real resources which the community desires to be able to command with money was designated by Keynes as a quan tity of consumption units, each unit being made up of a collection of specified quantities of their standard articles of consumption or other objects of expenditure; for example, the kinds and quantities of articles which are combined for the purpose of a cost-of-living index number.9? The relationship among the forces which determine the purchasing power of money was expressed by Keynes in the following equation: n = p(k - rk'), where n is the amount of lawful money and bank deposits in the community; p is the price of a consumption unit as defined above; k’ is the amount of the real resources that the community chooses to retain in the form of deposit money; and r is the proportion of deposits that are covered by reserves of lawful money and reserve deposits with the central bank.98 So long as k, k*, and r remain constant, changes in n will cause proportionate changes in the price level,p. 96john Maynard Keynes, Monetary Reform (New York: Harcourt, Brace and Company, 1924), p. 83. 97Ibid., pp. 83-84. 98Ibid., pp. 84-85. 196 But, this is not to contend, stated Keynes, that the rela tion between the quantity of money and prices was necessar ily proportional. Some economists assume that n is an independent variable in relation to k, k', and r. Keynes admitted that in the long-run, this is probably true, ’ ’ but this long-run is a misleading guide to current affairs. In 99 the long-run we are all dead." J In any short period of time, a change in n is likely to have a reaction on k, k', and r. This effect is larger, proportionally, for sizeable than for small changes in n. For some time, a small change in the quantity of money will induce only a slight effect on the level of prices, for there are certain frictions which prevent a moderate change in n from discharging its complete proportionate effect on p.^® However, a large change in the quantity of money, which destroys the initial friction, and particularly if it sets up a general expectation of further increases in the same direction, will cause a considerable change in the desire by the community to hold real resources in the form of money balances. These changes may be more than in proportion " ibid., p. 88. lOOBernstein, oj>. cit., p. 230. 197 | to the changes in p. A large change in p greatly affects individual fortunes. Hence a change after it has occurred, or sooner in so far as it is anticipated, may greatly affect the monetary habits of the public in their attempt to protect themselves from a similar loss in future, or to make gains and avoid loss during the passage from the equilibrium corresponding to its new value.^1 Although Keynes was an advocate of this interpre tation of the quantity theory when he wrote in 1923, he retracted much of the foregoing assertions in his later work, A Treatise on Money. In this later work, he stated that the Cambridge equation yields "a" value of money, much as Fisher's equation yields "a" value of money. But, he felt that the equation presented in his earlier book was not valid, since it assumed that money is spent only for consumer goods. Because money is spent for a vast multiplicity of goods for a wide variety of personal and business reasons, it is not correct to state that the price level, p, is appropriate for a multitude of 102 purposes. lO^Keynes, o£. cit., p. 90. 102yiiiiam Howard Steiner and Eli Shapiro, Money and Banking (revised edition; New York: Henry Holt and Company, 1947), p. 642. 198 Now the great fault of this treatment lay in the suggestion that the units relevant to its arguments are, strictly speaking, consumption units, so that p, being the price of a consumption unit, represents our "quawsitum," the purchasing power of money. But this implied that Cash-deposits are used for nothing except expenditure on current consumption, whereas in fact they are held, as we have seen above, for a vast multiplicity of business and personal purposes. Our units of Real-balances must, therefore, correspond to the multiplicity of purposes for which Cash-balances are used, and the price-level measured by p must be the price-level appropriate to this multiplicity of Keynes, therefore, conceives of a price level of transactions for which cash-balances are employed. He introduced an equation which will lead up to a price level that weights the various objects of expenditure, not in accordance with their relative importances to the consumer, but Min proportion to the anticipatory holding of real balances of which they are the occasion.Making use of a simple formula,, he suggests the following equation: P = M/C where, P is the general level of prices; M is the total quantity of cash-balances; and C is the total quantity of real balances. In this form, the equation directs attention to the fact lO^John Maynard Keynes, A Treatise on Money (New York: Harcourt, Brace and Company, 1930), I, p. 223. 104Ibid., p. 224. 199 that the price level is formed jointly by the decisions of the monetary authorities and the individuals within the community who hold cash balances. The volume of cash-balances depends on the deci sions of the bankers and is "created" by them. The volume of real-balances depends on the decisions of the depositors and is "created" by them. The price- level (P) is the resultant of the two sets of decisions and is measured by the ratio of the volume of the cash-balances created to that of the real-balances created.105 The price level, therefore, is a product of relevant decisions directed to either the determination of the size of cash-balances or to the size of real balances. No one individual "decides" what the price level shall be.106 Robertson1s interpretation of the equation. Robertson had already expurgated from his equations the 107 errors which Keynes criticized in his Treatise on Money. Robertson assumed that thefcommunity would attempt to maintain a sufficient quantity of money to purchase that proportion of the national income that it desires to 105Ibid. 10%. Cyril James, The Economics of Money, Credit and Banking (second edition; New York: The Ronald Press Company, 1935), p. 539. lO^gernstein, oj>. cit., p. 231. 200 retain in the form of money balance; and a quantity suf ficient to satisfy its need for annual real transactions. "This . . . will be different for different individuals according to the nature of their habits and employment, nor is it likely in the case of any individual to be the \ ■ • i l l 08 same at every moment.' It is the combination of these two needs and the quantity of money that determines the income price level and the transaction price level of the community. The relationship can be expressed in two equa tions. The first, the income price level equation, depicts the average turnover of money as it is spent in the purchase of goods and services which comprise part of 109 the real income or output during the specified period. Algebraically, it is expressed as follows: P 5 5 5 M/KR,where P is the income price level; M is the quantity of money in existence; R is the real annual national income; and K is the proportion of R which people desire to have sufficient money on hand to purchase. 110 The second equation, the transaction price level equation, depicts the average number of times every unit 108D. H. Robertson, Money (Chicago: University of Chicago Press, 1959), p. 27. 109Ibid. 110Ibid., p. 150. 201 of money is spent for any purpose whatsoever. Algebrai cally, it is expressed as follows: P’ = M/K'T, where P1 is the transaction price level; M is the quantity of money in existence; T is the real annual volume of transactions; and K' is the proportion of T that people desire to have enough money to conduct, ^ To these equations, there can be no objections, unless it is directed to the definition of M as defined by Robertson. Keynes, for instance, would challenge the idea of combining both income and business deposits into the same aggregate, asserting that the money held for the purpose of securing income and the money held for the purpose of conducting business are the product of, and 112 subject to, different considerations. To combine the two incomes, Keynes stated, was to create "a hybrid con- 113 ception having no particular significance. Robertson, however, asserted that even though the money stock is not exclusively determined by the influence exerted by incomes, it does not necessarily follow that M can not be usefully expressed as such a proportion. The crucial test as to whether a particular concept of velocity is or ■*-^Ibid. oj>. cit. , pp. 229-33. H 3Ibid. , II, p. 24. 202 is not of a "hybrid" nature is whether or not the concept being questioned relates a particular type of cash balance to the "outlay against which the cash balances are being held.^^ The concept is not "hybrid" in character if the concept in question does so; if it does not do so, it is. As long as we hold fast to the concept of a cash balance which is large or small relative to the out lay against which the cash balance is held, we have something . . . which "brings us at once into relation with volition ;"H5 Potentially, the entirety of M is expendable against output, and if during any given period a larger or smaller amount of it were to be so expended than was previously the case, P would change. It is of the utmost importance that under certain conditions money which has been imprisoned in what Mr. Keynes calls the "saving deposits" and "business deposits" may seep out, raise the aggregate of incomes and "income deposits" and drive up P.H6 Robertson and Keynes were cognizant of the effect of changes in the quantity of money on the other factors Arthur W. Marget, The Theory of Prices— A Re-examination of the Central Problems of Monetary Theory (New York: Prentice-Hall, Inc., 1938), I, p. 389. 115Ibld., p. 391. 116 Dennis H. Robertson, Essays in Monetary Theory (London: Staples Press Limited, 1940), p. 106. 203 in the equation. An increase in the supply of money that is sustained, and that affects P, manifests a tendency to enlarge the real annual income and the real annual volume of transactions so long as there are remaining factors n 7 which are unemployed or underemployed. ' In these instances, the income price level and the transaction price level are prevented from increasing in proportion to the increase in the quantity of money. Obviously, the rise in the national income which was affected by the stimulus of higher prices can not sustain itself indef initely; and when production increases are faltering, prices will begin to rise in proximate proportion to the increase in the quantity of money® On the other hand, a decline in the value of money as a consequence of an increase in the quantity of money may decrease both the proportion of the real annual volume of transactions and the real annual income that the community desires to maintain in the form of money balances. In such a situa tion, prices may increase more than in proportion to the 1-^D. H. Robertson, Money (Chicago: University of Chicago Press, 1959), pp. 32, 172-73. 118Bernstein, o£. cit., p. 232. 204 increase in the quantity of money. Robertson demonstrated that his equations can be modified to allow for present price quotations for transactions to be completed in the . (M + M ’)V' future, as shown in the following: P = , : i > — v j =r z where, , 119 M is latent money not yet created. Latent money is money which is not yet in existence, but which affects the current price level much as it it were in existence. Effects of Changes in the Supply of Money With an increase in the money supply, the commun ity finds itself in possession of larger money balances and, until prices have correspondingly increased, of larger balances of purchasing power. If, as supply increases, the demand for money is not correspondingly increased, the holders of the new money feel that their balances are excessive. 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. As these individuals henceforth increase their demand and l^Dennis H. Robertson, Essays in Monetary Theory (London: Staples Press Limited, 1940), pp. 110-11. 120 Ludwig Von Mises, The Theory of Money and Credit (New Haven: Yale University Press, 1953), p. 139. 205 expenditures for additional commodities, the effect permeates the system, flowing to other holders of cash balances. 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 dis posal. 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 inten sively the goods they want, so that these goods will also rise in price. Thus the increase of prices con tinues, having a diminishing effect, until all com modities, some to a greater and some to a lesser extent, are reached by it.^-21 While it may be possible that prices will rise proportionally to the changes in the money supply, if demand remains static, it is more reasonable to assume that during the period of adjustment the demand for money will shift. The size and the direction of the shift will vary under differing circumstances, for it is subject to two sets of pressures, one tending to decrease and one tending to increase it. The influences toward a smaller demand eminate from the decline in K, whereas the influences toward a larger demand for money are traceable to increases in T brought about by the jump in ^■^Ibid. 206 expenditures. The more secure the community feels, and the more they expect prices to rise, the shorter the period over whose purchases it will attempt to hold pur chasing power in the form of money. The demand may tumble to very low levels if the price increase is expected to be 1 22 precipitous. The effect which the increase in the money supply will have on the demand for money during the transition period depends, therefore, upon the relative response of K and T; if T increases more than K decreases, the demand for money will increase; but if K declines more than T rises, the demand will decrease. It is possible for either situation to predominate, and both may occur during the same expansion, particularly if the expansion com mences at the nadir of a depression. At first, owing to an absence of fear or price increases, T may accelerate fairly rapidly, while K declines but slightly. Later in the period, however, as productive capacity begins to approach a high degree of utilization, T is unable to maintain its rate of increase, whereas K is capable of plunging to very low levels. This is helpful in exposing 122chancjier, op. cit., p. 81. 207 the reasons why prices may rise, but slowly at first, as the money supply is augmented, but later clamber to exceedingly high levels if the increase is sustained. A decrease in the money supply produces effects roughly the reverse of those just delineated. With a decrease in the money supply, the community finds itself with smaller money balances, and also, until prices have adjusted downward, with smaller holdings of purchasing power in the form of money balances. If there is not a corresponding decrease in the demand for money, the decrease in the supply of money will mean that those with diminished holdings will feel that their money balances are too small and will be desirous of replenishing them. They will essay to do this either by offering goods for sale on more favorable terms, or by diminishing their demand and expenditures for goods and services. The result will be to place a downward pressure on prices in the form of either decreased demand or increased supply. Similar to the situation of an increase in the money sup ply, the effects of the price decline will tend to perme ate the economy, and continue until the value of money has risen sufficiently to reestablish an equilibrium between the supply of and the demand for money. If the 208 demand remained in its former state, the decline in the price level would be proportional to the decrease in the supply. The foregoing analysis applied to the transition period. In the long-run, with all adjustments consunSriated, the result of a change in the money supply is to cause prices to rise or fall proportionally. This may be attri buted to the fact that in the long-run, the demand for money is largely a product of factors independent of the money supply. However, during the period of transition, the demand schedule is almost certain to experience a shift, even though the exact extent of the shift will depend upon the forces at work in each specific instance. The demand for money tends to be reduced by the concomi tant decline in T. But, an increase in K, owing to a surge of growth of pessimism as to the future course of prices, incomes, and employment, may offset the tendency for prices to move in the opposite direction. It is possible, of course, for T to decline more than K increases, with the result that the lessening in the money supply will cause some reduction in the demand for money, ■^^Ibid. ^ p# g3 # 209 and prices, therefore, falling less than in proportion to the decrease in the money supply. The usual consequence, nevertheless, is for K to increase more than T declines, so that the demand for money is larger, and price's fall more than in proportion to the decrease in the supply.^24 Effects of Changes in the Demand for Money Shifts in the demand for money that originate from changes in either T or K, or both, may also precipitate fluctuations in the level of prices. But, prior to ana lyzing the effects of changes in the demand for money, it is essential to distinguish between an "increase" in demand and an "extension" of demand. An increase in supply, given demand, will reduce the value of an article, and currency is no exception. The addition to the supply of money is usually offered in exchange for goods and services, and the entry of this new buyer, or the increase in intensity or scope of an estab lished buyer, will raise the prices of those items he demands, and will diminish the value of what he is offering that is, currency. But, it is at this point that confu sion often makes an ingress if the necessary distinctions 124Ibid., p. 84. 210 are ignored. For a given commodity, an increase in demand will raise its value, while a fall in value for the same good will extend its demand; conversely, a rise in value "contracts" demand. Hence, an increase in the sup ply of currency, ceteris paribus. does not increase the demand for currency, but instead only extends the demand for it, thereby inducing people to retain larger balances of money because the decrease in value makes it possible to retain larger balances with equal sacrifices and necessary to hold larger balances to obtain equal conveniences. People will take the additional currency as they take additional whiskey when it is watered and offered to them at a lower rate, but that does not show that, in the absence of increase of demand in the narrower sense, they will take additional whisky or additional currency at the old r a t e . 1^5 If the demand for money by the community is decreased, either because of a decline in trade or because shifts in actual or anticipated conditions seem to make it appear wise to hold less money as a store of value, and ^^Edwin Cannan, "The Application of the Theoreti cal Apparatus of Supply and Demand to Units of Currency," Readings in Monetary Theory, The American Economic Assn.• (Homewood, Illinois: Richard D. Irwin, Inc., 1951), pp. 9-10. 211 if the supply of money is not correspondingly reduced, those whose demand has diminished will come into the market with their ,fsurplus” funds and will increase the volume of expenditures. Another alternative would be for them to reduce the volume of goods and services they offer for sale in the market arena. This decrease of supply and increase of expenditures tends to raise prices, and the prices increases will continue until the total pur chasing power of the money supply as held by the commun ity has dropped to the level demanded. It should be emphasized that a rise in the price level which has been initiated by a decrease in the demand for money may become cumulative, both because an original rise in prices can nurture anticipations of further increases and thereby decreasing even more the demand for money, and because the price increases create pressures on the extension of bank credit. The effects which are produced by an increase in the demand for money, originating in either K or T, or both, are approximately the reverse of those described above. Assuming there is not an offsetting increase in the money supply, the individuals in the community who have additional demand can build up their holdings only 2X2 by diminishing their expenditures or by tendering more goods and services for sale. This has a tendency to lower prices, and will continue to do so up to the point where the total value of the money supply has increased to the level demanded. There is the possibility that the movement of prices downward will become cumulative, lead ing to expectations of still further declines. When this occurs, the demand for money will continue to increase, with forces exerting a pressure toward a decline in the extension of bank credit.1^6 Some Obj ections to the Cash-Balances Approach Although the Cambridge version of the quantity theory represents a significant improvement over the approach espoused by Fisher, it still remains an inade quate exposition of monetary theory. Due to its simpli city, it fails to deal adequately with the host of complexities of the economic system. The fundamental objections to the cash-balances equations are concerned with the value of money they measure; and to the assumptions related to the real resources the community attempts to command, and the money 12&chandler, op. cit., p. 85. 213 holdings the community chooses to retain. The initial objection challenges the validity of the value of money in purchasing goods and services for ultimate use which the cash-balance approach proports to measure. This objection is valid if the total quantity of lawful money and deposit money in the community is taken as the quantity of money in the equations. As analyzed above, one of Robertson's equations circumvented this objection by employing, not the totality of the money supply, but only that portion of the lawful money retained by consumers, and the deposit money retained for the purchasing of real income. By defining the quantity of money in this manner, the equation achieves a formal validity and is applicable as an explanation of the value of money in purchasing goods and services for ultimate consumption. Furthermore, by defining the quantity of money in this manner, the equation is usable in determining the transaction value of money by simply inserting the quantity of lawful money retained to carry out business transactions and the volume of business deposits. It should be recognized that money flows from income balances to transaction balances through expenditure on real income, and from transaction balances it enters income balances before 214 moving to payments of the factors of production. A second objection to the cash-balances equations i is based on Keynes contention that unwarranted emphasis is given to the national income as a determining influence on the volume of real resources the community chooses to command with its money balances. If the intention of the equation is to show that the price level, being a trans action price level, is related to the volume of financial and commercial transactions as well as to the real income of the community, then the objection is valid. However, commercial and financial transactions are but a portion of the group of forces which influence the quantity of real resources the community commands with its money balances; the origination of the monetary system and industry, the monetary habits of the community, and prospective changes in the value of money must all be carefully integrated and considered. Perhaps the objection can be surmounted by assuming that at any given time, there is an amount of purchasing power that the community desires to hold in the form of money balances, and that this quantity is a product, not of the community's income, but of the net 127gernste^n} pp. cit.. pp. 237-38. 215 advantages it realizes from retaining a command over real resources in this form. Those factors which influence the marginal or net advantages of holding purchasing power in the form of money affect the real balances of the community, and the value of money.. ^-2 8 Hawtrey voiced another objection to the cash- balances equations. He declared that "it is not the case that people settle their cash holdings with direct refer ence to their purchasing power in terms of wealth." Rather, "every one settles what margin of unspent purchas ing power he shall keep by reference to his prospective receipts and payments in monetary units."129 ^he price level itself is not a segment of the calculation. Granted that the money holdings of business men and consumers depend upon anticipated receipts and expenditures, these receipts and expenditures are determined by the level of prices and the real incomes of the community. Balances are, therefore, most advantageously determined funda mentally, if not directly, by the level of real income in 128Ibid., p. 239. 129r. G. Hawtrey, "Money and Index Numbers," Readings in Monetary Theory, The American Economic Assn. (Homewood, Illinois: Richard D. Irwin, Inc., 1951), pp. 39-40. 216 the community and the proportion of that income that is desired to be able to purchase with money. To state that the real value of the total supply of money in the com munity is the factor which determines the price level may appear to be circular reasoning, since it is the price level which determines the purchasing power of the commu nity holdings of money. One partially independent factor, however, is the quantity of real resources the community desires to be able to command with its money balances. When all circumstances are considered, prospective, as well as present, the value of money tends to be at that point where the community desires to neither increase nor decrease the real value of their money holdings. Only through a change in the community's desire to hold money balances of purchasing power, or a change in the quantity 130 of money, can this equilibrium be toppled. There are also economists who object to this ver sion of the quantity theory because of its failure to provide an ample portrayal of the forces which tend to work toward a disturbance in the level of prices. The inference is not that those who use the equations are ■^^Bernstein, q£. cit., p. 240. 