Money, Credit And Prices
( Originally Published Early 1900's )
1. Relations of value, price, money and credit.—The discussion has taken up successively a series of closely related phenomena, value, price, money and credit. It remains to consider them in their mutual relations. Price we have considered as the expression of value in the terms of one commodity, money as the term in which price is expressed, credit as an agency thru which the use of money is economized. We must now inquire what it is that fixes the value of money, how the value of money is expressed in prices, and what effect credit has upon prices.
2. Value of money.—Commodities have value be-cause in the first instance they satisfy some desire of man's nature in the present organization of society; in other words because they have utility, and because the available supply is less than the demand for them. Like all other things money depends for its value not only upon its utility, but upon the demand for money and the supply of money. Its utility does not lie in the substance of which it is composed but in the service which it renders. It is a common impression in the case of standard gold money, that the money is valuable because it is gold, whereas it would be more accurate to say that gold is valuable because it is money. We all know that a silver dollar and a paper dollar are each worth a dollar, not because of the sub-stances of which they are made but because they do the work of a dollar.
Nor is the case of a gold dollar essentially different. It may be admitted that gold as a substance has utilities apart from its use as a monetary medium, but these are of second rank. Apart from its use as adornment its employment in the arts is extremely limited. On the other hand, a very large portion of the gold stock of the world is performing the function of money, and there can be no doubt that were gold deprived of its money function it would greatly depreciate in value as compared with other commodities. The use of gold as money heightens the value of gold, and the value thus given to gold is imparted to the other forms of money which do a similar service in the affairs of the world.
Like other commodities or services, the value of money depends upon the ratio between demand and supply. What these terms mean in relation to commodities in general has already been explained. In the case of money the elements which enter into both demand and supply are so complex that special analysis is desirable.
3. Demand for money.—What measures the demand for money? Obviously the demand for money differs from the desire for wealth. While in common parlance we are apt to confuse the two and speak of the well-nigh universal longing for riches as an insatiable demand for money, it is not in this sense that the phrase is used here. The demand for money is simply the work that money is required to do. That work, as preceding chapters have shown, is somewhat varied in character.
Money serves as the medium of exchange.
Money serves as the basis of credit.
Money serves as a store of value.
4. Population and the money demand.—Other things being equal, the demand for money grows with the volume of business. The United States today, with its population of over 100,000,000 persons, could not conceivably get along with no more money than when our national existence started. The growth of population, independently of any other factors, has created a far larger demand for money. Business activity does not depend upon population alone; China with its teeming millions is not a business force comparable to other nations with much smaller numbers.
In newer countries, such as the United States and Canada, increasing numbers have been also accompanied by increasing wealth. The greater the wealth the more frequent its interchange, and the greater will be the demand for money. In the United States the money employed per capita has been constantly increasing. In part such increase must be explained by a greater demand for money flowing from the rapid increase of wealth.
5. Industrial development increases money demand.—German writers have laid much emphasis on the distinction between a natural economy and a money economy. The phrases are not in use in the United States, tho nowhere is the contrast between the conditions which they describe more recent than here. Under a natural economy the German writers describe a condition of affairs by which men singly or in groups satisfy their needs directly without calling upon the aid of outsiders. The western frontiers-man and the southern planter of the last century rep-resented these types. For food, shelter and clothing each relied upon his own efforts or upon the efforts of those immediately associated with him. Money he needed only to a limited extent. If all society were organized upon such a basis the demand for money would be very small because there would be little work for money to do.
A natural economy is a direct contrast to what is termed a money economy. In its highest form money economy represents a condition of society in which no one produces any article whatever for his direct personal consumption. Such a condition of affairs is found in our cities today with minor and insignificant exceptions. Industrial centers like cities, however, offer a contrast to the agricultural communities. The farm grows a large quantity of crops which are used directly either for personal consumption or in the operations of farming as feed for live stock.
It is sufficient, perhaps, to have described these different conditions to make it clear how industrial development increases the demand for money. As the people of the United States have passed success-fully from a group of backwoodsmen to a nation of agriculturists and finally to a people of large industrial undertakings, the demand for money has grown insistently, for the money work of the nation has immeasurably increased.