217 unaware of the forces at work, but that the equations do not explicitly recognize the significance of these forces. Nor, do the equations depict the mechanics by which alter ation in the community’s preference for maintaining pur chasing power in the form of money balances affects the level of prices. It is evident that it is by increasing expenditures that the community attempts to decrease its real balances; and by decreasing expenditures that it attempts to enhance its balances of purchasing power. Keynes has shown that it is not difficult to interpolate the mechanics of a change in the level of prices, even 131 with the assumptions of the cash-balances equations. One of the most important oversimplifications is the disregard of the speculative demand for money. First, this results in ignoring one of the foremost reasons why the supply of money may fluctuate without parallel fluctuations in the level of money incomes, or why money incomes may change without parallel changes in the supply of money. SecondlyTto remain oblivious of the speculative demands of money is tantamount to ignoring the linkage between the theories of the rate of interest and of the 13lKeynes, o£. cit., pp. 224-29. 218 132 level of incomes through the demand for money. It is asserted that this theory cannot be regarded as an adequate theory of money due to the absence of any account of the rate of interest. Robinson stated, Changes in the quantity of money are of the ut most importance, but their importance lies in their influence upon the rate of interest, and a theory of money which does not mention the rate of interest is not a theory of money at all,133 In summary, while it is acknowledged that the cash balances equations are fundamentally correct, objec tions sprout from the contentions that they are incom plete. Properly interpreted, the theory espoused by the cash balances advocates is of great value in explaining one of the forces affecting the level of prices. It is worthy of note that cash-balances equations were developed during a period when large and rapid fluctuations in the quantity of money were affecting the desires of the community to retain purchasing power in the form of money balances.134 132payj cit., p. 251. 133 Joan Robinson, Introduction to the Theory of Employment (London: Macmillan and Company, 1938),pp.96-97. 134gernstein, o£. cit., p. 241. III. SUMMARY 219 This chapter has been concerned with an investi gation of two of the major forms which the quantity theory has taken, and of their practical relevance. The reader should consider whether the quantity theory has increased in practical validity now that a high degree of employment is the rule and mildly inflationary tendencies appear to be endemic. Some economists feel that it is possible that a cultural lag is once again being witnessed in terms of events and the theories designed to decipher these events. Analogous to the situation in the twenties and thirties when many economists laid stress on price changes when what was actually needed was an explanation of output fluctuations, so now it is possible that economic theory has swung too far in the other direction.^5 In ascertaining the value of money, the trans- action-velocity approach is the most direct and uncompli cated of the various theories. Money, being viewed exclusively as a medium of exchange, is connected directly with the flow of goods and services, and all transactions i ^ Day, o£. cit., p. 247. 220 are regarded as being consummated at the time of execution. This is a weakness of the theory, since a great number of transactions are effected on a "deferred- payment" basis. The theory is given mathematical expression by the equation of exchange, which presupposes that the value of the transactions executed in a given period is commensu rate with the volume of money being offered in exchange in that period. By so doing, it has to be assumed that deferred payment transactions do not exist, or with equal absurdity, that the deferred payments which accumulated in a given period are exactly offset by money transfers to cover the deferred payments transactions of the prior period. In addition, the totality of transactions which involve money transfers are the point of concentration in the theory. While this is not particularly a weakness of the approach, it does bring out the fact that the relation of money to incomes, as well as to gross and net national product, is not disclosed; yet, these relationships are of the most significant economic import. While it is obvious that the transaction-velocity approach does not uncover everything about money, it does yield an insight into the importance of changes in the 221 velocity of money and the relation of the quantity of money to the level and movement of prices.-^6 The cash-balances version is based on the assump tion that the value of money can be approached in terms of the motives for retaining cash-balances rather than non monetary assets. The assumption is that money is held in terms of its real worth, in terms of goods and services and securities at current prices. If the purchasing power of money balances appears excessive to the holders, a decrease in the demand for money will follow; money will increase in rapidity of circulation, and a committant increase in the quantity of money will ensue. Due to the interaction of supply and demand, prices will increase up to the point where the holding of money relative to the holding of nonmonetary assets is a matter of indifference. From the equilibrium position, there is no tendency for the utilization of money to cause prices to rise or fall. Nevertheless, this does not mean that nonmonetary causes cannot induce price fluctuations. A clear distinction between ’’ex ante1'expectations l-^Leland j. Pritchard, Money and Banking (Boston: Houghton Mifflin Company, 1958), p. 634. 222 and "ex post" realizations must be made if a proper evaluation of the effects which changes in the community's motives for retaining money balances have on the value of money is to be achieved. The theory does not insist that the motives of the individuals of the community for retaining purchasing power in the form of money balances be collectively realized. It was pointed out above that the total cash balances of the community behave in a paradoxical manner with reference to these motives. Nor is there any assurance that the real worth of the cash balances will run parallel to the motives of the com munity. Money balances of purchasing power will reflect, but not necessarily behave in congruence with, the community's motives. In the cash balances equations, k is not the length of the period over whose transactions the community elects^ to hold purchasing power in the form of money balances. Rather, it is similar to the other items in the equation; that is, an "ex post" concept. It is thus the length of the period over whose transactions the community retains purchasing power in the form of money balances. The dynamic aspects of the cash-balances theory 223 are drawn from the cognizance given to the discrepancies between the length of the period over whose transactions the community "holds” money balances of purchasing power and the length of the period over whose transactions the community "seeks" to retain money balances of purchasing power. If the community regards its money holdings of purchasing power as excessive or deficient, forces are set in motion which will alter the money holdings of the community, but not necessarily in the manner desired by the pub lie.-*-37 To conclude, the equations utilized in the transaction-velocity approach are concerned with the average value of money during a period of time, and has been labeled by Robertson as "money on the wing." The cash-balances equations are concerned with the value of money as of a given moment, and have been labeled by Robertson as "money sitting." The former placed emphasis on the total quantity of money and its velocity of circulation, whereas the later equations place attention on the proportion of income people choose to hold in the form of money balances. 137ibid., pp. 645-46. 224 Broadly speaking, the sitting money exercise is the more useful for enabling us to understand the underlying psychological forces determining the value of money; while the money on the wing exercise is the more useful for equipping us to watch with under standing the actual processes by which in real life the prices of goods and services change for reminding us that the quantity of money and the quantity of goods do not affect the price-level by some kind of occult planetary influence, but by modifying the capacity or willingness of human beings to buy or refrain from buying, to sell or refrain from selling. Robertson, Money (Chicago: University of Chicago Press, 1959), p. 32. CHAPTER V THE INCOME-EXPENDITURE APPROACH TO THE VALUE OF MONEY I. A PRELIMINARY SUMMARY OF THE GENERAL THEORY OF EMPLOYMENT John Maynard Keynes' book, The General Theory of Employment, Interest and Money, with which this chapter will be primarily concerned, can best be described as an oversaving-underconsumption theory. The stress was placed on both the excessively high position of the pro pensity to save, and the dearth of investment opportuni ties; both are viewed as the factors which prevent the attainment of a full employment situation.-*' Too, Keynes' approach was more than a simple value of money theory. Rather, it was an analysis of the relationship that tends to obtain among investment, saving, prices, production, distribution, spending, and consumption. Within its pur view was embraced the entire question of the efficiency ^Daniel Hamberg, Business Cycles (New York: The Macmillan Company, 1951), p. 136. 225 226 of the system and the continuity of its operation. The basic problem to be solved centered on the balance, or lack of balance, in the market between the goods and services produced and the effective demand necessary to move them. Because commodities are produced for exchange in terms of money, the following question must be answered: Among those who share in the money incomes which are produced, is the distribution of it, and the use to which it is put, such that the flow of money purchasing power into the market is able to generate quan tities of effective demand sufficient to clear the market of the goods and services produced? The initial step in the answering of this question is to analyze a given flow of income and the consequences that may ensue from the various possible uses of the income, since different possi ble uses of a given amount of income can affect subsequent prices and production, and, therefore, the income that will be received at a later date. — ..The,,income-exnenditure approach attempts to deal with the everyday problems of the value of money in terms of the influences which arise in a dynamic economy rather than with the long-run influences that are assumed to work . 227 themselves out in "normal" periods.^ But, in this approach, the value of money is far from the sole or even the princi pal matter of concern. It is merely one of a number of vital parts of the study of the factors which are involved in the study of the relationship between income and expenditures. The principle of effective demand Keynes' theory is best introduced by starting with am examination of the principle of effective demand. Total demand determines total employment, and unemployment is a product of a deficiency of total demand. Effective demand is manifest in the form of spending of income. As employ ment increases, income increases. A fundamental principle is that consumption will increase as real income of a community increases, but not by as much as the increase in income. As employment increases, income increases. A fundamental principle is that consumption will increase as real income of a community increases, but not by as much as the increase in income. In order to sustain an increase in ^Eugene E. Agger, Money and Banking Today (New York Reynal and Hitchcock, 1941), p. 151. 228 employment, it is necessary that sufficient demand be present, and it is essential that real investment fill the gap between consumption and total income. Therefore, employment cannot increase without an increase in invest ment. This is the core of the principle of effective demand as espoused by Keynes, and will be expanded upon in the following paragraphs.^ Keynes employed the term "demand1 1 in reference to the aggregate demand of the whole economic system. Whereas the usual demand analysis is in terms of the individual firm and industry, with a schedule depicting the various amounts of a commodity which will be purchased at a series of prices, Keynes chose to use the amount of labor employed as the measure of output as a whole, since the output of the entire economic system cannot be measured in terms of any single physical unit such as wheat or steel. The total proceeds expected from the sale of the output pro duced with a given amount of labor establishes the aggregate demand "price" for that amount of labor employed in producing that amount of output. The aggregate demand ^Dudley Dillard, The Economics of John Maynard Keynes--The Theory of a Monetary Economy (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1958), p. 29. 229 function can be depicted as a schedule of the proceeds anticipated from the sale of the output created from dif fering amounts of employment. Total proceeds, that is, the aggregate demand price, increase as more output is produced through the use of additional labor. In a capitalistic economy, where production is driven by the desire for profit, every businessman attempts to employ that number of workers which will maximize his profits. The sum of the employees in the economy repre sent the aggregate of those employed by all businessmen. To induce the businessmen as a whole to offer any given aggregate amount of employment, it is necessary that they expect to receive a certain minimum volume of proceeds. The minimum figure which will just bring forth employment on a given scale is called the aggregate supply price of that quantity of employment, and is a function which can be depicted as a schedule of the minimum quantity of pro ceeds necessary to bring forth varying amounts of employ ment. A greater amount of employment will be offered to workers by businessmen as the expected proceeds increase in amount. At the point where the aggregate supply func tion and the aggregate demand function are equal, a particular quantity of employment will be offered to 230 workers; this is the point of effective demand. At the point of effective demand, businessmen expect to maximize their profits. If either more or less employment were to be demanded or supplied, profits would fall. But, Keynes did not maintain that the particular amount of employment will correspond to the amount neces sary to obtain full employment. Aggregate supply and aggregate demand may be equal at the full employment level, but this is a special case which will occur only if the demand for investment happens to equal the gap between the aggregate supply price corresponding to full employment and the volume of spending by the community for consumer goods and services. Keynes contended that investment will typically fall short of the level required for full employment, so that a gap will exist between total spending and that amount required to reach full employment. In other words, the aggregate demand schedule and the aggre gate supply schedule will intersect at a point of less than full employment. An equilibrium is then established from which there is no tendency to fluctuate in the absence of some external force. Full employment is but a limiting or special case among a number of alternative 231 4 positions. The essence of Keynes' theory is found in the construction of his analysis of the aggregate demand func tion. The general theory is a theory of aggregate demand, since it is concluded that employment depends on demand, and total demand depends on total income. With total income being equal to total output, it would be equally valid to label his approach as a theory of aggregate out put . Total income is derived from the production of con sumer goods and investment goods. In a stage of less than full employment, any increase in employment is a product of both types of production, and income recipients will divide their increased income between consumption spending and saving. Since Keynes assumed the aggregate supply function to be given, his thesis is that employment is determined by the aggregate demand function, which in turn, is a product of the propensity to consume and the volume of investment as of a given period.5 ^Elmer Clark Bratt, Business Cycles and Forecast ing (third edition; Chicago: Richard D. Irwin, Inc., 1948), ^Dillard, o£. cit., pp. 31-35. 232 The Propensity to Consume Consumption demand is considered to be dependent on the size of income and the share of it that is spent on consumer goods. The amount of consumption will change with different levels of income, as will the proportion which consumption spending represents out of total income, the absolute amount increasing as income increases, and decreas ing as income decreases. The relationship between income and consumption spending may be regarded in the form of a schedule, displaying how the functional relationship varies for individuals or communities as income changes. It is favorable to employment if the propensity to consume is high since the gap between income and the con sumption out of income corresponding to various levels of employment will be smaller. The gap between income and consumption will be greater if the propensity to consume is relatively low, so that the maintenance of high levels of employment must be supported by relatively larger quantities of investment.^ The Inducement to Invest The effective demand for investment is much more ^Ibid., pp. 37-38. 233 subject to capricious fluctuations than is the effective demand for consumption. Basically, investment means producing more than is currently consumed, and takes the form of additions to the accumulated wealth of the commun ity. The inducement for businessmen to construct factories and machines, and to invest in other forms, arises from the expectation that such spending will sustain or augment profits. However, since these profit expectations are often based on precarious estimates of the future, invest ment spending is often subject to critical fluctuations. Businessmen will borrow, stated Keynes, up to the point where the cost of borrowing funds to finance the new investment is equal to the anticipated return on the investment. It can, therefore, be summarized that the inducement to invest is determined by the entrepreneur's analysis of the relation of profitability of investment relative to the rate of interest on money for investment. Keynes labeled this expected profitability as the "marginal efficiency of capital." The marginal efficiency of capital may be thought of as the anticipated rate of return or profit, expressed as a percentage, on real investments of the most efficient type. It is the highest rate of return over cost which is 234 anticipated as a result of producing a marginal unit of a certain type of capital asset.^ Investment activity will continue as long as the expected rate of return is greater than the rate of interest. If new assets can be constructed for less than the.;purchase price of existing assets of the same type, and if the absolute return on each is identical, then it will be profitable to build a new one rather than buy an old one. This explains what is meant when reference is made to the fact that the expected rate of profit is in excess of the rate of interest. Due to his desire to emphasize the dynamic setting in which the present is linked with the future through the expectations of investors, Keynes employed the term "margi nal efficiency of capital" rather than the expected rate of profit or some other conventional term. In the dynamic |setting of capitalism, the investor is very wary about investments that will yield their value, if at all, only over a number of future years. Unforeseeable events which could intervene and handicap the realization of the complete John Maynard Keynes, The General Theory of Employ ment , Interest and Money (New York: Harcourt, Brace and Company, 1936), pp. 135-36. 235 yield of an asset become larger as the period of time lengthens. The role of capital assets as the link by which investors bridge the gap between the present and the future is a cornerstone of Keynes' entire theory.** Keynes assumed that every new investment competes with every existing investment, so that there is a tendency for the secular long run rate of return to decline. This, however, can be offset, at least temporarily, by a corres ponding fall in the rate of interest; but, there is a floor to the long run rate of interest which prevents it from falling much below two per cent. Hence, under modern conditions, the expected rate of return is seldom likely to exceed the long run rate of interest.9 The rate of interest is considered to be a product of two things: (1) the state of liquidity preference; and (2) the quantity of money. The liquidity preference presents the demand side of the price of money, and the quantity of money, <the supply side. Liquidity preference represents the desire by individuals to hold balances of ^Dillard, oj>. cit., pp. 40-41. ^Bratt, o£. cit., p. 191 236 money; the quantity of money refers to the volume of lawful money and bank deposits in circulation in the system.10 The community’s desire for liquidity can be explained by examining the reasons for using money. Class ified according to motive, these include the transaction motive, the precautionary motive, and the speculative motive. The demand for money for the transactions motive refers to the need for money as a medium of exchange for ordinary, everyday transactions. For any given level of employment, the requirements for money in this capacity is relatively constant. The precautionary motive for holding money arises due to the need for handling unforeseen emergencies and contingencies. Again, the amount normally retained for this purpose is relatively stable. The type of liquidity preference which is considered to be so vitally important in relation to the rate of interest is that which concerns the speculative motive. Keynes defined this motive as "the object of securing profit from knowing better than the market what the future will bring forth." 10Dillard, op. cit., p. 42. 1 1 •^Keynes, op. cit., p. 170. 237 Money retained in this capacity is held as a store of wealth. Since the primary reason for holding money in this form is uncertainty concerning the movement of the rate of interest, individuals are willing to retain money balances on the chance that conditions will change so that they will be able to convert their holdings into earning assets on more favorable terms at a later date, and on terms which will be sufficiently better to offset any loss of earnings that might be made by parting with liquidity at the present The long run rate of interest is especially sensitive to . changes in this motive for holding balances, since the longer the period, the greater the uncertainty of events which could influence the direction and level of the interest rate schedule. In view of these circumstances, the demand for money to satisfy the speculative motive is much more volatile than are money demands to satisfy the precaution ary and transaction motives. According to Keynes, when the demand for funds to satisfy the speculative motive increases, the rate of interest will increase, and when the liquidity preference for this motive weakens, the rate of interest will fall. Liquidity preference rises and falls with changes in the attitudes held by the public 238 toward the economy and the political future. Hence, the level and stability of the rate of interest is dependent upon factors which are largely psychological in n a t u r e . ^ Turning to the supply side of the forces which determine the rate of interest, Keynes reasoned that the supply of money is determined by the banking system, not by the public. The public is limited to influencing the rate of interest if its demand for balances increases; whereas, the banking authorities are in a position to answer any changes in the demand for funds by either increasing or decreasing the quantity available, and thereby preventing the rate of interest from changing. Consequently, banking and monetary authorities occupy a strategic position in influencing the rate of interest. By pursuing a policy of flexible money supply, the banking system can, within limits, control the interest rate' schedule.^ To conclude, the income-expenditure theory of Keynes can be stated in the following manner: (1) the volume of total employment determines total income; (2) depending upon the size of the propensity to consume, con sumption expenditures depend on the level of income, and, ^Dillard, oj>. cit., p. 44. ^Ibid., p. 45. 239 therefore, the amount of employment; (3) aggregate employ ment is a product of effective demand, which is composed of consumption expenditures and investment expenditures; (4) when aggregate demand is equal to aggregate supply, an equilibrium situation prevails; therefore, aggregate supply is equal to the effective demand for consumption goods and investment goods; (5) in equilibrium, where aggregate demand is equal to aggregate supply, the former is deter mined by the propensity to consume and the amount of invest ment; therefore, the aggregate supply function, the pro pensity to consume, and the inducement to invest determine the volume of employment; (6) both the propensity to consume and the aggregate supply function, which depends primarily on physical conditions of supply, are relatively stable, and, therefore, the volume of investment is the main cause of fluctuations in employment; (7) the amount of investment depends on the marginal efficiency of capital . and the rate of interest; (8) the marginal efficiency of capital is determined by the replacement cost of capital assets and the expectations of profit yields; and (9) the rate of interest is determined by the state of liquidity preference and the quantity of money.^ 14lbid.T pp. 48-49. 240 II. BASIC TERMINOLOGY OF THE GENERAL THEORY OF EMPLOYMENT Any treatment of Keynes' theory of employment should be prefaced by at least a summary statement of the definitions employed in his exposition. The definitions will be set forth in the order in which he introduced them, reserving some for introduction at those places in the analysis where they can be viewed more clearly, provided such postponements do not seriously impede the development of the presentation. Factor Costs Factor costs are all the payments to the factors of production, exclusive of payments to other entrepreneurs , ♦ for their current services. User Costs User costs equal the payments which are made to other entrepreneurs, plus the extra costs involved in utilizing the equipment rather than leaving it idle. Profit Profit is the value of the resulting output which exceeds the sum of factor costs and user costs. It is the the amount the entrepreneur attempts to maximize when 241 determining what volume of employment to offer. Total Income Total income is the composition of factor costs and the entrepreneur's profit which results from the employment given by the entrepreneur. This may also be considered to be the proceeds of that volume of employment. 15 Aggregate Supply and Demand Price and Their Significance Aggregate supply is the "expectation of proceeds" from the output of a given quantity of employment which just makes it worth while to the entrepreneur to offer that amount of employment. Employment depends on the aggregate I supply price, since employment will tend to be set at that level which will maximize the excess of proceeds over factor and user costs. Then the relationship between the aggregate supply price, Z, and the amount of employment, N, needed for the output can be written Z = ^(N), which can be called the aggregate supply function. Aggregate demand function can be expressed as l^Keynes, op. cit., pp. 23-24. 242 D = f(N), where D is the proceeds which entrepreneurs anticipate that they will receive from the employment of N workers. Therefore, if at any given value of N, the expected proceeds, D, are greater than Z, the aggregate supply price, entrepreneurs are given the incentive to increase employment beyond N, up to the point where the value of N for which Z has become equal to D. N is given by the intersection of Z = ^(N) and D = f(N); for it is at this point of intersection that expected profits are maximized. The value of D at this point of intersection with the aggregate supply function is the ''effective demand." The intersection of the two functions fixes the point of maximum expected profits for entrepreneurs, as well as the level of employment; this is the point of effective demand. For any peculiar set of circumstances, it is an exclusive value, and can be considered to be deficient only if it corresponds to a level of less than full employment. Keynes did not contend that supply creates its own demand in the sense that f(N) and ^(N) are equal for all levels of N, or that there is a tendency for i^Ibid.a pp# 24-25. 243 the stable equilibrium value of N to be at the full employment level.^ on the contrary, Keynes contended that it is quite possible that an insufficiency of aggregate demand prevents the level of employment from attaining the full employment station, and to keep it from this optimum point for indefinite periods. It then became imperative for Keynes to explain why aggregate demand can be wanting in this sense. This is equally imperative in understanding his trade cycle theory since he felt that full employment is a special case which is seldom, if ever, accomplished. Robertson claimed that Keynes had created some confusion in this context due to his inconsistency in using the notion of effective demand to signify, at one place, ! what an entrepreneur "can" expect to garner from any given level of employment, while at other times using it to mean what the entrepreneur "does” expect to garner.In sug gesting that a possible discrepancy between these two uses may be critical in explaining the process by which recovery ^Raymond J. Saulnier, Contemporary Monetary Theory --Studies of Some Recent Theories of Money, Price, and Pro duction (New York: Columbia University Press, 1941),p. 312. •^D. H. Robertson, "Some Notes on Mr. Keynes Gen eral Theory of Employment-Qusarterly Journal of Economics, LI (November, 1936), p. 169. 244 from business doldrums is accomplished, Robertson tendered the following argument: if D and Z are equal at less than full employment, and if entrepreneurs do expect that an increase in expenditures will be balanced by an increase in income, the incremental employment will result in an increase in total profit even if, as Keynes argued, the money expenditures do not all return as income. This addi tion to the entrepreneur’s profits, even if it is less than he had anticipated, that is, is less than sufficient to equate D to Z, may nevertheless raise his hopes enough to warrant undertaking further increments to expenditure. This piecemeal return of confidence may eventually justify itself, as the recovery begins to take steps forward in the Marshallian tradition. In what Robertson termed the ’’natural recuperative powers of the economic system,” the discrepancy between expectations and realizations may become a highly important factor. In other words, employ ment is not necessarily contained within an equilibrium station at a point below full employment; that cumulative forces may continuously exert pressures toward a level of more complete employment due to stimulation by changes in 19 anticipations. 19lbid.T pp. 168-70. 245 Labor Units and Wage Units Concepts which economists frequently utilize today, such as the national dividend, the general price-level, and the stock of real capital, were all rejected by Keynes on the premise that they lacked the precision which causal analysis demands. It is important to note, however, that these concepts have undergone extensive development since 1936. Studies by the British Treasury, the United States Department of Commerce, and the National Bureau of Economic Research, are among the groups which have contributed to path-breaking advances, so that Keynes would undoubtedly have altered his opinions on these matters.20 Nevertheless, it is interesting to examine his approach to these concepts. Keynes proposed to substitute in their place "two ; fundamental units of quantity, namely, quantities of money- value and quantities of employment."21 The unit of employ ment is the "labor-unit," which is held to be . . . sufficiently defined for our purposes by taking an hour's employment of ordinary labour as our unit and weighting an hour's employment of special labour in proportion to its remuneration.22 9 n Alvin H. Hansen, A Guide to Keynes (New York: McGraw-Hill Book Company, Inc., 1953), pp. 54^55. ^Keynes, o£. cit., p. 41. ^ Ibid. 246 The money-wage of this labor-unit is labeled the "wage- unit." Hence, "if D is the wages (and salaries) bill, W the wage-unit, and N the quantity of employment, E = N.W."?§ Keynes then stated that . . . much unnecessary perplexity can be avoided if we limit ourselves strictly to the two units, money and labour, when we are dealing with the behavior of the economic system as a whole; reserving the use of units of particular outputs and equipments to the occasions when we are analyzing the output of individual firms or industries in isolation; and the use of vague concepts, such as the quantity of output as a whole, the quantity of capital equipment as a whole and the general level of prices, to the occasions when we are attempting some historical comparison which is within certain (perhaps fairly wide) limits avowedly unprecise and approximate.^ In addition, Keynes asserted that changes in cur rent output should be measured "by reference to the number of men employed (whether to satisfy consumers or to produce fresh capital equipment) on the existing capital equip ment. "25 From the point of view of the concept of measure ment, the selection of these units have the advantage of simplicity, which is important when undertaking an examina tion of the economy as an aggregate. Nevertheless, there are also a number of very significant difficulties which ^ Ibid. 24~Ibid. ^ p# 43 ^Ibid., p. 44. 247 command recognition. The most conspicuous problem arises in the attempt to define the "ordinary labor," a matter which must be solved prior to determining the quantity of labor-units in any given type of labor. Output for the industry or the economy cannot be measured in these units prior to answering this question. The problem is particu larly important, since it bears on the possibility of constructing the type of measures which would be employed in gauging the appropriateness of any given policy. Weighting laborers' work according to their productivity would entail the myriad of difficulties of productivity imputation. Such productivity compilations could not be used if the goal is, as Keynes' ostensibly appears to be, the fabrication of "precise" measures. He stated that the ordinary worker's remuneration will serve as the base for all other types of labor; but if wage rates are a product of factors other than productivity factors, then the con sequent index will not be accurate, and will certainly not meet the standard of precision. To substantiate this criticism, note need only be made of the differences which exist in the bargaining power of different clusters of laborers in terms of wage rates or other forms of 248 remuneration which they receive.^ Keynes also supported the contention that labor is paid in accord with its marginal product.27 However, there is serious reason to doubt such contentions, particularly in areas of less than perfect competition. Alterations in the relative position of different labor groups in terms of bargaining power could indicate, according to his approach, alterations in output. Even though Keynes presented the labor-unit as an hour of employment of ordinary labor, he measured output I in terms of the number of men e m p l o y e d . 28 In addition, to measure output through the medium of employment, in terms of labor-units, may tend to divert attention from the fluctuations in labor produc tivity during the various phases of the business cycle. Finally, if any significance is attached to the distribu tion of labor among alternative uses, in the sense that a certain kind of allocation could result in the extension of productive facilities beyond their market potentiali ties, then Keynes1 approach is an inadequate method of 2^saulnier, oj>. cit., pp. 314-15. 2?Keynes, op. cit., pp. 17-18. 28ibid., pp. 41, 44. 249 sunraiating the aggregate labor factor. Attention needs to be focused on the progress of the particular sections of the economy and not just on the direction of the whole. The question arises as to whether the goal of the economy is to simply have all men working, regardless of such other considerations as efficiency and growth.29 Savings, Investment, and Income Savings, investment, and income were very important concepts in Keynes' theory. A preliminary statement of his idea of income will be helpful. Considering the following concepts to be relevant within a given period of time, let A equal the proceeds from selling finished output to consumers and other entrepreneurs; let A^ equal purchases of finished output from other entrepreneurs; let G equal i the value of capital equipment, which includes both unfinished and finished goods. Then, to compute the income from the period, some part of A - G - A-^ will be attri buted, not to this period, but to the capital equipment which was in existence at the beginning of the period. It is necessary to deduct from the sum of the foregoing a 29saulnier, o£. cit., pp. 315-16. 250 "certain sum, to represent that part of its value which has been (in some sense) contributed by the equipment inherited from the previous period."30 There are two alternative methods to employ in calculating income; one is to start with the production angle, the other is to start with the consumption angle. Let each be considered in turn. First, assume that B* had been spent on the maintenance and improvement of the capital equipment if it had not been used during the period; and let G 1 equal the value of the equipment at the end of the period. Then, G’-B’, conceptually, is the max imum net value of the equipment which might have been conserved from the last period if it had not been used to produce A. (G-A^) equals the value of the capital equip ment at the end of the period minus any additions to the equipment during the given period. (G’-B1) - (G-A^) is the measure of the sacrifice of value due to the production of A, or is the "user cost" (U) of A. The sum of user cost and "factor cost" (F) equals "prime cost" of the A. The entrepreneur’s income, which he desires to maximize 30Keynes, o£. cit., p. 52. 251 and which is of pre-eminent importance in determining the level of employment, will equal A-(U - F). Aggregate income of the community is A-U, with F being excluded from this concept, since it equals the incomes of the non entrepreneurs. This manner of income computation was con sidered by Keynes to be of utmost importance to the processes of production.31 Second, the concept of income was developed by Keynes from the point of view of consumption. The entre preneur is liable to suffer involuntary losses in any given period, . . . occuring for reasons beyond his control and irrespective of his current decisions, on account of (e.g.) a change in market values, wastage by obsoles cence or the mere passage of time, or destruction by catastrophe such as war or earthquake.32 Losses on capital equipment due to causes such as these are distinguished from the voluntary losses which were enu merated above. That portion of such losses which is invol untary but not totally unexpected is termed "supplementary costs," (V), i.e., "the excess of the expected deprecia tion over the user-costs."33 Thus, from the entrepreneur's 31ibid., pp. 52-54. 3^Ibid., p. 56. 33ibid. 252 point of view, A-(U - F)-V is the significant consumption concept, since V has the same effect on his psychology as though it had come out of his gross profit. Losses of this type will be taken account of by the individual or the corporation through a debit entry to an income account. This is analogous to a contingency account which conserva- 34 tive accounting practices observe. In this respect, the ’’aggregate net income’’ is equal to A-U-V. The expected changes in V were not viewed by Keynes as having the same effect on consumption as do the invol untary changes in the value of capital equipment which are unexpected and are classified as "windfall” changes.35 The distinction between supplementary costs and windfall changes, which must be drawn if income is to be expressed in these terms, is partly a traditional or psychological one, and with no definitive criterion for estimating such differences. He concluded that . . . we cannot get closer to a quantitative definition of supplementary cost than that it comprises those deductions from his income which a typical entre preneur makes before reckoning what he considers his net income for the purpose of declaring a dividend (in the case of a corporation) or of deciding the scale of 34jjansen, o£. cit., p. 56. ^Keynes, o£. cit., pp. 57-58. 253 his current consumption (in the case of an individual} ^6 At best, however, there is ambiguity attached to this concept of net income. A brief and cursory review of the highly complicated and technical literature on depreci ation policy and inventory valuation discredits any assertions of being unequivocal or unambiguous. As in the handling of index numbers of prices and production, the 0 7 economist has to work with something less than perfection. Too, questions arise concerning the extent to which wind fall changes will affect consumption, even though Keynes' very general statement that supplementary costs can be construed to encompass any deduction that the usual entre- | preneur considers it fitting to include in computing net income minimizes such weaknesses. He does not claim that the concept of net income, and hence, net saving and net investment, are unambiguous, but does insist that these terms refer to consumption and that the ostensibly unambiguous concepts of income, savings, and investment are more significant due to their relevance to the theory 38 of production and employment. 36jbid., p. 5 9. ^Hansen, q£. cit. , pp. 57-58. 3®Saulnier, oj>. cit., p. 318. 254 Keynes, based on the definition of income given above, came to the conclusion that savings and investment, in any given period of time, were equal. If, for any given period of time, A-U equals aggregate income, A-A-^ equals purchases by consumers, and if savings equal the amount of income remaining after expenditures on consumption, then saving equals (A-U)-(A-Ax) or A^-U; too, net saving for the 'iQ i margin or net income over consumption equals A^-U-V. Investment is subsequently defined as nthe current addition to the value of the equipment which has resulted from the productive activity of the period," or the portion of income generated in the period which has not passed in consumption.^ It follows that investment for the period is equal to A^-U, and that the net addition to investment, that is, net investment, equals A-^-U-V. Provided it is agreed that income is equal to the value of current output, that current investment is equal to the value of that part of current output which is not consumed, and that saving is equal to the excess of income over consumption--all of which is conformable both to common sense and to the traditional usage of the great majority of economists--the equality of saving and investment necessarily follows.^1 ^Keynes, o£. cit., pp. 61-62. 40Ibid., p. 63. 41Ibid. 255 Keynes felt that the idea that savings could exceed investment, or vice versa, was an outgrowth of the study of the expansion and contraction of bank credit. A more lucid conception of his treatment of this problem of inequality may be garnered from his statement of why equilibrium exists even when an increase in bank credit takes place: The notion that the creation of credit by the banking system allows investment to take place to which "no genuine saving" corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of the others. If the grant of a bank credit to an entrepreneur additional to the credits already existing allows him to make an addition to current investment which would not have occurred otherwise, incomes will necessarily be increased and at a rate which will normally exceed the rate of increased investment. Moreover, except in conditions of full employment, there will be an increase of real income as well as of money-income. The public will exercise "a free choice" as to the proportion in which they divide their increase of income between saving and spending; and it is impos sible that the intention of the entrepreneur who has borrowed in order to increase investment can become effective (except in substitution for investment by other entrepreneurs which would have occurred other wise) at a faster rate than the public decide to increase their savings. . . . No one can be compelled to own the additional money corresponding to the new bank-credit, unless he deliberately prefers to hold more money rather than some other form of wealth. Yet employment, incomes and prices cannot help moving in such a way that in the new situation someone does choose to hold the additional money.42 42Ibid., pp. 82-83. 256 Hence, Keynes demonstrated that an expansion in bank credit for the purpose of investment results in an increase of both savings and investment to an equivalent amount. The identity of savings and investment as formu lated by Keynes, while fundamentally correct, is subject to question in terms of the adequacy of his approach for the analysis of certain strategic economic processes. His method veils the changes or processes in savings and invest ment and necessitates that separate devices be set up to proceed with his special analysis. Robertson's method, stated Saulnier, facilitates the expression of changes in credit expansion and contraction, as well as changes in velocity of circulation of money, within a given period of time, directly in terms of the savings and investment 43 concepts. Another alternative to analysis of savings and investment phenomena is found in the writings of the Swedish school. Since the traditional concepts of the savings and investment processes allowed for fruitful use of the discrepancy of the two in analyzing income changes, selected concepts of these Swedish economists have been ^Saulnier, o£. cit♦, p. 321. 257 employed along with Keynes* approach in an effort to more ' fully describe the significance of changes in savings and investment. Thus, use of the Swedish concepts of ex ante and ex post does not do injury to Keynes* use of realized equivalents; but, by introducing ex ante discrepancies, it is possible for planned savings to differ from planned 44 investment. A further problem concerns the period of time which must be selected when arguing, for instance, that a decrease in consumption expenditures at a given moment will result in an exactly equal decrease in the community's income at another moment in time. Granted that it is true that the expenditure of a given amount of purchasing power must result in the receipt of a similar amount of purchasing power, the question is directed at the length of time necessary to realize the response of the income-disbursing agencies to the alteration in receipts.^5 Keynes' identity between savings and investment precipitates such a problem,' due to his assumption of spontaneous adjustment without a Marvin Peterson and D. R. Cawthorne, Money and Banking (New York: The Macmillan Company, 1949),p.432. ^Saulnier, op. cit., pp. 322-23. 258 lag between the event and its consequences. In conclusion, by assuming that investment and savings are equal, it becomes necessary to analyze the determinants of the level of income and the rate of utili zation of productive resources. Keynes, in searching for the solution to the performance of the economy, emphasized the psychological and institutional forces which cause the community to alter the amount which it desires to save compared to the amount of investment it desires to make at prevailing rates of return. He analyzed these conditions in terms of three categories of forces: (1) the propensity to consume; (2) the marginal efficiency of capital; and (3) the rate of interest. Attention is now turned to a study of these forces. III. THE PROPENSITY TO CONSUME AND THE MULTIPLIER As shown in the preliminary summary, Keynes traced a very close relationship between the propensity to con sume, which represents the manner in which income is divided between consumption expenditures and investment spending, and the level of employment. The discussion of the role which this concept plays in the whole theoretical structure must await the examination of Keynes’ theory of interest and investment. The Average Propensity to Consume Explanation of the concept. The propensity to consume was defined by Keynes as "the functional relation ship X between Yw, a given level of income in terms of wage-units, and Cw the expenditure on consumption out of that level of income, so that Cw = X(Yw) or C = W ’X(Yw)."46 The aggregate demand function is defined as that which "relates any given level of employment to the 'proceeds' which that level of employment is expected to realize."47 The propensity to consume sets that portion of the "pro ceeds" relevant to the aggregate demand function which are derived from spending on consumption goods; the other part is composed of spending on investment goods, and will be discussed in the following section. The level of income is the prime determinant of the amount which will be spent on consumption, with income, in turn, being determined by employment. In addition, there are other factors which influence the size of consumption expenditures, namely, objective circumstances and subjec tive needs and habits. The form of the consumption 4%.eynes, o£. cit., p. 90. 47jbid., p. 89. 260 function, that is, its "slope” and "position," is determine: by the slowly moving subjective factors, and gives it a "fairly high degree of stability." Marked "shifts" in the consumption function are a product of the objective factors, due to rapid changes which the external factors may precipitate.^ The subjective factors are assumed by Keynes to be given, so that primary attention is granted to the objec tive factors. Nevertheless, some attention should be paid to the subjective factors as outlined by Keynes. Briefly, the eight main motives which lead individuals to save are as follows: (1) the motives of precaution; (2) pride; (3) avarice; (4) calculation; (5) independence; (6) improvement; (7) enterprise; and (8) foresight. The motives which prompt individuals to spend can be categorized under the headings of shortsightedness, miscalculation, enjoyment, ostentation, and extravagance. In addition, governmental units and businesses will refrain from spending for motives of enterprise, liquidity, improvement, and financial prudence ^Hansen, o£. cit. , p. 70. ^Keynes, o£. cit., pp. 108-9. 261 Now the strength of all these motives will vary enormously according to the institutions and organiza tion of the economic society which we presume, accord ing to habits formed by race, education, convention, religion and current morals, according to present hopes and past experience, according to the scale and tech nique of capital equipment, and according to the prevailing distribution of wealth and the established standards of life. . . . We shall . . . take as given the main background of subjective motives to saving and to consumption respectively.^ Keynes assumed that the propensity to consume is a product of just the objective factors, all of which are grouped under six major divisions. They are as follows:-*^ (1) "A change in the wage-unit." At any given level of employment, consumption spending will change in the same proportion as the value of the wage-unit,although there may bexcircumstances where allowance must be made if changes in the value of the wage-unit are coincident with a change in the distribution of a given real income. (2) "A change in the difference between income and net income." Admitting that net income is the factor of prime importance in terms of the propensity to consume, he stated that changes in income which are not reflected in net income, and vice versa, are of doubtful "practical importance" as concerns consumption expenditures. ^Ibid., pp. 109-10. ^ljbid., pp. 91-96. 