6. Extension of credit lowers demand for money. —Having in view the enormous development of business during the last century, not only in the United States but thruout the whole civilized world, it is clear that there would be at present an overwhelming demand for money had there not been during this period a parallel development of the machinery of credit, which was described in the preceding chapter. The demand for money is conditioned, as we have seen, by the volume of exchange, but directly only by such exchanges as are effected by means of money. Where the exchange is effected by credit the demand for money is limited to the amount necessary to serve as a basis of credit.
If in a community which experienced no change in the volume of business a credit organization was developed which made it possible to conduct exchanges with one-fifth of the money previously current, it is perfectly clear that the demand for money would diminish, and the money would fall in value or be dispensed with by exportation or by use in the arts. As a matter of fact, the development of credit does not take place in this way. It usually accompanies an increased volume of exchanges. Its effect is not so much actually to decrease the demand for money as it is to prevent the demand for money from growing as rapidly as it otherwise would.
7. Money hoards and rapidity of circulation.
Money, we have seen, serves a use as a hoard or store of value. It is not a use which the economist approves but it is none the less one with which he has to reckon. If such use of money is extensive there will be a greater demand for money than when hoarding is practically negligible. With the general progress of enlightenment this form of money demand tends to diminish. But while the habit is disappearing there are occasional recrudescences which are apt to occur when they are most harmful, namely, in times of panic.
The use of money as a store of value diminishes its efficiency for the purposes for which it is intended. It therefore increases the demand for money since an inefficient instrument does less work. Conversely, whatever increases the efficiency of money lessens the demand for it. Whatever increases the rapidity with which money circulates therefore diminishes the demand. It is one of the advantages of the introduction of banking habits that men carry less money in their pockets, and thus money acquires a greater 'rapidity of circulation.
8. Supply of money.—The supply of money is the quantity of standard money in existence. The supply of money in any given country when any commonly used standard, such as gold or silver, is employed as money is automatically regulated thru international trade. If the supply is excessive prices rise, and the country having such prices becomes a good country in which to sell goods. Merchants in other countries improve the opportunity and in settlement of the exchanges gold, for instance, is exported. Such export reduces the quantity of gold in one country and increases it in the others, thus bringing about an equilibrium.
A similar process would be involved between countries using silver as the monetary unit. Where standards differ, exchanges are hampered and the supply of money is not so regulated. When fiat money usurps the place of standard money its volume is apt to be in excess of the trade needs of the country issuing it and its value, thru excess of supply, diminishes. In other words prices rise.
9. Changes in the money supply.—When, as in the case of fiat money, the supply of money is dependent upon nothing more certain than the capricious needs of government, the value of money will vary rapidly and violently. In the case of money based on gold, changes are less rapid. From country to country the processes of exchange effect, as we have seen, an automatic distribution of the money metal and bring about a comparative equality of prices.
In the world at large there may be notable changes in the supply of money. These changes in the production of gold from year to year are not so great as in the case of agricultural products, for example. A demand for money cannot be immediately met by increasing the supply. The processes of mining are laborious. A fall in prices or a high value of gold will indeed induce mining operations which might otherwise be unprofitable, but this will not materially change the volume of the product. Rising prices of commodities will render the working of some mines unprofitable.
The product of agriculture is used up practically each year, and changes in its amount are quickly reflected in prices. It is, however, not the annual production but the existing stock which controls the value of gold. Such changes as are observed from year to year make only an inappreciable change in the money supply.
It is otherwise with the great gold discoveries. When gold was discovered in California and Australia a flood of the yellow metal was turned into the commerce of the world. After the first year or two the gold stock was considerably increased; prices rose and the value of gold declined. Later came a lull in gold production. The increase of supply was no longer sufficient to meet the increase in the demand for money, and prices fell. With the more extensive exploitation of the Rand of South Africa, the annual gold production began to rise until it exceeded the height of the California output. The stock of gold in the world was considerably augmented and an era of rising prices was ushered in.
10. Money values expressed in prices.—The value of money is equivalent to its purchasing power. There is no way of expressing this purchasing power except in terms of what money will buy—in other words, by the commodities which will be exchanged for a given quantity of money. Hence, price and value of money are reciprocal terms. When prices are low the value of money is high because a given quantity of money will command a large amount of commodities. If prices are high the value of money is low because a smaller quantity of commodities can be purchased by a given quantity of money. If the price of any single article could be a criterion of the prices of all articles this reciprocal relation would be plain at a glance. The price of any single commodity, however, is the result of a combination of factors of which the value of money is only one.