262 (3) "Windfall changes in capital-values not allowed for in calculating net income." Because they bear "no stable or regular relationship to the amount of income," changes of this type are considered to be among the most significant forces which can affect short-run changes in the propensity to consume. (4) "Changes in the rate of time-discounting; i.e., in the ratio of exchange between present goods and future goods." In the short period, only substantial changes in the rate of interest are likely to affect the propensity to consume; otherwise, changes in the rate of interest in regard to consumption are likely to be "secondary and relatively unimportant." (5) "Changes in fiscal policy." Changes in the taxing policies of the government are deemed to have a significant effect on consumption spending. For instance, a tax structure which is heavily progressive in structure is conducive to an upward shift of the consumption function (6) "Changes in expectations of the relation between the present and the future level of income.” This is held to be important for a given individual, whereas, for the community as a whole, it is likely to average out and to exert relatively little effect because of their 263 uncertainty. Keynes1 conclusion is that, provided the money value of the wage-unit is given, the consumption constitu ent of the aggregate demand function, that is, the pro pensity to consume, is relatively stable. The factors (3), (4), and (5) may exert some force, insofar as they are not in any fixed relationship to income, Yw . However, in general terms, none are likely to disturb the propensity to consume in ordinary times. If changes are set in motion, they are likely to originate from changes in Yw itself. Finally, the shape of the aggregate demand function is normally given by "the fundamental psychological law . . . that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income. As a consequence of the relationship between income and consumption, it follows that if employment increases, and hence income, "... not all the additional employment will be required to satisfy the needs of addi tional consumption."53 Therefore, 52Ibid., p. 96. ^Ibid. ^ gy ^ 264 . . . employment can only increase pari passu with an increase in investment; unless, indeed, there is a change in the propensity to consume. For since con sumers will spend less than the increase in aggregate supply price when employment is increased, the increased employment will prove unprofitable unless there is an increase in investment to fill the gap.^4 Criticism of the concept. Before a further exposi tion of Keynes* theory is undertaken, the propensity to consume concept deserves additional study. Granted that the idea of a propensity to consume is of undoubted importance, it is not entirely satisfactory in several respects. A first question concerns the idea that perhaps anticipated income is as important as currently realized income in determining the propensity to consume. If the former is of significance, then the consumer must be assumed to have a store of wealth from which to draw; and if this is a significant determinant, it is possible that his spending may be conducted in terms which include the current value of anticipated income. While this in no way destroys the basic argument espoused by Keynes, it does point out that the problem may not be as settled as is often contended.55 54jbid., p. 98. ^^Saulnier, o£. cit., p. 329. 265 It is also possible that the propensity to consume is influenced not only by the wealth held in the form of illiquid assets, but also by the amount of purchasing power in the form of money balances over which the consumer has control. Decisions by consumers in cases where purchases are postponable can have considerable effect on the flow of money demand into the system. Of course, any judgment of the effects of such action by consumers must be prefaced by a knowledge of the conditions under which such changes take place, of how the banking system behaves, and of how consumers choose to act in attempting to accomplish their ends That the consumption function is subject to sub stantial instability is a growing conviction among many economists. Burns stated that he was unaware of . . . any statistical studies that indicate absence of capricious shifts in the consumption function. It seems . . . that it is exceptionally difficult to determine short-run shifts (other than seasonal) of the consumption function empirically, and that this seriously limits the effective use of the Keynesian analytical apparatus for many problems of short-run economic change.^7 56Ibid., pp. 329-30. -^Arthur p. Burns, The Frontiers of Economic Knowledge(Princeton: Princeton University Press, 1954), p. 218. 266 jFor a given level of income, the propensity to consume is ’ influenced by a host of forces, among them population size, income distribution, price level behavior, liquid asset holdings, availability of consumer credit, alterations in expectations about future incomes, future supplies of goods, and the direction of future prices.-*® All this indicates that consumption is susceptible to considerable variation in response to short-run changes in income. Actually, data on the consumption function displays a definite secular rise. The reason for the secular rise in the propensity to. jconsume lies in the continual upward trend in the com- i munity's conception of a proper standard of living. Arti cles which were once reserved only for the rich are now considered indispensable necessities.^^ Fellner gave support to this, stating that his studies indicate that . . . a person whose income rises beyond "normal incomes" in the community saves a relatively higher portion of the addition to his income, whereas no such stimulus to thrift arises when everybody's income rises."60 H. Steiner, Eli Shapiro and Ezra Solomon, Money and Banking--An Introduction to the Financial System (4th ed.; New York: Henry Holt and Company, 1958), p. 477. S ^ H a m b e r g , o p . cit., p . 1 9 0 . ^^William Fellner, Monetary Policies and Full Employment (Berkeley, Calif.: University of California Press, 1 9 4 7 ) ______________ 267 Thus, significant questions may be raised over Keynes’ use of the consumption function as a constant in his theory, and the applicability of any deductions drawn therefrom. A further question arises in the form of a chal lenge of the exclusive use of aggregates when analyzing consumer demand. Might not it be wise to take into account the distribution of total demand among different types of goods, as of a given period? To illustrate, assume that as income changes, consumption is distributed differently, in that as income increases, durable good purchases which were postponed during the previous period are affected. Hence, consumers may adjust their budgets as income changes by varying their purchases of durable goods. In this instance] the demand for durables will be seen to increase as income increases, but by a greater amplitude than income. The point which is brought out is that rather important fea tures of the economic complex may be veiled when con- 61 ceptual apparatus is employed only in terms of aggregates? The Marginal Propensity to Consume and the Multiplier Keynes continued the development of his theory with ^■^■Saulnier, o|>. cit. , p. 330. 268 the introduction of the concepts of the marginal propen sity to consume and the multiplier. The former is defined, symbolically, as dCw/dYw, and depicts the relationship between an increment in consumption and an increment in income. The value of the ratio will tend to fall farther and farther below unity as income increases. For any given increment in income, Yw, brings about an increment in con sumption expenditures, Cw, and in investment expenditures, Iw, so that YW=CW-IW . It is also possible to express the equation as Y^k*^, "where 1-1/k is equal to the marginal propensity to c o n s u m e . "^2 multiplier, k, indicates that "when there is an increment of aggregate investment, income will increase by an amount which is k times the increment of investment."63 Thus, the greater the marginal propensity to consume, the greater the value of k, and vice versa. In this manner, a relation between k and the aggregate demand function is established. Keynes levied a great deal of importance on the investment multiplier. Making use of the employment multi plier concept as originally conceived by Kahn, Keynes explained how an increment in investment spending will ^Keynes, o£. cit. , p. 115. ^ Ibid. 269 cause an increase in employment and total income which is a multiple of the original investment. Cognizant of the fact that there is no reason to expect the employment multi plier and the investment multiplier to be equivalents, Keynes, nevertheless, found it convenient for purposes of elucidation to assume that the two are identical. Then, assuming that the marginal propensity to consume is 9/10, the value of k will be 10; "and the total employment caused by (e.g.) increased public works will be ten times the pri mary employment provided by the public works themselves, assuming no reduction in other directions."^ There is no particular reason why the incremental investment came from the public sector; he merely used this as an illustration. Before proceeding, it may be helpful to distinguish between the "payments multiplier" and the "income multi plier." If one hundred unemployed men were hired by the government for one hundred units of money, it is possible that these workers would spend the entire amount at retail stores. The retailers involved, however, cannot regard the entire one hundred units as income which is applicable to their marginal propensities to consume, since they must 64Ibid., pp. 116-17. 270 replenish their stocks unless choosing to disinvest in inventory holdings. In this case, only that portion of receipts which represents net income to the retailers is applicable, and the same reasons will apply to those firms from which the retailers obtain their stocks. As this example shows, therefore, the length of time necessary for the K to affect incomes will be influenced by the length of time required for the money, through successive turnovers, to become final income of a similar amount.65 The assumption which Keynes made in his first ideduction concerning the investment multiplier as it applies I to public works, that is, that there is no off-setting reduction in investment expenditures in the private sec tors, is subject to qualification. In terms of a formal statement, especially of the relation of past consumption to past income, the principle of the multiplier is without defect. But, when it is applied as a means of controlling present and future income, a number of weaknesses manifest themselves. This general enumeration of weaknesses may be labeled 65 Peterson, ojd. cit., p. 435. 271 "leakages," that is, the alteration in the public's use of the funds in the form of reductions in private spending, or changes in the community's use of funds, when the government undertakes an expansionary program. In the first place, stated Keynes, unless the monetary authorities take offsetting action, the rate of interest is likely to rise due to an increase for cash financing of the program, and for working capital purposes. These needs are necessitated by the increased employment which will come about, and associated increases in prices; a rise in the rate of interest would retard investment in other areas. At the same time, an increase in;the cost of capital assets would tend to reduce the marginal efficiency of capital to the private investor. To offset this decline, the rate of interest would have to decrease in size. The possible effect which increases in the pricing structure could have is well illustrated by a remark made by Williams. One of the chief dangers in a spending program is that if not wisely applied it may raise prices and wage rates and interfere with its own success. One of 66K.eynes, o£. cit., pp. 119-20. 272 the chief weaknesses of Keynes’s analysis is his failure to see the importance of wages as a factor in cost of investment. In this country the confusion about wages and recovery, the failure to see that high wage rates are a result and not a cause of recovery, has done much to impair the effectiveness of deficit A7 spending and other recovery measures.D/ Second, the "confidence" of the general public may be shaken by a government policy of public works spending. If the public reacts by increasing their liquidity prefer ences, or by decreasing the marginal efficiency of capital, investment again may be retarded unless positive measures are undertaken to offset the public's actions.68 j Radical programs by the government can have discon certing effects on private investment incentives. Changes I in business expectations due to fear of higher tax i J schedules in the future, or perhaps even ultimate govern ment appropriation of capital, may prove to deter private investment outlays, and thereby cancel, or at least reduce, the quantity of secondary employment created. An example of this would occur when businessmen, even though they feel 67J o h n j j Williams, "Deficit Spending" Readings in Business Cycle Theory (Philadelphia: The Blakiston Company, 1944^ p. 289-90. 6®Keynes, o£. cit., pp. 119-20. 273 the increase in consumer purchases as a consequence of the new income injected by the government, choose to reinforce their cash positions and allow inventory disinvestment to take place.69 The effect of radical government programs will vary with the situation at hand as well as with the acceptance given to the program. Novel departures from tradition may seem radical at first introduction, while continued use of them may bring a reappraisal of the effects which are con ducive to private investment at a high level. Thus, the injection of new expenditures into the system by the government may induce businessmen to become more optimistic about the future and to encourage such a policy. Income recipients may then begin spending a greater portion of their income, banks may relax their credit restrictions, and businessmen may expand their production. Under cir cumstances such as these, the effects of the multiplier may be greater than originally anticipated, 69 Rollin G. Thomas, Our Modern Banking and Mone tary System (second edition; New York: Prentice-Hall, Inc.. 1950), p. 478. ^^William Howard Steiner and Eli Shapiro, Money and Banking (revised edition; New York: Henry Holt and Company, 1947), p. 661. 274 Third, a portion of the effect which the multiplier produces, may leak out to foreign countries, with a conse quent loss of secondary effects. On the other hand, any leakages to foreign countries have favorable repercussions on their economies, with consequent gains to our economy. Finally, when substantial amounts of investment are under consideration, allowance must be made for the progressive decline in the power of the multiplier due to a tendency for the marginal propensity to consume to decrease as income increases. "The marginal propensity to consume is not constant for all employment, and it is probable that there will be, as a rule, a tendency for it to diminish as employment increases."71 Thus, the two factors which ! were considered to be the prime determinants of the inducement to invest by Keynes, that is, the rate of inter*- est and the marginal efficiency of capital, may be unfa vorably affected by an effort to stimulate aggregate employment through the medium of public spending. This all adds up to the fact that it is extremely difficult to 72 attach any specific value to the multiplier. ^Keynes, o£. cit. , p. 120. 72gaulnier, o£. cit., p. 333. 275 Even though it is recognized that the concept of the multiplier is of significant importance in organizing thought on the effects of government spending, doubt is cast on the manner in which Keynes used the concept in dealing with causal relationships. In order to show where Keynes’ theory of the multi plier involves error, a criticism advanced by Haberler is first considered. Haberler pointed out that Keynes' con struction of the relation between the marginal propensity 1 to consume and the multiplier, or i_ AC. = k, indicates AY that in a ’’formal” sense it is conceivable to allot a value to the multiplier on the basis of knowledge derived from the marginal propensity to consume. Formerly, Haberler pointed out, this is quite true. But in actuality, he insisted, it is not possible to do so. The difficulty arises, he stated, due to Keynes' treatment of ”a relation ship by definition as a causal or empirical relationship 7 3 between investment and income.'J It becomes evident that when the nature of the 73Gottfried Haberler, "Mr. Keynes' Theory of the 'Multiplier': A Methodological criticism,” Readings in Business Cycle Theory (Philadelphia: The Blakiston Company, 1944), p. 195. 276 considerations which determine both the multiplier and the marginal propensity to consume are examined, that the former cannot be determined from the latter even though the two are formally related to one another. This distinction was explained by Haberler as follows. Two concepts of the marginal propensity to consume were employed by Keynes. First, there is the "formal" sense, in which k = , z l c ; . ~ A . Y and second, the "ordinary or psychological" sense, where the factors which influence the use of income are considered.^ The problem is that it is impossible to derive the value of k from the data which can be examined in connection with the second concept of the marginal pro pensity to consume. It was pointed out by Haberler that the size or value of the multiplier will be a product of a host of circumstances, such as leakages of expenditures into money balances, on the length of time which is allowed to elapse, on the effect of new expenditures on the marginal, efficiency of capital, and the strength of the income velocity of money.75 Another approach may be taken to reveal Keynes' 74-lbid., p. 198. 75ibid., p. 199. Ill error in this respect. It cannot be contested that AY=AC+AI. Keynes then defined k as equal to rri'c " when A. Y he states that 1-l/k = A , . 9. . . • Substitution of this state ment of k into the equation AY ~ k-A 1 results in having A Y = ( c— )'Al . In this form, the "equation shows that ay it is necessary to know what the change in income will be in order to tell what effect a change in investment will have on incomet"76 jn effect, Keynes was guilty of begging the question in his essay to depict the effect which an increase in investment will have on income. The impact of new investment is dependent upon a host of variables, of which those mentioned by Haberler are but a few. The effect on the cost structure which the injected spending would have is one problem; others would include the inter action between profit expectations, interest rates, wage rates, prices, and the stage of the trade cycle. All these factors change with time and do not necessarily produce identical results over time.^ In essence, Keynes' defini tion of k as equal to — 2£“c "determines the value of the ■ * “ A. Y 78 multiplier after the effect on income has been produced. 76saulnier, ££• £i£* > P* 335. 77peterson, op. cit., p. 436. ^^gaulnier,lo£.cijt. 278 In summary, the multiplier represents a significant addition to the study of the relationship between money, consumption, and investment. The fact that "leakages" prevent exact prediction of the result of an injection of money does not constitute a significant objection to the principle itself. The size of the multiplier, however, will be affected by the manner in which the program for money injection is undertaken, so that provisions for mini mizing the size of "leakages" should be taken into consideration. IV. THE MARGINAL EFFICIENCY OF CAPITAL AND THE RATE OF INTEREST In the Keynesian equation of Y = C + I, the pro pensity to consume is but one element to analyze; therefor^ i attention should be turned to analysis of the factors which determine the amount of income which will be created by the production of investment goods. Keynes reasoned that the production of investment goods is determined by the relation between the marginal efficiency of capital and the rate of interest. Both of these factors have unique definitions in his theory. 279 The Marginal Efficiency of Capital Statement of the concept. The marginal efficiency of capital was defined by Keynes . . . as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price.79 In a form which is perhaps less obscure, Chandler consid ered it to be . . . the annual amount, stated as a percentage of the cost of the capital, that the acquisition of the new capital good is expected to add to the enter prise' s net revenues after deduction of all additional costs of operation except the interest costs on the money used. 0 The significance of the concept is that if the rate of interest is less than the marginal efficiency of capital, the demand price for certain types of capital assets will be larger than the supply price, so that pro duction will tend to adjust to a higher level of employ ment and income. If the marginal efficiency of capital is less than the rate of interest, the situation is reversed, with a tendency for employment and income to 79 Keynes, o£. cit., p. 135. ^Lester V. Chandler, The Economics of Money and Banking (third edition; New York: Harper and Brothers, 1959), p. 238. ......... 280 fall. The concept specifically relates the prospective profit and the current replacement cost of the marginal increment of capital goods to one another. For the com munity as a whole, the marginal efficiency of capital is given by the greatest of all the marginal efficiencies of particular capital goods. The investment demand schedule for capital as a whole, is a concept which depicts the relationship between the marginal efficiency of capital and the various rates of investment. This schedule, when considered from the static point of view, should show that the rate of the marginal efficiency of capital declines as the rate of interest increases, due to the increase in relevant supply prices and decreases in the anticipated profitability of marginal increments of particular capital goods.^2 "in other words, the rate of investment will be pushed to the point on the investment demand-schedule where the marginal efficiency of capital in general is equal to the market rate of interest."83 is presumed that entrepreneurs ^Keynes, o£. cit., p. 136. 82saulnier, o£. cit., p. 338. ^Keynes, o£. cit. , pp. 136-37. 281 will not purchase those capital assets whose anticipated rates of return are less than the rate of interest. Factors influencing the concept. Attention is now turned to a consideration of some of the major factors, other than the rate of interest, which influence the marginal efficiency of capital. The size and composition of the current stock of capital assets, particularly its adequacy in relation to the current demand for output, is of utmost importance in affecting the inducement to invest. By capital accumula tion is meant the production of real physical fixed capital, that is, plant and e q u i p m e n t .84 if the existing stock of capital assets is relatively obsolete and not large enough to produce at minimum unit costs the rate of output currently demanded, large amounts of new capital investments may be expected to yield high rates of return. Alternatively, if the current stock of capital assets is large in relation to current demand for output and if the capital is of the most efficient type presently available, ^^Kenneth K. Kurihara, Monetary Theory and Public Policy (New York: W. W. Norton and Company, Inc., 1950), pp. 204-5. 282 only small amounts of capital investments will be Q c considered profitable. Another factor of influence is technological development. The marginal efficiency of capital can be shifted upward by changes in technology which are of a "capital-using” type. Innovations of this type are such as to require more capital per unit of output. This pro cess may be called "deepening” of capital, and is a conse quence of increasing complication of a productive process. On the other hand, if technological developments are such as to be of the "capital-saving" nature, then the induce ment to invest will not be as strongly stimulated. This can be attributed to the fact that less capital is needed per unit of output when the innovation results in an increase in productivity, but without making net additions to existing equipment.^ The level and structure of the tax system is another important influence on the marginal efficiency of capital. Since the significant manner in which to calcu late the anticipated profit from any capital investment ^^Chandler, loc. cit. ^^Kurihara, op. cit., p. 208. 283 is to deduct taxes before arriving at the net return, high taxes or the anticipation of increased taxes depresses the marginal efficiency of capital, for taxes are realistically considered to be a part of doing business. Any tax which affects the cost of doing business affects the marginal efficiency of capital and hence, the level of investment.®^7 It is difficult to isolate the consequences which taxes have on the marginal efficiency of capital, due to the myriad of other factors which must also be considered. For example, the increasing effect which low taxes exert on investment may be offset by the decreasing effect of high taxes on consumption, leaving a net result of zero in terms of aggregate income and employment.®® A final influence on the marginal efficiency of capital which is considered, is business confidence. "Business confidence is the general expression for busi nessmen's subjective evaluation of the profitability of future investment opportunities.”®9 In general terms, it epitomizes anticipations of profit and apprehensions of ®^Steiner, Shapiro and Solomon, oj>. cit., p. 493. ®®Kurihara, oj>. cit., p. 200. ®9Ibid., pp. 196-97. 284 loss. More specifically, it expresses the entrepreneur's estimate of the marginal efficiencies of various capital assets. As such, the state of confidence of the business community is a strategic factor influencing the propensity to invest and consequently the level of output and employment. The immediate past and prevailing conditions both affect expectations concerning the future. It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty. For this reason, the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.90 This convention of projecting into the future the current situation, and especially the immediate past, works as an aggravating factor in the trade cycle. In a down swing, an original decline is apt to engender anticipations of continued contraction, while in a period of expansion, an initial rise in profitableness of production is likely 9®Keynes, o£. cit., p. 148. 285 to breed anticipations of still further profits. In part, due to the uncertainty of what the future will bring, economic expectations are inordinately disposed to create waves of excessive pessimism and optimism. Each individual entrepreneur, cognizant of the untrustworthi ness of his own opinion with respect to the future, relies largely on those of others, which are likely to be as un reliable as his own. The result is that public temperament ranges from the extremes of exaltation to melancholia. “At one time it exhibits the exuberance and optimism of a New i»91 Era. Then it lapses into dark discouragement and despair. In these periods of alternating overoptimism and over pessimism, entrepreneurs are apt to overestimate and under estimate the profits which investments are likely to yield. It is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent in conditions of full employment are made in the expec tation of a yield of, say, 6 per cent, and are valued accordingly. When the disillusion comes, this expec tation is replaced by a contrary "error of pessimism," with the result that the investments, which would in fact yield 2 per cent in conditions of full employment, are expected to yield less than nothing; and the result ing collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent in conditions of full ^Chandler, op. cit., p. 239. 286 QO employment, in fact yield less than nothing. While it is not easy to assess the relative impor tance of the state of ’’business confidence” as a factor influencing the marginal efficiency of capital, this factor should not be granted undue importance. On the other hand, it is impossible to adequately deal with the cyclical and shetrt-run shifts of the marginal efficiency of capital if expectations are ignored. However, it can quite easily be overstressed as a determinant of expectations. Such real factors as the state of technology, the rate of population growth, and the supply of capital goods relative to other factors of production must all be assigned proper weight.^3 Too, when considering the role of expectations in economics, the manner in which estimates lead into businessmen’s decisions and resulting actions are no more important as a link in the logical chain than are observable events which lead into the entrepreneurial estimates. In this respect, Keynes makes a significant contribution in remind ing economists that ’’the estimate justifying an investment may be the child of the impulse to invest rather than its ^^Keynes, o£. cit., pp. 321-22. ^Chandler, o£. cit., p. 240. 287 94 parent. Most probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. Enterprise only pretends to itself to be mainly actuated by the statements in its own prospectus, however candid and sincere. . . . Thus if the animal spirits are dimmed and the spontane ous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die; though fears of loss may have a basis no more reasonable than hopes of profit had before.95 After allowing for possible changes in the rate of interest, the net result seems to be that the marginal effi ciency of capital is apt to be highly variable due to the instability and Uncertainty of future estimates. From this3 !it is possible to deduce that the concepts of the invest ment demand schedule and the inducements to invest are obscure and vague to an equal extent. This variability makes the role of investment in maintaining a satisfactory volume of output, employment and income a very considerable task. Feeling that the rate of interest is too sticky ^Albert G. Hart, "Keynes' Analysis of Expectations and Uncertainty," The New Economics--Keynes' Influence on Theory and Public Policy, ed. Seymour E. Harris (New York: Alfred A. Knopf, Inc.,1948), p. 419. QC Keynes, o£. eft., pp. 161-62. ^Saulnier, o£. cit., p. 339. 288 for it to long remain below the marginal efficiency of capital, Keynes turned to more direct methods. "I expect to see the state . . . taking an ever greater responsibil- 97 ity for directly organizing investment." This involved not only his theory of interest, but policy deductions as well. But, prior to tackling Keynes' theory of interest, several criticisms of his theory of the marginal efficiency of capital should be pointed out. Criticism of the concept. The initial criticism directed at this aspect of Keynes' theory concerns his con ception of the marginal efficiency of capital in terms of the entire community. The problem is that the most illum inating data for purposes of economic analysis and policy implication are likely to be those which scrutinize the anticipated returns on capital investments for different areas of the economy. His procedure of accounting for unemployment in terms of a single rate of interest and a single marginal efficiency of capital embraced a measure of simplification which could obscure a number of criti- 98 cally important causal factdrs. ^Keynes, op. cit., p. 164. ^Saulnier, o£. cit., p. 341. i 289 Another question arises in relation to the shape of the aggregate investment demand schedule. The problem centers around the manner in which this schedule would behave if the marginal efficiency of capital was varying at the same time that the amount of capital changed, the amount of efficiency of labor increased, new and more productive natural resources were discovered, created, and utilized, and new techniques of production were being introduced. Problems such as these would have to be solved if the productivity of capital is to be adequately 99 explained. Finally, Keynes* theory of expectations is subject to its most crucial short-coming when he attempted to distillate a system of contingent expectations into what has been labeled as "certainty equivalents." Recall that Keynes defined an entrepreneur's expectation of proceeds in terms of . . . that expectation of proceeds which, if it were held with certainty, would lead to the same behavior as does the bundle of vague and more various possibilities which actually makes up his state of expectation when he reaches his decision.^00 ^ Ibid. t pp. 341-42. ■^^Keynes, o£. cit., p. 24. 290 Hart contended that the certainty equivalent is "ignis fatuus," since the business policy which is correct for a complex of uncertain anticipations is not identical in kind to that appropriate for any conceivable group of certain expectations. Two characteristics of business planning contain the key to the uncertainty problem. First, in the interim between the present and any future date, with exception to the very nearest, supplementary information can be expected, so that there is an improvement in the estimates for each date as it draws nearer. Second, relating to the output of any future time is the fact that many decisions can be postponed until additional informa tion can be secured. While postponement may or may not be costly, flexibility (of which liquidity is one segment) is a factor which is worthwhile incurring costs for, since it avoids wasting information that may accrue in the interim period which elapses between the time when plans are made and when they are actually executed. The Theory of the Rate of Interest Keynes1 concept of the rate of interest is appreciably different from that held by most other ^■^^Hart, oj>. cit., pp. 421-22. 291 economists at the time of the introduction of his book, The General Theory of Employment, Interest and Money. | Traditionally, the rate of interest was held to be a product of the interaction of the schedule of the demand for capital and the schedule of the supply of savings. But, in Keynes' analysis, interest is considered to be a factor independent of the demand for capital; it is the rate which must be paid to savers to conduce them to hold assets other than money. Since the general public con siders it more desirable to retain money balances and bank deposits than real capital assets, such assets must yield a return large enough to overcome the great appeal which money and bank deposits hold for the saving public. Statement of the concept. Keynes considered this portion of his theory as being of particular interest, since it is in this connection that monetary factors are injected into the general theory as determinative influences. It is immediately pointed out that the rate of interest and the marginal efficiency of capital are deter mined independently of one another, and taken together determine the level and rate of new investment. Whereas 292 the marginal efficiency of capital governs the terms on which loanable funds are demanded for investment purposes, the rate of interest governs the terms on which loanable funds will be currently supplied. Prior to setting forth his interpretation of interest theory, Keynes attacked the fundaments of the traditional theory. The latter theory asserted that the rate of interest is a product "of the schedule of the marginal efficiency of capital with the psychological pro pensity to save"^-®^ But, it is impossible, Keynes claimed, to determine the rate of interest merely from these two factors. The idea that the rate of interest serves as the balancing factor which brings the demand for loanable funds into equilibrium with the supply of loanable funds, that is,, savings, breaks down as soon as it is seen that the rate of interest cannot be determined simply from a knowledge of these two factors. The following is Keynes' answer to the traditional approach. In developing his interest rate theory, Keynes viewed the individual as making two different decisions. First, the individual decides in what proportions he will ^^Keynes, op. cit., p. 165. 293 divide his income between consumption and savings. Second, he must decide how to hold :that portion of either present income or past income which he has saved. Keynes con ceived of the individual as thinking in terms of merely two alternatives; namely, maintaining it in the form of an immediate liquid balance, or purchasing illiquid assets, "leaving it to future market conditions to determine on what terms he can, if necessary, convert deferred command over specific goods into immediate command over goods in 1 03 general."- 1 - The consequence of the decision as to con sumption and savings is represented in the marginal pro pensity to consume and to save; the decision as to how the savings are to be retained is represented by what Keynes labeled the liquidity preference of the individual. The schedule of liquidity preference for the individual was defined by Keynes as a curve showing "the amounts of his resources, valued in terms of money or of wage-units, which he will wish to retain in the form of money in different sets of circumstancesFor the community, the definition is equally applicable, as they will desire to hold varying amounts at differing rates of 103Ibid., p. 166. lO^Ibid. 294 interest. The curve is depicted as one which will show that a rise in the rate of interest will decrease the idemand for cash, while a fall in the rate of interest will increase the demand for cash. It can be said that the rate of interest is determined by liquidity preference and the quantity of cash, since it is "nothing more than the inverse proportion between a sum of money and what can be obtained from parting with control over the money in exchange for a debt for a stated period of time."^-> Thus, ( the rate of interest can be defined, stated Keynes, in terms of the factors which equate the supply of and demand for cash, and not as the price which equates the "demand for resources to invest with the readiness to abstain from present consumption."106 The rate of interest is not a return for waiting, as traditional thought held it to be, but a return for sacrificing liquidity. In any given circumstance, the liquidity preference and the supply of cash determine the rate of interest. Liquidity-preference is a potentiality or func tional tendency, which fixed the quantity of money which the public will hold when the rate of interest is given; so that if r is the rate of interest, M the quantity of money and L the function of liquidity- preference, we have MKLCr) . This is where, and how, 105Ibid., p. 167. 1Q6Ibid., p. 167. the quantity of money enters into the economic scheme.107 Keynes ascribed a great deal of importance to the tendency of individuals to retain cash, and considers in some detail the reasons why cash is retained. The reasons for so doing are as follows. First, the income-motive, which is due to the necessity to "bridge the interval between the receipt of income and its disbursement."108 The strength of this motive will depend on the amount of income received and the length of time which elapses between its receipt and its disbursement; second, the business-motive, which is traceable to the necessity to "bridge the interval between the time of incurring business costs and that of the receipt of the sale-proceeds.nl°9 The size of the balances needed for this purpose depends on the value of the current production and on the number of individuals who must handle the output. Third, the precautionary-motive,which is due to the necessity of providing for . . . "contingencies requiring sudden expenditures and for unforeseen opportunities of advantageous pur chases, and also to hold an asset of which the value is fixed in terms of money to meet a subsequent lia bility fixed in terms of money.110 107Ibid., p. 168. 108Ibid., p. 195. 109Ibid., llOIbid,, p. 196. 296 Fourth, the speculative-motive is the most important motive, since it transmits the consequences of a change in |the money supply. The intention of holding money for this i (purpose is to secure'profit from knowing better than the market what the future will bring forth. It normally evidences . . . a continuous response to gradual changes in the rate of interest, i.e., there is continuous curve relating changes in the demand for money to satisfy the speculative motive and changes in the rate of interest as given by changes in the prices of bonds and debts of various maturities. I- * - 2 Analyzing the liquidity preference as a whole, it can be seen as a schedule which relates the money supply to the rate of interest. The schedule will take the form of "a smooth curve which shows the rate of interest falling as the quantity of money is increased' . ’ -^3 it has been pointed out that the holding of money for transaction and precautionary reasons is largely a product of the level of income and the state of general economic activity. The demand for money to satisfy these motives is relatively stable and irresponsive to any changes except of the afore mentioned type.*-*-4 On the other hand, the aggregate demand 111Ibid., p. 170. 112Ibid., p. 197. 113Ibid., p. 171. 114Ibid., p. 197. 297 for money to satisfy the speculative motive is extremely volatile, and displays a tendency to respond continuously ;with the rate of interest. i The characteristic of the speculative motive to be so sensitive was attributed to two general reasons by Keynes. In the first instance, there is uncertainty as to the course of future rates of interest, that is, "as to the complex of rates of interest for varying maturities which will rule at future dates. This means the individual is not certain of the terms upon which he will be able to convert less than fully liquid assets into cash in the future. Secondly, if the individual feels that the present level of interest rates is too high, he will attempt to sell assets and increase cash holdings. By contending to "know better than the market," the individual will leave the market, and attempt to enter at a profit, that is, at lower debt prices. It can thus be stated that for a given liquidity preference schedule, the rate of interest is determined by the quantity of money, or given the quantity of money, the rate of interest is determined by the position of the liquidity preference curve. 115Ibid., p. 168. 298 According to the theory, the rate of interest can change for reasons attributable to either of these two determining influences. From the above, it can be deduced that the monetary authorities can affect the rate of interest through open market operations, providing that the liquidity preference schedule remains constant. Keynes placed special emphasis on the need for caution in judging the appropriateness of any particular policy by the central monetary authority. Distinctions must be drawn between changes in the rate of interest which are a consequence of changes in the supply of money available to satisfy, ceteris paribus, the specu lative motive, and those changes which can be attributed to a shift in the entire liquidity preference schedule. It is quite likely that open market operations would affect the rate of interest through both channels; affecting expectations concerning the future policy of the monetary authority as well as the aggregate money supply. The size of the cash balances which individuals hold for the purposes of satisfying their transaction and precautionary motives are not entirely independent of the 116Ibid., pp. 197-98. 299 balances held for speculative purposes. Nevertheless, for purposes of examining the effects of changes in the rate of interest on the other factors in the system as a first approximation, the two former types may be safely regarded as independent of the latter. This assumption will be 117 carried into the forthcoming illustration. In the community, M is designated as that portion needed to satisfy the total money supply, and is composed of Mi, which equals the transaction and precautionary motives, and M£, which equals the portion needed to satisfy the speculative motive. In turn, the liquidity preferences of the community can be divided into L]_, which primarily depends on the level of income, and L2 , which primarily depends on the interaction between the present rate of interest and the state of expectations. Hence, M=M-^ + M2 = Ll(Y) + where M^ is the amount of money needed to satisfy L^, and where M2 is the amount of money needed to satisfy L2 , and where L2 is the liquidity function of the 118 rate of interest, r, which determines L2 * Employing these equations, Keynes proceeded to investigate (1) the effect on Y and r of a change in M; (2) the factors which determine the shape of L-^; and (3) 117Ibid. , P. 199.______ 118Ibid.. pp. 199-200.______ 300 the factors which determine the shape of L£• Considering the first problem, Keynes stated that a change in M is 'likely to affect r, with the change in the latter leading to a new equilibrium by distributing its impact by chang ing M2 and partly by changing Y and thus M^. The manner in which the increment to M will be distributed between M^ and M2 in the new equilibrium position will depend on the effect which the reduction in r has on investment as well as the effect which the increased investment has on Y. Since the level of Y is partly influenced by r, a given change in M has to cause a change in r which is sufficient enough for the consequent changes in M-^ and M2 to equal the given change in M. In handling the second problem, Keynes considered the income-velocity of money as the ratio of Y to M^. Hence, with V representing the income-velocity of money, L^(Y) = Y/V = M-l . The value of V is not necessarily con sidered to be a constant, as its value will depend on the social and institutional framework of the community. Fgf purposes of the short-run, however, Keynes treated it as essentially constant. ll9Ibid., p. 200-01. 301 The third problem involves the relation between 1^ and r. As was mentioned earlier, is a product of the ■uncertainty which prevails over the future course of the rate of interest and results in the holding of M2. Perforc% M2 will not assume a definite shape or quantitative relation to a particular rate of interest of r. uWhat matters is not the absolute level of r but the degree of its diver- *1 o n gence from what is considered a fairly safe level of Even with this qualification in mind, however, a fall in r, 1 with expectations constant, will probably be linked with an increase in M2 . Even if the general opinion as to what constitutes a safe level of r is constant, every drop in the market rate increases the spread between the "safe” rate and the market rate; and second, every drop in r reduces the cost of liquidity, or alternatively, the earn ings in illiquidity. Thus a monetary policy which strikes public opin ion as being experimental in character or easily liable to change may fail in its objective of greatly reducing the long-term rate of interest, because M2 may tend to increase almost without limit in response to a reduc tion of r below a certain figure. The same policy, on the other hand, may prove easily successful if it appeals to public opinion as being reasonable and prac ticable and in the public interest, rooted in strong l20Ibid. r 302 conviction, an by an authority unlikely to be superseded. As this points out, the monetary authorities are subject to certain limitations in their ability to establish any par ticular complex of interest rates. These may be summarized in the following manner: (1) The monetary authorities might restrict themselves to one type of operation, such as limiting open-market operations to a short-term "bills only" policy; (2) Once the rate of interest has fallen to a certain level, the community's liquidity preference may become b o absolute that everyone favors the holding of cash in lieu of a debt which carries so low a rate of return; (3) Risk, time preferences, and the expenses involved in bringing the borrower and lender together may put a floor on the rate of interest;122 (4) The rate of interest will not decrease if the liquidity preference of the community shifts to an extent equal to or greater than the increase in the quantity of money; (5) If the rate of interest is lowered temporarily by an injection of new money, prices may rise due to increased supply costs and money supply, so that the liquidity preference of the community will have to increase, which will in turn increase the amount of 121Ibid., p. 203. ^22Ibid., pp. 207-8. 303 money needed to maintain a given rate of interest; (6) While the increase in the money supply might lower the rate ;of interest, the injection of money may cause the marginal F efficiency of capital to fall more rapidly than the rate of interest, and thereby leaving the effective relationship between the two unimproved if not aggravated; and (7) Even though the increase in the quantity of money may lead to a decline in the rate of interest, the impact of the injection of the money may cause the community to reduce their propensity to consume.These "slips between the cup and the lip" are important qualifications to Keynes' theory of interest in particular, and to the efficacy of monetary authority in general. Evaluation of the theory of interest. It is possible to criticize Keynes' liquidity preference theory of interest in many respects. However, economists seem to agree on particular weaknesses and contributions which Keynes made, and this section will be restricted to those most frequently discussed. Keynes is criticized for not adequately defining 123Ibid., p. 173. 304 his concept of "cash." The failure to do so is of prime significance in an interest theory which leans so heavily on liquidity preference. The individual has a range of choice in striving for liquidity which is not limited to a choice between holding a long-term debt, buying a capital asset, or retaining money in the form of demand deposits. Liquidity comes in a variety of "degrees" to satisfy a myriad of different purposes and needs. To distinguish between liquidity and illiquidity is impossible as well as inappropriate. The concept of liquidity preference should be prefaced by a general statement of the various alterna tives open to individuals, and an analysis of the factors of influence which confront individuals in weighing the respective attractions of the numerous alternatives. Keynes has left himself open to sevens criticism in this area by over-simplifying the investment processes.*-24 Another weak spot in Keynes' theory of interest is found in his criticism of the traditional theory of interest. He felt that the "psychological time-preferencesi of the individual require him to make two separate decisions, namely, choosing the proportion of income to 1 24 Saulnier, o£. cit., pp. 348-49. 305 save (propensity to save) and to spend (propensity to consume), and deciding in what form to keep the savings set aside (liquidity preference). We shall find that the mistake in the accepted theories of the rate of interest lies in their attempting to derive the rate of interest from the first of these two constituents of psychological time- preference to the neglect of the second.125 Then Keynes proceeded to turn right around and commit the same error that he accused the accepted theories of doing; he neglected the saving aspect where liquidity had formerly 126 been neglected. ° This was made clear when he stated that . . . it should be obvious that the rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before. On the contrary, the mere definition of the rate of interest tells us in so many words that the rate of interest is the reward for parting with liquidity for a specified period.127 On the positive side, Keynes made a number of significant contributions. One of the most important has 125 Keynes, oj>. cit., p. 166. 126 Tjardus Greidanus, The Value of Money-A Dis cussion of Various Monetary Theories and an Exposition of the Yield"Theory of the Value of Money (New York: Staples Press Incorporated, 1950), pp. 209-12. 127 Keynes, op. cit., pp. 166-67. 306 been the insight he gave into the behavior of speculative balances, particularly as regards the effects of changing anticipations on the rate of interest. Whenever it is expected that the monetary authority will attempt to greatly increase interest rates, the effectiveness of such a policy is likely to be significantly reduced. For instance, after a recession phase has come to an end, and security prices are high and yields low, due to a refla- tionary policy of cheap money, a time may arrive when any further additions to the money supply will be absorbed overwhelmingly in speculative balances. During a time such as this, investors will generally believe that the present level of the rate structure will not be m a i n t a i n e d . -*-28 The importance of Keynes' interest theory, as con trasted with traditional theories, in conditions of unemployment is emphasized by Wright. For if the rate of interest be explained primarily in terms of demand and supply for free resources, or "capital disposal," how can one explain the existence of a rate at a time when "free resources" (starving men) are walking the streets unclaimed? -. . . Only by some such analysis as Keynes's can one explain why the rate does not go to zero in times of unemployment. 128jjenry H. Villard, "Monetary Theory," A Survey of Contemporary Economics, ed». Howard S. Ellis (Philadel phia: The Blakiston Company, 1949), pp. 334-35. 307 The Keynesian theory of the minimum rate of interest is therefore a real, a substantially new, and a valid addition to the body of economic science.^ 9 Thus, Keynes'analysis can be considered to be superior to the traditional theory when accounting for the influence of the rate of interest when the supply of free productive units offers no impediments to capital formation. When unemployment exists, there is not as much competition between consumption and investment spending, so that con sumption can increase concomitant with an increase in investment. In underemployment circumstances, it is closer to the facts to state that interest is paid to encourage savers to release balances for investment as opposed to stating that it is paid to encourage them to cut back on consumption so that resources would be freed for the construction of capital investments.-^® Many economists contend that Keynes' liquidity preference theory of interest was not a replacement of the traditional loanable funds theory, but rather an addition to interest theory as a whole. "It seems to me," stated 129 David McCord Wright, "The Future of Keynesian Economics," The American Economic Review, XXXV (June, 1945), pp. 293-94. 130peterson> cit., pp. 438-39. 308 Hicks, "that either of these methods is perfectly legitimate; the choice between them is purely a matter of convenience."131 This is not to deny that Keynes made a I I contribution, but merely that he did not forge as far as is occasionally thought. Rather, his great emphasis on the influence of hoarding on the rate of interest constituted an invaluable addition to the theory of interest as it had been developed by the loanable fund theorists, who incorporated much of Keynes' ideas into their theory to make it more complete. ^ 2 To substantiate the assertion that the loanable funds and the liquidity preference theories of interest do support one another, a statement by one of the staunchest support ers of Keynes' theory, A. P. Lerner, is presented. In saying that the "cash" theory of interest is preferable to the "Loans" theory, I do not deny that the actual rate of■interest is in fact agreed upon by the suppliers and demanders for loans. I only mean to assert that in estimating the effect of any event on the rate of interest we are likely to be misled unless we take into account the effects of the event on the supply and demand for the stock of cash. For example, the simple "loans" theofy might lead to the conclusion that an increase in the profitability of investment in new capital goods, by increasing the demand for loans, must raise the rate of interest. R. Hicks, Value and Capital--An Inquiry into some Fundamental Principles of Economic Theory (second edition; London: Oxford University Press,-1948), p. 161. ■^^Hamburg, o£. cit., pp. 181-83. 309 But if the investors and others are led by the same increase in the profitability of investment to reduce their own holdings of money by investing or spending out of their previous stocks of cash, the supply of loans will increase more than the demand for loans and the rate of interest will fall. This is liable to be overlooked if we concentrate on the effect on the de mand for loans, but is seen at once if attention is directed to the effects of the initial event on the supply and demand for the stock of cash.133 V. THE THEORY OF PRICE MOVEMENTS Having analyzed Keynes' concept of the marginal efficiency of capital and the rate of interest, attention can now be directed to his theory of the relationship between effective demand and the general level of prices. Statement of the Theory of Prices As previously defined, effective demand is the point of intersection between the aggregate demand function and the aggregate supply function, and is in equilibrium at the point of full employment. Effective demand is considered to be deficient if less than full employment obtains, and increases in it will result in increases in 13 Abba P. Lerner, "Interest Theory--Supply and Demand for Loans, or Supply and Demand for Cash?" The New Economics--Influence on Theory and Public Policyi ed. Seymour E. Harris (New York: Alfred A. Knopf, Inc., 1948), pp. 659-60. 310 output, employment, and income. On the other hand, if effective demand is increased after the full employment level is reached, the results are quite different, since the entire effect will be on prices. Keynes1 theory of money and prices was developed in regard to the concepts of effective demand and the quantity of money. However, prior to analysis of the impli cations of these concepts, it should be pointed out that he was not merely interested in the effects which changes in the money supply have on effective demand or simply with the effects of the latter on the level of prices and output. Hence, he was concerned with the aggregate demand function and the aggregate supply function, and the price and output results which flow from the intersection of the two functions at various points. In turn, the various factors which determine the shape, position, and movement of the two functions must be examined. This must be continually kept in mind when examining Keynes' theory of 134 prices. This is brought out in his definition of price theory, which is as follows: ■^^Saulnier, oj>. cit., p. 355. 311 The analysis of the relation between changes in the quantity of money and changes in the price- level with a view to determining the elasticity of prices in response to changes in the quantity of money. ^5 The exposition of Keynes’ price theory was initia ted with a very simplified example, into which qualifica tions are later introduced. In the first instance, all productive units are considered to be homogeneous and interchangeable in their productive efficiency, and with constant wage returns prevailing as long as there is an unemployed surplus. On the basis of these assumptions, Keynes reasoned that prices will not be affected by an increase in the quantity of money so long as there is unem ployment, and that employment will rise in exact proportion to any rise in effective demand due to an increase in the quantity of money; once the level of full employment is attained, any further increase in effective demand will result only in an increase in the wage-unit and prices. Therefore, if during conditions of unemployment the supply factor is perfectly elastic, and perfectly inelastic once full employment is attained, and if increases in the quantity of money engender proportional changes in ^ ‘ Hceynes, o£. cit., p. 296. 312 effective demand, the quantity theory of money can be expressed as follows: So long as there is unemployment, employment will change in the same proportion as the quantity of money; and when there is full employment, prices will change in the same proportion as the quantity of money. In order to introduce realism into the theory of prices, Keynes proceeded to introduce a number of important qualifications into the above general statement. The qual ifications, all of which are interrelated and interdepend- 1 37 ent, are as follows. First, the change in effective demand which results from a change in the quantity of money may not follow in exact proportion to the latter. The effect of a given change in the quantity of money, stated Keynes, is primarily worked out through the rate of interG est and thence into effective demand. The quantitative degree of this effect will depend on the schedule of liquidity preference, the schedule of marginal efficiencies the investment multiplier, and the complicating factors as enumerated below. Nevertheless, when all the factors are taken into consideration, an increase in the quantity of money will, except in "highly exceptional circumstances’ , ’ result in a determinate amount of increased effective •^^Ibid. -^-37Ibid. ? pp. 296-303. 313 demand. Second, due to the fact that the productive units are not homogeneous, diminishing returns rather than con stant returns will set in as output increases. Third, if the supplies of productive resources are not entirely inter changeable, due to the inelastic supply conditions of some resources, bottlenecks may develop prior to reaching full employment. The prices of such resources will then have to rise to a level sufficient to deflect demand into other directions. Fourth, as employment increases, there will also tend to be discontinuous increases in money wages. As full employment is approadhed, therefore, any increase in effective demand is likely to be partially absorbed in satisfying the tendency of the wage-unit to rise. Fifth, increases in the remuneration of other productive factors will not all change in the same proportion due to differ ences in price rigidities and elasticities. Marginal user cost will be of increasing significance as the full employ ment level is approached. With the above factors in mind, Keynes defined full employment as being at that point . . . when output has risen to a level at which the marginal return from a representative unit of the factors of production has fallen to the minimum figure at which a quantity of the factors sufficient to 314 1 88 produce this output is available. "True inflation" is held to set in at that point where any further increases in effective demand are entirely spent on the cost-unit, with no increases in out put taking place. It is only at this point that monetary expansion no longer divides its effects between the cost- unit and output; all previous increases in the quantity of money were merely questions of degree of division between the two factors.139 Up to this point, Keynes had been concerned with the short-run implications of changes in the money supply on the level of prices and employment. The long-run situa tion differs in that the relationship between the quantity of money and national income is dependent of liquidity preferences. Secondly, price level stability will be determined by the relative strength of two real factors: the rate of increase in the efficiency of the productive system, and the strength of the wage factor in pushing upward. 138Ibid., p. 303. 140Ibid., p. 309. 139Ibid. 315 Evaluation of the Theory The principal significance of the theory of prices las constructed by Keynes lies more in his methodology than in his conclusions. For example, he held that changes in effective demand which originated from changes in the money supply operate via the rate of interest, and are influenced by the marginal efficiency of capital, the liquidity pre ference, and the investment multiplier. Unless values can be assigned to their variables, the theory cannot be stated in quantitative terms with any extent of precision. Since the values to be assigned are unknowns, the crucial signi ficance of the theory must be found in the concepts themselves. This is the very essence of economic thinking, stated Keynes, The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organized and orderly method of thinking our particular problems .14-1 Keynes implied that the level of employment and output can be controlled by the use of monetary devices. The view that any increase in the quantity of money is inflationary (unless we mean by inflationary merely that prices are-rising) is bound up with the ^^Ibid., p. 297. 316 underlying assumption of the classical theory that we are always in a condition where a reduction in the real rewards of the factors of production will lead to a curtailment of their supply.14^ Believing that even if the real rewards to the factors of production are diminished they will continue to offer their services, he asserted that output will increase with an increase in the quantity of money. However, such a pro position depends on a rather long, indirect, and compli cated line of causation concerning the impact of changes in the money supply. Angell found that moderate enforced injections into the money supply are absorbed in "idle" balances rather than in increased business activity. The heart of these difficulties lies in the fact that the relation of the quantity of deposits to general economic activity is apparently not suffi ciently close or uniform to make it seem probable, especially with regard to short periods, that such enforced fluctuations in deposits will be accompanied by parallel fluctuations of desirable sorts in the leading categories of general activity.14- 3 Finally, Keynes' emphasis on price changes may have the undesirable effect of channeling attention from the importance of the relation between costs and prices, that 142Ibid., p. 304. 143James W. Angell, The Behavior of Money--Explor atory Studies (New York: McGraw-Hill Book Company, 1936), p. 160. 317 is, the eost-price relationship. Thus, such an approach may lead to inadequate analysis of the causal forces behind business activity. If prices and costs are sub stantially fixed or rigid, and if the economic system is subject to considerable variation in the extent to which capital is utilized, then profit conditions may yield more insight into the workings of the system than would price movements. To illustrate, if a plant is operating at well under its capacity level, an expansion of demand may lead to a drop in average unit costs and larger profits without any change in average revenue. Hence, attention which is unduly placed on price movements may not be adequate for explaining output and employment variations. VI. EVALUATION The following evaluation considers only the more significant of the contributions and criticisms generally attributed to the income-expenditure theory of Keynes. A more detailed evaluation has been included with every major section of the analysis, so anything more than a brief evaluation at this point would be superfluous. 144saulnier, o£. cit., pp. 358-59. 318 The Keynesians claim an advantage over the transaction-velocity and cash-balance approaches in terms | of increased realism. The former feel that the substitu- * tion of the three-fold schedule relationships, that is, liquidity preference, marginal efficiency of capital, and the propensity to consume, for the all-encompassing V or K in the latter types of analysis, are more specific in character and significance.^-* Thus, the disciples of the income-expenditure school have made a valuable contribution in the placing of a very necessary emphasis on factors, not those that had gone unrecognized, but on those which had not been given appropriate attention. The approach is especially applicable to analysis of problems of a short-term nature, and through its concen tration on the relation between investment and consump tion functions as well as on the retention of balances for different purposes, has provided a vital supplement to economic theory. Of segments of Keynes theory, the liquidity prefer ence theory of the rate of interest as an explanation of ^-*Frederick A. Bradford, Money and Banking (6th edition; New York: Longmans, Green and Company, 1949), pp. 588-89. 319 short-run, depression phenomena, has been most generally accepted. When the role which interest performs is viewed !from Keynes’ angle, it is evident that the central bank is relatively important in attempting to affect the marginal efficiency of capital or the rate of interest in such manner as to stimulate an increase in income.1^6 Because of this theory, new emphasis was placed on the efficacy of fiscal policy as a tool for stimulating the level of total investment. One of the most important negative criticisms of Keynes is that his theory was overly concerned with ’ ’equilibrium" situations. An analysis of the logic of his approach shows that the "underemployment equilibrium" could transform itself into a series of economic fluctuations; which fluctuations, once initiated, are unlikely to smooth themselves out into such an equilibrium.The equili brium will not come about, stated Burns, for the following reasons: In the first place, windfall profits will be unevenly distributed, and the adjustment of individual 146peterson, ojd. cit., p. 442. l^Albert Gailord Hart, Money, Debt and Economic Activity (2nd ed.; Englewood Cliffs, New Jersey: Frentice- Hall, Inc., 1948), p. 191. 320 firms to their widely varying sales experiences will induce a change in the aggregate of their intended investment. In the second place, unemployed resources will exercise some pressure on the prices of the factors of production, and here and there tend to stimulate investment. In the third place, if an expan sion in the output of consumer goods does get underway, it will induce additions to inventories for purely technical reasons; further, the change in the business outlook is apt to stimulate the formation of new firms, and to induce existing firms to embark on investment undertakings of a type that have no close relation to recent sales experience. In the fourth place, as income expands, its distribution is practically certain to be modified; this will affect the propensity to consume, as will also the emergence of capital gains, the willingness of consumers to increase purchases on credit, and the difficulty faced by consumers in adjusting many of their expenditures to increasing incomes in the short run.-*-^” If problems are to be understood, the economic system must be studied in terms of fluctuations, not as a fictitious one which is in equilibrium. Keynes held that the demand for capital goods was closely related to the amount of current consumption. In the past, there have been times when the purchase of investment goods was made much in advance of the current prospective need for the output which the machines would produce. Such obstacles as legislative and institutional impediments to the increase in capital assets may force •^^Arthur F. Burns, The Frontiers of Economic Knowledge (Princeton: Princeton University Press, 1954), pp. 8-9. 321 the entrepreneur to satisfy an increase in the demand for consumption goods by a more intensive use of existing capital facilities through the use of greater quantities 149 of labor input. Another criticism directed at Keynes concerns his unwarranted use of aggregates and the consequent inadequacy of his treatment of the great multitude of individual responses and conditions which are assumed to act in harmony. The treatment of savings and investment as equals precludes examination of the leads and lags between the various monetary flows in the economy which are of strate gic importance in understanding a host of complex situa tions.150 Although such an approach yields useful summaries, Burns pointed out, they fail to reveal the processes by which they are fashioned. The conception of a business cycle as a synchronous expansion of all economic activities followed by a synchronous contraction, which theorists often hold, is not drawn from life. Expansions and contractions occur together, side by side, at every stage of the business cycle. . . . These divergencies in economic fortune are no less important for the understanding of business cycles than is the dominance of expansion ■^-^Peterson, o£. cit., p. 442. 150Joseph A. Schumpeter, ”J. M. Keynes: 1883-1946,1 1 The American Economic Review, XXXVI (September, 1946), pp. 512-13. 322 during some periods and of contraction during others!'*'*' VII. SUMMARY Keynes' theory is based on the psychological "law" that individuals will tend to increase their consumption as their income increases, but by less than the increase in income. From this, the deductions are made that, as employment and income increase, there must be an increase in investment sufficient to absorb the increased savings or else there will be a deficiency of returns to businessmen. The propensity to consume expresses and determines the spending habits of the community; the inducement to I invest, a product of the marginal efficiency of capital and the rate of interest, must be strong enough to absorb those resources not directed to the current consumption indus tries. The theory is concerned, then, with explaining how it can come about that, with a given propensity to consume and a given rate of investment, the level of employment can be less than full employment. In a situation such as this, Keynes explained, involuntary unemployment exists in ■ * ■ • * ■ * ■ Burns, o£. cit., pp. 19-20. 323 the sense that employment would increase if there was an increase in the price of wage-goods relative to money wages; ;more jobs would be offered and more accepted than at the 'previous low level of prices. Keynes asserted that there are no grounds on which to substantiate the belief that there are forces operating which will automatically adjust the spending habits of the community on consumer goods and services with the invest ment activities of businessmen in such a manner that full employment will necessarily be obtained. In addition, the richer the community becomes, and the larger its stock of capital goods becomes, the more difficult it is to make the proper adjustment for achieving full employment; the former due to the weakening of the propensity to consume, the latter due to the inability to discover attractive areas for new investment. The problem resolves itself, therefore, into an examination and explanation of the forces and factors which govern the propensity to consume and the inducement to invest. Keynes' treatment of the value of money is sketchy at best. In his analysis, with the assumption of homoge neous productive units at constant costs per unit, employ ment and output will increase with increases in the 324 quantity of money up to the point of full employment. Thereafter, prices and factor costs will increase proportionally with increases in the money supply. A distinction is drawn, however, between new money added to an individual’s income and money which flows into speculative balances as a result of the bank credit creation for a non-income transaction. Even if the new money flows into the income stream after initial expendi ture by the recipients, the level of income may not be sufficiently high to absorb the entire increment into ordinary convenience balances, so that speculative balances will then absorb the remainder of the increment. CHAPTER VI MONETARY THEORY AND THE QUANTITATIVE INSTRUMENTS OF THE FEDERAL RESERVE SYSTEM The Federal Reserve System is equipped with a number of instruments by which it attempts to affect the rate, level and direction of economic activity. The principal instruments which the System utilizes are open market operations, the discount rate, and changes in reserve requirements. Only these three quantitative instruments will be considered in this chapter. I. INSTRUMENTS OF MONETARY REGULATION The Discount Policy and Rate This is a tool employed by the Federal Reserve System in attempting to influence the volume and cost of bank reserves. The discount rate is merely the rate of interest charged by the Reserve bank on their loans. Decreases in the discount rate make it cheaper for member banks to acquire reserves, while increases in the rate make it more costly for the member banks to acquire 325 326 reserves by borrowing. Discount policy is most effective when banks are afforded ample opportunity to loan, when excess reserves are at a minimum within the system, and when government obligations are at a significant discount, that is, "locked- in" due to a relatively tight money market. But conditions such as these have not prevailed since the 1920's. With the expansion of debt during both the depression and the second world war, complemented by the "pegging" policies of the Federal Reserve authorities until the accord was reached in March, 1951, every bank portfolio bulged with government issues, which it could sell without capital loss when adjustment of reserve positions were required or desired. Only after the abandonment of the "pegs" and a growth in the tightness of the money markets was member bank borrowing from the Reserve banks lifted from the desuetude into which it had wallowed for nearly two decades.* Discount policy ostensibly influences the cost and availability of credit in two fundamental ways: (1) by H.eland J. Pritchard, Money and Banking (Boston: Houghton Mifflin Co., 1958.), p. 374. 327 altering the cost of acquiring reserves, and (2) through the psychological impact of an announced change in central (bank policy. Due to the traditional reluctance of member banks to borrow from the Federal Reserve, the influence of the rate on cost is largely vitiated. Borrowings from the Reserve banks are normally intermittent in nature and are often done as an emergency measure. Too, large depositors are inclined to be critical of such borrowings since they take precedence over the claims of depositors in case of insolvency, as well as the fact that such borrowings are more expensive than funds obtained through deposit inflows,2 Thus, a change in the discount rate may have little direct i influence on a bank that is either ineligible to borrow or has little need or desire to borrow. If discount policy is to exert a direct and proportionate effect on the cost of borrowed funds in the money markets, ’’there must be a con tinuous and unbroken chain of relationship between the cost of Reserve bank credit and the cost of commercial bank credit. . . 2 The Board of Governors of the Federal Reserve System, The Federal Reserve System--Purposes and Functions, (4th ed., Washington, D.C.: 1961) p. 45. ^Pritchard, oj>. cit., p. 375. 328 Even though the causal relationship between changes in the Federal Reserve discount rates and the pre vailing money market interest rates is very tenuous, the "availability” of business credit can be materially influenced by a change in discount policy. This aspect of the problem is as much attributable to psychological factors as it is to an increase in the cost of acquiring reserves. It is relatively safe to concede that a change in discount policy does exert to some degree an important psychological effect on the entire business community as well as on the banks. Thus, due to the prestige of the Board of Governors, a pronouncement on discount policy, (reflecting the judgment of the Federal Reserve as to whether there was too much, too little, or a satisfactory supply of money for handling the country's business), is likely to have a significant though variable effect.^ An increase in the rate, for instance, would most likely be interpreted by banks as either a stop sign, or at least a "go slow" sign; a warning that they should tighten up on 4-The Board of Governors of the Federal Reserve System, "General Methods of Regulation," Money and Economic Activity— Readings in Money and Banking, Lawrence S. Ritter, editor, (1st edition; Boston; Houghton Mifflin Company, 1952), p. 104. 329 their lending practices. Such an effect would not neces sarily be reflected in customer rates as much, perhaps, as in an increase in the rationing of available credit. In I this respect it is up to the discretion of the individual bank as to whether any heed need be paid to the Federal Reserve pronouncements. In addition, the actions of the Federal Reserve authorities have often been more of a con firming than of an initiating nature, as the change in the rate usually follows rather than leads the rates estab lished in the money markets.'* This lag can be explained in part due to the fact that changes in the discount rate may reflect, not a change in the Federal Reserve credit policy, but only a technical adjustment to bring the discount rate into closer adjustment with market rates so as to support the current extent of restraint or ease. Too, the lag in the change of the discount rate may be attributed to the desire on the part of the Board of Governors to employ it as a complement to open market policies, with each making the other more effective.^ ^Pritchard, o£. cit., p. 375. ^Clay J. Anderson, "Member Bank Borrowing From The Federal Reserve Banks," Money and Economic Activity--Read ings in Money and Banking, Lawrence S. Ritter, ed.,(2nd ed.; Boston: Houghton Mifflin Company, 1961), p. 125. 330 The Legal Reserve Requirements The principle underlying reserve requirements as a jmethod of credit control is that by lowering or raising reserve requirements, the Federal Reserve authorities are able to expand or contract the quantity of member bank reserves which are categorized as excess reserves. Since an expansion of bank credit by member banks is dependent on the existence of excess reserves, an increase or decrease in the volume of such reserves may tend to bring forth an equivalent change in the volume of credit. While the primary aim of changes in the discount rate and open market operations is to influence the total quantity of reserves and with it the amount of excess reserves, changes in reserve requirements directly alter only the volume of excess reserves. Total reserves may remain unchanged, yet by expanding or contracting the excess reserves within the system, potential lending capacity and expansion of the member banks is altered.^ When changes in the reserve requirements are made, two things happen. 'First, the secondary reserve or liquid ^Charles R. Whittlesey, Principles and Practices of Money and Banking (Revised edition; New York:, MacMillan Company, 1954), p. 266. 331 asset position of member banks is immediately changed. Second , there is an immediate change in the deposit- expansion multiplier throughout the banking system. The actual effect of the latter will depend on the distribution of deposits by type as well as on the distribution of O deposits by bank classification. This instrument is well adapted to several purposes. First, it is extremely capable of absorbing or creating large amounts of excess reserves. Second,, ; it is an excel lent medium for announcing important policy decisions to the community, since such changes are so overt and highly publicized that the public can readily comprehend their meaning. In effect, they allow the Board of Governors to impress upon the banks and the public that they have set their policy and regard i t as very s i g n i f i c a n t .^ As a tool of monetary control, changes in the per centages of required reserves are subject to a number of limitations which the other two quantitative instruments escape. First, changes in reserve requirements permeate ®Board of Governors, Federal Reserve System-- Purposes and Functions, op. cit. p. 523. ^Lester V. Chandler, The Economics of Money and and Banking (3rd edition; New York: Harper and Brothers, Publishers, 1959) p. 166. 332 all member banks at the same time and to the same extent, regardless of the reserve needs of a particular bank. Second, the usefulness of this instrument in controlling the volume of bank credit is limited due to the fact that reserve requirements as set down by the Federal Reserve authorities apply only to member banks. They cannot, therefore, have any direct effect on the credit policies of non-member banks.^ Third, frequent and delicate adjust ments in the money supply are more easily made through the use of discount and open market operations. The Board of Governors have traditionally employed reserve requirement changes only in instances when large scale changes through out the entire system were desired. The Open Market Operations The majority of Federal Reserve undertakings which affect the reserve positions of banks are related to short term fluctuations in the economy’s needs for bank credit and are effected through the employment of open market operations. These operations have a direct impact on mem ber bank reserves, regardless of who buys or sells the lOpritchard, op., cit., p. 378. 333 securities placed on or taken off the market by the Federal Reserve. The fact that open market operations are under- ; taken solely on the basis of the initiative of the Federal 11 Reserve distinguishes them from other instruments. The important factor in open market operations is not the purchase and sale of the securities by the Federal Reserve, for this is merely a means to an end. The reason, the end, is to increase or decrease the amount of reserves held by member banks. The securities are simply the vehicle by which the Federal Reserve authorities change the 12 volume of member bank reserves. In general, the past decade has seen the System limit its open market operations to short term securities, preferably Treasury bills and other securities maturing in 15 months or less. Securities of these maturities are quite close to cash in terms of liquidity and are exchanged in a relatively active and continuous market. By confining its operations to this sector of the maturity schedule, the System is able to minimize any direct effects on the ^Board of Governors, FederalReserve System-- Purposes and Functions, op. cit., p. 32, l^whittlesey, o£. cit., p. 264. 334 supply of and demand for specific securities sold, and thus with a minimum of influence on prices and yields. The extent to which open market operations are useful as a device for controlling the supply of credit, and in that manner affecting prices and the volume of bus iness activity, depends upon three conditions and relation ships. First, the supply of excess reserves held by banks must not be so vast that the resources of the Reserve banks would be obliterated in an attempt to eliminate them through selling activities. Second, the Reserve banks must be free to alter their purchasing and selling operations as the economic situation demands. Third, banks cannot have chronic excess reserves, for if such a case prevailed, open market purchases would dissipate themselves in the form of additional excess reserves, with no expansion of 13 credit undertaken by the banks. It should be noted that purchases by the Federal Open Market Committee can only create the basis for the potential expansion of credit. Simply because the banks have the capacity does not mean that expansion will occur; they must also have the occasion to make safe and profitable loans. With open market ■^Pritchard, op. cit. p. 382. 335 operations of the selling type, however, banks are forced to either contract credit extended or to decline I opportunities to lend. Open market operations have an advantage over dis count policy in that the Federal Reserve can take the initiative and actually compel an expansion or contraction in bank reserves. On the other hand, a change in the dis count rate would be largely ineffective unless banks responded to the change in the rate. The need to coordinate open market operations with discount policy was one of the early lessons in the conduct of experience in this realm. The problem of coordination between the two manifests itself in several ways. First, if member banks are in debt to the Reserve banks, the former may use the proceeds from the open market operations to pay off indebtedness to the latter rather than add to their reserves. The increase in liquidity takes the form of reduced indebtedness rather than an increase in reserves The second instance in which the coordination problem arises occurs when open market operations are undertaken in preparation for changing the discount rate. For example, the Federal Open Market Committee may sell secur ities so as to tighten credit and lead member banks to the 336 discount window if they desire additional reserves. The member banks are then forced to incur the penalty of a higher discount rate than in effect. Such a procedure is commonly labeled as "making the discount rate effective.^ It is evident that the Federal Reserve, through its open market policy, can influence the incentives that operate on the creation of demand deposits at the commer cial bank level. By selling securities, the Federal Reserve tends to tighten member bank reserves and pressure commercial banks into contracting their earning assets and retiring deposits. By purchasing securities, the Federal Reserve augments member bank reserves and encourages commercial banks to enlarge their earning assets and create demand deposits.-^ In summary, the Federal Reserve officials tend to utilize open market and discount operations as complemen tary tools for coping with short-term instabilities in bank reserve positions. An important characteristic of the interworking of these two instruments is that they ^Whittlesey, o£. cit., p. 265. ^Albert G. Hart, Money, Debt and Economic Activity. (2nd edition; Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1948), p. 101. 337 tend to vary inversely with one another; the more reserves supplied by open market operations, the smaller the borrow ings from the discount window tend to be, and vice versa. In providing bank reserves for the long-term needs of the economy, the Federal Reserve relies on both open market operations and changes in reserve requirements. Reserve requirements may also be changed in those special situa tions where significant changes in the quantity of bank reserves need to be cushioned or absorbed.^ II. SOME GENERAL OBSERVATIONS ON THE INFLUENCE OF MONETARY INSTRUMENTS Credit and monetary policies exert widespread effects in encouraging and discouraging spending. The most direct effect of a general tightening of credit is felt by those who utilize borrowed funds. The growth of the money supply is also restrained by credit tightness and thereby deters increases in the size of cash balances retained by individuals, businesses and other spending groups. A tightening of credit has significant deterrent ^Board of Governors, Federal Reserve--Purposes and Functions, op. cit., pp. 57-61. 338 effects on expenditures made out of existing cash balances, as well as from funds obtained through the disposal of assets, where no credit extension and no money creation are involved. There are a number of ways in which these indirect effects may come about. The credit restraint may induce interest rates to rise and thereby reduce the value of capital assets, so that investment in construction and producer’s goods may be discouraged. It may come about through a dampening of optimistic expectations for both investors and consumers. Consumers and investors may decide to increase their savings, either because the increased interest rates make saving more attractive, because they are not sure about their future requirements, or because they cannot secure the desired amount of credit. A policy of credit ease tends to induce opposite effects. Spending with borrowed funds is encouraged, as is spending out of current income and past savings. If functioning properly, credit ease accomplishes this by promoting the feeling that prices may creep upward, by raising the capitalized value of assets, and by making it less necessary and profitable to save. In most situations, the response which a change in credit ease or restraint will elicit depends on the 339 existence of an unsatisfied fringe of borrowing or poten tial borrowing. If credit is difficult to obtain or more expensive than previously, this ’’fringe" may be deterred from either borrowing as much as they desired, or from borrowing at all. Under most conditions, this fringe of potential borrowers exists, and an easing of credit condi tions will encourage them to borrow in greater amounts or for purposes which were not regarded as profitable or useful in periods of greater credit restraint. A period of tighter credit generally results from a decrease in the availability of credit relative to the demand for it. The tightening may be the product of a contraction in the supply without a corresponding decline in demand, or because the demand for credit increased with out a corresponding decline in demand, or because the demand for credit increased without an equivalent increase in supply, or some combination of these two situations. A period of greater ease in credit is the product of an increase in supply relative to the demand for it. Conditions of credit ease are generally prevalent in periocfe of economic depression, except when there are difficulties within the banking system, or when there are extreme pressures for liquidity on the part of investors and 340 consumers. In such periods, the policy would be to encourage the development of credit ease.^ III. AN EVALUATION OF GENERAL MONETARY CONTROL Federal Reserve policies attempt to influence the supply, availability, and the cost of money by increasing or decreasing the quantity of funds available to banks for the extension of credit or for meeting currency needs with out depleting their reserves below the required level. The impact of Federal Reserve policies are reflected in the quantity of money, in the market value and liquidity of particular assets, and in the general liquidity of the entire economy. The policies are reflected, ultimately, in the spending and saving decisions of income receivers and of those who control cash balances and other assets. Some Limitations to Monetary Policy One of the foremost problems which the Federal Reserve authorities have constantly tried to dispell con cerns the ability of monetary policy to control the price 1 7 _<”Influence of Credit and Monetary Measures on Economic-Stability,” Federal Reserve Bulletin, Vol.39 No.3 (The Board of Governors of the Federal Reserve System, Washington, D.C.: March 1953). 341 level. Experience has shown. . . that (1) prices cannot be controlled by changes in the amount and cost of money; (2) the Board's control of the amount of money is not complete and cannot be made complete; (3) a steady average of prices does not necessarily result in lasting prosperity; and (4) a steady level of aver age prices is not nearly as important to the people as a fair relationship between the prices of the commodi ties which they produce and those which they must buy. A matter of much discussion centers on the role which the rate of interest partakes in the working of the economy and as an object of monetary manipulation. An immediate question arises in terms of the efficacy of changes in the rate of interest in controlling spending activity. A sizable amount of business expenditures are sheltered from the restraints of interest costs. The fol lowing are but a few examples of the reduced potency of the rate of interest as a tool of monetary restraint. First, borrowing by businesses has diminished relatively, with more emphasis being placed on internally generated funds, l&The Board of Governors of the Federal Reserve System, "Proposals to Maintain Prices at Fixed Levels Through Monetary Action.1 1 Money and Economic Activity-- Readings in Money and Banking, Lawrence S. Ritter, editor (1st edition; Boston: Houghton Mifflin Company, 1952),p.242, 342 that is, undistributed profits, depreciation allowances and related charges. Second, the net impact of borrowed ;funds is reduced through the use of systematic amortization of loans. Third, the excessively high tax rates of corporate earnings means that approximately 50 per cent of all interest charges are deductible as business expenses. It is readily evident that the indirect market rationing which takes place through interest rates is related to the direct rationing process by lenders of avail-j able funds. But just as higher taxes and more flexible loan contracts have made inroads on the effectiveness of the rate of interest, so likewise have other financial developments served to lessen the control exerted by the monetary authorities over the availability of loanable funds. The Federal Reserve System wields no authority over such financial intermediaries as life insurance companies, savings banks, savings and loan associations, investment 19 companies and pension funds. Monetary regulation is also handicapped in that policies utilized in one period of the business cycle can ^Arthur F. Burns, Prosperity Without Inflation (New York: Fordham University Press, 1958), pp. 46-49. 343 strew debris about the economy which interferes with appropriate regulation in another period. Too, the problem of timing is a formidable obstacle. The lack of dependable clues to the correct timing and magnitude of offsetting actions against instability is a problem which is bound to be crudely handled until knowledge of the working of the 20 system is more complete and more quickly available. The problem of time lags can be added to the difficulties which handicap the efficacy of monetary policy; lags between the time action is initiated and the time when its effects are 21 felt may vary appreciably. In summary, these factors, in addition to signifi cantly increased government expenditures and the large holdings of Treasury securities by all financial institu tions, have tended to emasculate much of the traditional potency of instruments of monetary restraint. The Effectiveness of Monetary Policy It has come into vogue to assign to "income” the o0 ■^Edward S. Shaw, Money, Income, and Monetary Policy (Chicago, Illinois: Richard D. Irwin, Inc., 1950) p. 408. ^Warren L. Smith, "The Effects of Monetary Policy on the Major Sectors of the Economy," Money and Economic Activity--Readings in Money and Banking, Lawrence S.Ritter, editor (2nd ed.; Boston: Houghton Mifflin Co.,1961),p.192. 344 pre-eminent position as a determinant of economic activity, with a consequent neglect of the significance of the supply |of "assets." Too, it is held by many that fluctuations in the rate of investment can be traced by ascribing exclusive attention to the manner in which income is divided between consumption and investment. The sequel of this has been the rise in popularity of fiscal policy, which is held to bear directly on income, and the decline in popularity of monetary policy, which is held to exercise a more mild and circuitous effect on economic activity due to its primary impact on the value and composition of assets. This idea has been challenged in more recent times. It is argued that every outlay of money necessitates an individual or firm to decide as to how much money should be retained; and every decision to retain involves a decision as to the form of wealth the asset should take, that is, as money deposits, or securities, or productive equipment. In this sense, the background to asset holding may be as significant and pervasive as income in governing expenditures. If this analysis is correct, it follows that the influence of monetary policy on assets may be just as strategic and forceful as is fiscal policy's influence upon income in the determination of spending, employment, 345 and prices. In actuality, capital values and income are 00 merely two aspects of the same basic phenomenon. Those who deprecate the effectiveness of monetary policy on the grounds that the schedule of interest rates is not a prime factor of consideration in the demand for loanable funds are arguing amongst themselves, not with the supporters of monetary policy. In dealing with the demand for credit, the Federal Reserve has never placed exclusive reliance on the effect of changes in interest rates. "Availability of credit has always played an equal or greater role, both in central bankers' and in practic ing commercial bankers' thinking."23 To ignore the effect of availability in the allocation of loans is to ignore the realities of commercial banking. The Changing Significance of Near Monies Note should be given to the current controversy reigning over the size of the money supply. Part of the problem can be attributed to difficulties of definition, 00 Howard S. Ellis, "Limitations of Monetary Policy," United States Monetary Policy--Its Contribution to Prosperity Without Inflation (Columbia: The American Assembly, 1958)., pp. 150-51. 23Ibid. p. 154. 346 another part to changes in the employment of cash balances. Due to a broadening in the general concept of what indi viduals, businessmen, governments and central banks construe as "money,” more attention is now being directed to the total of liquid assets rather than just the total of demand deposits, coin and currency as traditionally defined. The conventional narrow definition--checking account deposits, paper money and coins--includes only non- interest-bearing money. But besides this, there are interest-bearing liquid assets that people consider as money. And these go beyond time and savings deposits at commercial banks. They include deposits in mutual savings banks, savings and loan shares, short-term U.S. Government securities, and U.S. sav ings bonds, not to mention paper sold in the open market by finance companies and commercial houses. The interest-bearing money does not turn over anywhere nearly so fast as the noninterest-bearing variety. Nevertheless, these other liquid resources provide a sense of security and normally can be availed of to be spent at any time. 24 This is certainly applicable to Keynes' tripartite division of cash balances. Of particular interest in this respect has been the "certificate of deposit," a relatively new money ^First National City Bank of New York, "The Alleged Shortage of Money," Monthly Economic Letter, (May, 1963), pp. 52-55. market instrument which has grown prodigiously in the last two years. At the end of 1962, it was estimated that there iwas approximately six billion dollars invested in such paper, whereas the estimates at the end of 1960 totaled only one billion dollars. These certificates are aimed at interest sensitive funds, particularly those held by corporations.^5 The banks hope to increase their earning power through the use of such instruments, as well as to increase the stability of their deposits. Because funds raised in this manner are relatively stable, banks are able to safely extend their loan and investment maturities. The raising of the maximum rates as allowed under Regulation Q has permitted commercial banks to effectively compete for funds on the basis of maturities greater than six months. In addition, most government dealers make secondary markets for these certificates. This has augmented the extent of liquidity of such certificates, and thereby enhanced their appeal in the general money market. Such certificates have had an important impact on ^Federal Reserve Bank of New York, "Certificates of Deposit’ , ' Federal Reserve Bulletin, Vol. 45, No. 6, (June 1963), pp. 82-84. 348 the schedule of interest rates. nBy absorbing funds that otherwise would probably have entered the markets for j other short-term instruments, they have exerted an upward pressure on short-term interest rates.^ The utilization of Regulation Q as an instrument for deliberately fostering increased interest rates on time and savings deposits (certificates of deposit fall within this context) has proven to be, under current conditions, a far more effective stimulus to the expansion of credit than has the traditional instruments which expand the volume of free reserves. For two primary reasons, free reserves have tended to lose much of their ability to encourage credit expan sion. First, even though the Federal Reserve may be sup plying ample free reserves to the member banks, it may be concurrently cooperating with the Treasury in supporting a floor under short-term interest rates. Due to the establishment of relatively high short-term rates, banks are given less incentive to lengthen maturities and finance investment expenditures, and thereby significantly offset the expansionary potential offered by free reserves. ^Ibid., p. 87. 349 Second, the large backlog of demand which characterized the earlier postwar period has been satisfied, so that the economy is now less responsive to the stimulus of an easy money environment. Today, excess capacity has replaced the unsatisfied demand for durables, as has price stability replaced the fear of inflation, with the result that free reserves and increased credit availability are often viewed with indifference by both bankers and businessmen. With the apparent inefficacy of conventional easy money measures as a vehicle for increasing general economic activity, the Federal Reserve authorities switched from easy money to higher rates; that is, Regulation Q was changed so that commercial banks are able to pay higher rates on time and savings deposits. With a phenomenal increase in deposit-type savings of $27 1/2 billion in 1962, savers appear to have responded enthusiastically. But it is on the investment demand side that the effects of the higher interest rates are so important. The influx of high cost funds has encouraged commercial banks to increase their investments as mortgage lenders and as purchasers of tax-exempt securities. In brief, "under present conditions, higher rates are providing credit 350 expansion and economic growth far more effectively than easy money.”2^ Those who assert that the money supply has not kept pace with the growth of Gross National Product during the postwar period are overlooking three important factors. First, the traditional definition of the money supply is too rigid and narrow; it is antiquated. Recent times have witnessed a great increase in time and savings deposits, as well as a huge increase in the various forms of highly liquid near monies which the public holds. Second, the psychological attitude of the public, as well as the general state of liquidity for the entire system is of much more significance than the mere quantity of money in the system. This holds true even if one supports the Quantity Theory of Money. Third, the money supply is still ”grow- ing up” to its fivefold increase which occurred during World War II.28 27 Raymond Rodgers, ”The Political Fight Over Interest Rates” Bankers Monthly May 15, 1963, (Chicago: Rand McNally and Company) , p. 16. 28Ibid., p. 18. 351 IV. SUMMARY The ability of the Federal Reserve System to influence the economic system has been a subject of con siderable debate for several decades. Although fiscal policy may achieve more popularity during one segment of history, monetary policy has shown new life and is now considered to be a potent weapon for control. Only by realizing that the economic system cannot be controlled by the mere use of one economic device to the exclusion of another will stability and growth be attainable in the future. Many economists, for a number of reasons, feel that monetary policy has lost much of its effectiveness in recent years. First, a host of economic and political developments appear to have reduced the effectiveness of Federal Reserve instruments in terms of their ability to restrain general credit expansion, particularly in the short-run. Second, the side effects of credit restraint cannot be ignored if a particular policy is in operation for a period of several years. The traditional assumption that a fairly uniform impact is exerted on various sectors of the economy when general credit controls are employed 352 no longer seems valid. Such controls do not seem to touch activities undertaken by the federal government, nor con sumer instalment purchasing without a definite lag. On the other hand, the housing industry in particular, and small businesses in general, are apt to be affected by credit restraint quickly and keenly. Third, due to the severe limitations within which the Federal Reserve policies operate, it would not be wise to depend solely or principally on the Federal Reserve System as the 29 * guardian of the integrity of the dollar. Since the Federal Reserve authorities can influ ence only the supply side of the credit problem, it is vital that adequate recognition be given to the importance of the demand side when considering the efficacy of monetary instruments in contributing to national economic goals. Gn the demand side, the Treasury and other government agencies, and the host of pressure groups which owe their strength to government policies, must be compatible with the effects of the Federal Reserve authorities if legitimate credit conditions are to suc ceed. The deprecation of the credit policies of the 29gurns, 22. • cit. , pp. 63-65. 353 Federal Reserve authorities to a role subservient to the Treasury, as the case has been for nearly half the period the Federal Reserve System has been in existence, is to emasculate the credit powers of the Federal Reserve, and thereby endanger the integrity of the dollar. In terms of long-run goals> the general economic policies of the Federal Government, private businesses, and individuals must be in accord with sound money policies if the value of the dollar is to be sustained. Even under the best conditions. . . there are limits as to what may reasonably be expected of the instru ments of credit control. Credit policy cannot all by itself guarantee continuous prosperity, full employment, stable price levels, economic growth, increasing productivity, a rising level of living, and all the other 'prime goals' posited as the objectives of a good society. . . . But credit policy can make its proper contribution toward a healthy economy if allowed to do so.30 To conclude, it is readily apparent that the instruments of influence as wielded by the Federal Reserve authorities derive their form as well as their justifica tion from monetary theory. It is primarily through the three aforementioned tools that they influence economic 30james Washington Bell and Walter Earl Spahr, Proper Monetary and Banking System .for the United States (New York: The Ronald Press Company, 1960), p. 142. 354 activity. By affecting the manner in which the money supply is handled, as well as its size and rate of turnover, the Federal Reserve attempt to influence the economy in a manner which is most congruent with immediate and long-term goals. CHAPTER VII SUMMARY This thesis has presented a statement and analysis of the more prominent theories of the value of money. The theories given particular attention were the transaction- velocity theory of Irving Fisher, the cash-balance theory of the Cambridge school, and the income-expenditure theory of John M. Keynes. The foundation for the presentation of the theo ries of money value was established in Chapters II and III. In Chapter II a definition of money was tendered, and the functions performed by money were sketched. Also included was a definition of value in exchange and the relevance of price to value. The methods by which the value of money is measured were given due attention, and included a defini tion of an index number, and a review of some of the limi tations which are inherent in any index number. Finally, Chapter II concluded with an analysis of the significance which price changes exert, both on the distribution of income and wealth, and on the size and distribution of real output. 356 Chapter III extended the background for the study of the three paramount theories by introducing the cost of production theory, the bullionist theory, and the supply and demand theory of the value of money. These latter three theories facilitate the forthcoming explanation of the leading three theories by providing an introduction to the development of the theory of the value of money. In the final section of the chapter, the two approaches to the quantity theory of money are introduced on a preliminary basis. From this, the next two chapters examine in more detail the primary theories. Chapter IV undertook an investigation of the two major forms of the quantity theory and their relevance to monetary problems. The transaction-velocity approach is the most direct and simple of the two. Money is viewed almost exclusively as a medium of exchange, since the theory is concerned with the flow of goods and services in direct relation to the stock of money. Mathematical expression is achieved by the use of the equation of exchange, which is based on the supposition that the value of the transactions executed in a given period is equiva lent to the quantity of money being offered in exchange in that period. This necessitated the assumption that 357 deferred payments had a neutral effect during the period. In addition, the totality of transactions which involve money transfers are the point of concentration in the theory. While it is obvious that the transaction-velocity approach does not expose all the intricacies concerning money, it does yield an insight into the importance of changes both in the velocity of money and the relation of the quantity of money, in terms of both stock and turnover, to the level and movement of prices. The cash-balances version of the quantity theory was the concern of the second half of Chapter IV. This theory is based on the assumption that the value of money can be approached in terms of the motives for holding cash balances rather than nonmonetary assets. The assumption is that money is retained in terms of its real worth, in terms of the goods and services available at current prices The demand for money will diminish if the purchasing power of money balances appears excessive to the holders; this will cause an increase in the rapidity of turnover, and a consequent increase in the quantity of money will ensue. As a result of the interaction of supply and demand, prices will theoretically rise up to the point where the holding of money relative to the holding of nonmonetary assets is 358 a matter of indifference. From the equilibrium position, there is no tendency for the utilization of money to cause prices to rise or fall. In the cash-balances approach, a clear distinction has to be made between "ex ante" expectations and "ex post" realizations if an adequate evaluation of the effects which changes in the community's motives for retaining money bal ances have on the value of money is to be achieved. The theory does not insist that the motives of the individuals of the community for retaining purchasing power in the form of money balances be collectively realized. It was pointed out that the total cash balances of the community can behave in a manner which is paradoxical to these desires. Nor is there any assurance that the real worth of the cash balances will run parallel to the desires of the community. Money balances of purchasing power will reflect, but not necessarily behave in congruence with, the community's desires. The dynamic aspects of the cash-balances theory are drawn from the attention given to the discrepancies which may exist between the length of the period over whose transactions the community "holds" money balances of purchasing power and the length of the period over whose 359 transactions the community ’'seeks" to retain money balances of purchasing power. If the community regards its money holdings of purchasing power as excessive or deficient, forces are set in motion which will alter the money hold ings of the community, but not necessarily in the manner desired by the public. The two theories analyzed in Chapter IV viewed money from two different but related vantage points. The equations utilized in the transaction-velocity approach are concerned with the average value of money during a period of time, whereas the equations employed in the cash- balances version of the theory of money value are concerned with the value of money as of a given moment. The former placed emphasis on the total quantity of money and the velocity of turnover; the latter placed attention on the proportion of income people choose to hold in the form of money balances. Chapter V is entirely devoted to the general theory of John Maynard Keynes. This theory is based on the pro position that individuals tend to increase their consump tion as income increases, but by an amount less than the increase in income. From this the deductions are made that, as income and employment increase, investment must 360 increase in sufficient proportion to absorb the increased savings or else there will be a deficiency of profits to businessmen. The marginal efficiency of capital and the rate of interest determine the size of investment expenditures, while the amount of consumption spending is determined by the propensity to consume and the size of income. The theory is concerned, therefore, with explaining how it can come about that, with a given propensity to consume and a given rate of investment, the level of employment can be at less than the full employment level. Attention then turns to an examination of the factors behind the propen sity to consume and the determinants of investment. In treating the significance of the value of money and the role it performs in the economy, Keynes gave but a very sketchy analysis. Assuming the productive units are homogeneous and available at constant costs, Keynes stated that employment and output will increase concomitantly with increases in the quantity of money up to the point of full employment. Thereafter, prices and factor costs will increase proportionally with increases in the money supply. A distinction is made, however, between new money added to an individual1s income and money which flows into 361 speculative balances as a consequence of the bank credit creation for a non-income transaction. Even though the new money may flow into the income stream after the initial expenditure by the recipients, the level of income may not be sufficiently high to absorb the whole of the increment into ordinary transaction and precautionary balances, leav ing the remainder to be absorbed by speculative holdings. Chapter VI presented a review of the three general instruments of monetary control as employed by the Federal Reserve authorities. The three instruments represent an attempt by the Federal Reserve authorities to influence the rate, direction and level of economic activity. As was brought out in the study of the three primary theories of the value of money, the quantity of money in the system, the forms in which the community holds their balances of purchasing power, and the purposes to which they plan to employ these balances are the factors to which monetary instruments are directed. The efficacy of these monetary tools is concomitantly facilitated and attenuated by the institutional and psychological factors which operate within the economic system. Over and above these factors, the monetary authorities are confronted with political pressures and a constantly fluctuating and changing 362 environment. It is only in this context that monetary policy can be properly evaluated as a force operating to maintain and preserve the value of money. To conclude, it is evident that monetary theory is still in a nascent stage. With the rebirth of monetary theory in the postwar period, tremendous strides have been taken. As this thesis pointed out, the integration of monetary theory and general economic theory was a much needed step forward. But yet, a myriad of complex and challenging problems are still to be solved. The problems currently facing the monetary theorist run the gamut from arriving at a satisfactory definition of the money supply, to encouraging higher rates of economic growth without sacrificing the integrity of the dollar. International as well as domestic consideration must now be given weight in policy determination. While the life of the central banker is not an easy one, it is ultimately the monetary theorist who must seek and find new tools, while improving the effectiveness of existing ones. Alas, lying in the center of the controversy is the problem of the integrity of money, the purchasing power of money; the value of money. BIBLIOGRAPHY BOOKS Agger, Eugene E. Money and Banking Today. New York: Reynal and Hitchcock, 1941. Anderson, B. M. Jr. The Value of Money. New York: The Macmillan Company, 1922. Anderson, Clay J. "Member Bank Borrowing From The Federal Reserve Banks." Money and Economic Activity--Readings in Money and Banking. Edited by Lawrence S. Ritter. Second edition. Boston: Houghton Mifflin Company,1961. Angell, James W. The Behavior of Money— Exploratory Studies♦ New York: McGraw-Hill Book Company, Inc., 1936. Bell, James Washington and Walter Earl Spahr. A Proper Monetary and Banking System for the United States. New York: The Ronald Press Company, 1960. Bernstein, E. M. Money and the Economic System. Chapel Hill: The University of North Carolina Press, 1935. Bradford, Frederick A. Money. Revised edition. New York: Longmans, Green and Company, 1933. _______ . Money and Banking. Sixth edition. New York: Longmans, Green and Company, 1949. Bratt, Elmer Clark. Business Cycles and Forecasting. Third edition. Chicago: Richard D. Irwin, Inc., 1948. Burns, Arthur F. Prosperity Without Inflation. New York: Fordham University Press, 1958. _______ . The Frontiers of Economic Knowledge. Princeton: Princeton University Press, 1954. Cannan, Edwin. "The Application of the Theoretical Apparatus of-Supply and Demand to Units of Currency." 364 365 Readings in Monetary Theory. The American Economic Association. Homewood, Illinois: Richard D. Irwin,Inc., 1951. Chandler, Lester V. An Introduction to Monetary Theory. New York: Harper and Brothers, 1940. _______ . The Economics of Money and Banking. Third edi tion. New York: Harper and Brothers, 1959. Crowther, Geoffrey. An Outline of Money. Revised edition. New York: Thomas Nelson and Sons, Ltd., 1948. Crum, William Leonard, Alson Currie Patton, and Arthur Rothwell Tebbutt. Introduction to Economic Statistics. New York: McGraw-Hill Company, Inc., 1938. Day, A. C. L. Outline of Monetary Economics. London: Oxford University Press, 1957. Dillard, Dudley. The Economics of John Maynard Keynes— The Theory of a Monetary Economy. Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1958. Edie, Lionel D. Money, Bank Credit and Prices. New York: Harper Brothers and Company, 1928. Ellis, Howard S. German Monetary Theory, 1905-1933. Cambridge, Massachusetts: Harvard University Press, 1934. Ely, Richard T. and Thomas S. Adams and Max 0. Lorenz and Allyn A. Young. Outlines of Economics. Fourth edi tion. New York: The Macmillan Company, 1925. Fellner, William. Monetary Policies and Full Employment. Berkeley, California: University of California Press, 1947. Fisher, Irving. The Making of Index Numbers, Second edi tion revised. New York: Houghton Mifflin and Company, 1922. . The Money Illusion. New York: Adelphi Company, 1928. 366 Fisher, Irving. The Purchasing Power of Money--Its Deter mination and Relation to Credit Interest and Prices. New revised edition. New York: The Macmillan Co.,1925 jFoster, William Trufant and Waddill Catchings. Money. Third edition revised. New York: Houghton Mifflin Company, 1927. Garis, Roy L . Principles of Money, Credit and Banking. New York: The Macmillan Company, 1934. Gordon, Robert Aaron. Business Fluctuations. New York: Harper and Brothers, 1952. Greidanus, Tjardus. The Value of Money--A Discussion of Various Monetary Theories and an Exposition of the Yield Theory of the Value of Money. New York: Staples Press Incorporated, 1950. Haberler, Gottfried. "Mr. Keynes" Theory of the 'Multi plier': A Methodological Criticism." Readings in Business Cycle Theory. Philadelphia: The Blakiston Company, 1944. Halm, George N. Economics of Money and Banking. Homewood Illinois: Richard D. Irwin Co., 1956. ________ . Monetary Theory--A Modern Treatment of the Essentials of Money and Banking. Second edition. Philadelphia: The Blakiston Company, 1946. Hamberg, Daniel. Business Cycles. New York: The Macmillan Company, 1951. Hansen, Alvin H. Monetary Theory and Fiscal Policy. New York: McGraw-Hill IBook Company, 1949. Hanson, J. L. Monetary Theory and Practice. London: MacDonald and Evans, Ltd., 1956. Hart, Albert G. "Keynes' Analysis of Expectations and Uncertainty." The New Economics--Keynes1 Influence on Theory and Public Policy. Seymour E. Harris, editor. New York: Alfred A. Knopf, Inc., 1948. 367 Hart, Albert G. Money, Debt and Economic Activity. Second edition. Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1948. Hawtrey, R. G. Currency and Credit. New York: Longmans, Green and Company, 1934. _______ . "Money and Index-Numbers." Readings in Monetary Theory; The American Economic Association. Homewood, Illinois: Richard D. Irwin, Inc., 1951. Hayek, Friedrich A. Prices and Production. London: George Rutledge and Sons, Ltd., 1932. Hicks, J. R. "A Suggestion for Simplifying the Theory of Money." Readings in Money and Banking. The American Economic Association. Homewood, Illinois: Richard D. Irwin, Inc., 1951. _______ . Value and Capital--An Inquiry into Some Fundamen tal Principles of Economic Theory. Second edition. London: Oxford University Press, 1948. Higgs, Henry, editor. Palgrave1s Dictionary of Political Economy. Vol. Ill, N-Z. London: The Macmillan Company, 1926. James, F. Cyril. The Economics of Money, Credit, and Banking. New York: The Ronald Press Company, 1935. Kemmerer, Edwin Walter. Money--The Principles of Money and Their Exemplification in Outstanding Chapters of Monetary History. New York: The Macmillan Company,1935. Kent, Raymond P. Money and Banking. Fourth edition. New York: Holt, Rinehart and Winston, 1961. Keynes, John Maynard. A Treatise on Money. New York: Harcourt, Brace and Company, 1930. Vols. I and II. _______ . Monetary Reform. New York: Harcourt, Brace and Company, 1924. _______ . The General Theory of Employment, Interest and Money. New York: Harcourt, Brace and Company, 1936. 368 Kilborne, Russell Donald. Principles of Money and Banking. New York: McGraw-Hill Book Company, 1932. King, Willford Isbell. Index Numbers Elucidated. New York: Longmans, Green and Co., 1930. Korteweg, S. and F. A. G. Keesing. A Textbook of Money. New York: Longmans, Green and Company, Ltd., 1959. Kurihara, Kenneth K. Monetary Theory and Public Policy. New York: W. W. Norton and Company, Inc., 1950. Laughlin, J. Lawrence. Money and Prices. New York: Charles Scribner's Sons, 1924. Lerner, Abba P. "Interest Theory-Supply and Demand for Loans, or Supply and Demand for Cash?" The New Econom ics --Keynes' Influence on Theory and Public Policy. Seymour E. Harris, editor. New York: Alfred A. Knopf, Inc., 1948. Marget, Arthur W. The Theory of Prices--A Re-Examination of the Central Problems of Monetary Theory. Vol. I., New York: Prentice-Hall, Inc., 1938. Marshall, Alfred. Money, Credit and Commerce. London, Macmillan and Company, Limited, 1924. Mill, John Stuart. Principles of Political Economy--W_ith Some of Their Applications to Social Philosophy. Editor W. J. Ashley. London: Longmans, Green, and Company, 1920. Mills, Frederick C. The Behavior of Prices. New York: National Bureau of Economic Research, Inc., 1927. Mitchell, Wesley C. Business Cycles--The Problem and Its Setting. New York: National Bureau of Economic Research, Inc., 1928. Peterson, J. Marvin and D. R. Cawthorne. Money and Bank ing. New York: Macmillan Company, 1949. Phillips, Chester Arthur. Readings in Money and Banking. New York: Macmillan Company, 1922. 369 Pigou, A. C. "The Value of Money." Readings in Monetary Theory. The American Economic Association. Homewood, Illinois: Richard D. Irwin, Inc., 1951. Pritchard, Leland J. Money and Banking. Boston: Houghton Mifflin Company, 1958. Ritter, Lawrence S. "Money, Income, and Economic Activity." Money and Economic Ac tivity--Readings in Money and Banking. Lawrence S. Ritter, editor. Second edition. Boston: Houghton Mifflin Company, 1961. Robertson, Dennis H. Essays in Monetary Theory. London: Staples Press Limited, 1940. _______ . Money. Chicago, Illinois: University of Chicago Press, 1959. Robinson, Joan. Introduction to the Theory of Employment. London: Macmillan and Company, 1938. Rufner, Louis A. Money and Banking in the United States. New York: Houghton Mifflin Company, 1938. Saulnier, Raymond J. Contemporary Monetary Theory-- Studies of Some Recent Theories of Money, Prices, and Production. New York: Columbia University Press, 1941. Schumpeter, Joseph A. Business Cycles, Vols. I and II. New York: McGraw-Hill Book Company, 1939. The Board of Governors of the Federal Reserve System. "General Methods of Regulation." Money and Economic Activity--Readings in Money and Banking. Lawrence S. Ritter, editor. First edition. Boston: Houghton Mifflin Company, 1952. _______ . "Proposals to Maintain Prices at Fixed Levels Through Monetary Action." Money and Economic Activity --Readings in Money and Banking. Lawrence S. Ritter, editor. First edition. Boston: Houghton Mifflin Company, 1952. Selden, Richard T. "Monetary Velocity in the United States." Studies in the Quantity Theory of Money. 370 Editor, Milton Friedman. Chicago: University of Chicago Press, 1956. Shaw, Edward S. Money, Income, and Monetary Policy. Chicago, Illinois: Richard D. Irwin, Inc., 1950. Smith, Warren L. "The Effects of Monetary Policy on the Major Sectors of the Economy." Money and Economic Activity--Readings in Money and Banking, Lawrence S. Ritter, editor. Second edition. Boston: Houghton Mifflin Company, 1961. Steiner, William Howard and Eli Shapiro. Money and Banking Revised edition. New York: Henry Holt and Company,1947. Steiner, W. H., Eli Shapiro, and Ezra Solomon. Money and Banking--An Introduction to the Financial System. Fourth edition. New York: Henry Holt and Company,1958. Thomas, Rollin G. Our Modern Banking and Monetary System. Second edition. New York: Prentice-Hall, Inc., 1950. Villard, Henry H. "Monetary Theory." A Survey of Con temporary Economics. Howard S. Ellis, editor. Philadelphia: The Blakiston Company, 1949. Von Mises, Ludwig. The Theory of Money and Credit. New Haven: Yale University Press, 1953. Warren, George F. and Frank A. Pearson. Gold and Prices. New York: John Wiley and Sons, Inc., 1935. Westerfield, Ray B. Money, Credit and Banking. Revised edition. New York: Ronald Press Company, 1947. Whittlesey, Charles R. Principles and Practices of Money and Banking. Revised edition. New York: MacMillan, 1954. Williams, John H. "Deficit Spending." Readings in Busi ness Cycle Theory. Philadelphia: The Blakiston Company, 1944. Woodworth, George Walter. The Monetary and Banking System. New York: McGraw-Hill Book Company, 1950. 371 Wright, Ivan. Readings in Money, Credit and Banking Principles. New York: Harper and^Brothers, 1926. PUBLICATIONS OF THE GOVERNMENT AND LEARNED SOCIETIES Ellis, Howard S. "Limitations of Monetary Policy." United States Monetary Policy--Its Contribution to Prosperity Without Inflation. Columbia, The Americanr-Assembly, 1958. Federal Reserve Bank of New York. "Certificates of Deposit." Federal Reserve Bulletin. Vol. XLV, No. 6, June 1963. Robertson, Dennis H. "Some Notes on Mr. Keynes’ General Theory of Employment." Quarterly Journal of Economics. Vol. LI, November 1936. Cambridge, Massachusetts: Harvard University Press, 1937. Schumpeter, Joseph A. "J. M. Keynes: 1883-1946." The American Economic Review, Vol. XXXVI, No. 4, Part 1, September 1946. The Board of Governors of the Federal Reserve System. "Influence of Credit and Monetary Measures on Economic Stability.” Federal Reserve Bulletin. Vol. XXXIX, No.3, March 19531 _______ . The Federal Reserve System--Purposes and Func tions . Fourth edition. Washington, D. C.: 1961. Wright, David McCord. "The Future of Keynesian Economics." The American Economic Review, Vol. XXXV, No. 3, June 1945. PERIODICALS First National City Bank of New York. "The Alleged Short- age of Money." Monthly Economic Letter, May, 1963. Rodgers, Raymond. "The Political Fight over Interest Rates." Banker!s Monthly♦ May 15, 1963. Chicago: Rand McNally and Company. UNIVERSITY OF SOUTHtKH CALIFORNIA LIBRARY

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Creator Kinyon, Frederick McLeod (author)

Core Title The theory of the value of money

Degree Master of Arts

Degree Program Economics

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag economics, general,OAI-PMH Harvest

Language English

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Advisor Garis, Roy L. (committee chair), Anderson, William H. (committee member), Phillips, E. Bryant (committee member)

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