11. Prices of commodities.—Changes which take place in the prices of commodities may be due either to changes which affect the commodity only or, since price is the relation of the commodity to money, to changes which take place in the value of money. Change in price may therefore arise from a change in (1) the demand for, or (2) the supply of the commodity. Changes of this nature are reflected in the price of one commodity as compared with another; their positions in the price scale change.
A change in the demand for money will change prices. If the demand increases without change of supply an increased burden is placed on each money unit. There are more exchanges to be made but there is the same money with which to make them. Hence units of money must command larger quantities of commodities; prices fall and this indicates the in-creased value of money. Conversely, when the demand for money decreases, prices rise and the value of money falls.
Changes in the supply of money work similar results in prices. If the supply diminishes prices fall and the value of money increases. Should the supply of money increase, the prices of commodities rise and the value of money falls.
It may be noted that when prices change by reason of differences in the demand for and supply of commodities, some commodities may rise in price, while others fall. Such readjustments in prices of commodities are constantly taking place. On the other hand, should price changes be wrought by changes in the value of money, we should expect uniform action upon prices, a general rise of prices or a general fall.
12. Measuring price changes: Simple as these propositions appear to be, no little difficulty is experienced in demonstrating their truth by an appeal to the facts. In actual experience the two sets of forces fixing prices, those affecting commodities and those affecting money, are never separated. Particular price movements run counter to general price movements and obscure them. Like those who are unable to see the forest for the trees, there have been some who were unable in the shifting of many prices to discern any- general movement whatsoever. They have therefore been led to question' whether changes in the monetary situation have had any effect upon prices and have been ready to ascribe such changes to almost any cause but the true one.
13. Index numbers.—The study of prices has long been a subject of particular solicitude, not only to the men actually engaged in business but to the students of business affairs. To separate the general from the particular, economists have invented what is known as the index number. The purpose of this device is to ascertain the average change in prices of a group of commodities. The prices of a given period or a given time are selected as a base and the price of each commodity is determined.
The advantage, of taking as a base the average price for a series of years is that this course makes it possible to eliminate as far as possible the influence which, in a shorter period, unusual conditions might have had on the price of a particular commodity. When the base price is ascertained other prices during, before and after the period of the base are expressed as percentages of this base. Commodities A, B, C and D, will each have a different base, but when the base is turned into a percentage it becomes uniform for all, namely 100. We may suppose that at a later period A is represented by 110, B by 106, c by 102, and D by 98. Now if these figures be averaged the result is 104, and this represents for the group an average rise in price of 4 per cent over the base. One of the commodities indeed declined in price, but this does not alter the fact that the general tendency is to advance the price.
In following the method, briefly indicated, of constructing an index number, each article has been given an equal importance in determining the change. If instead of abstract designations A, B, C and D, concrete articles had been named, such as wheat, iron, wool and indigo there might be some doubt as to the propriety of giving each an equal importance in fixing the result. To avoid such questionings various methods have been devised to give an appropriate weight to the different articles ; such weights have been arranged in accordance with the foreign trade, or with the estimated national consumption or the expenditure of workingmen's families.
None of these highly complicated methods have, however, led to substantially different results from the simple arithmetical average. It is clear that if each article moved upward in price exactly 5 per cent it would not matter how many articles were added to the list nor how they were combined, and one could not get any other general result than a five per cent advance. If some articles increased four per cent and others six they would, if equally divided, show an average of five per cent, but no method of combination could make the advance less than four, or more than six per cent. In other words, in a group of prices the general tendencies outweigh the particular ones, and no combination of different results according to any plausible system of weights will emphasize the particular tendencies at the cost of those which are general.
14. Course of prices.—Various index numbers have been compiled in many countries. Differences due to a different choice of articles, different initial bases for the calculations, and occasionally different methods of grouping or averaging the price indexes of the different commodities produce different price levels for the same date in the different indexes; but the movements of prices show a remarkable similarity. The oldest of these, calculations are those of the Lon-don journal, The Economist. Another English computation of wide repute, that of Mr. Augustus Sauer-beck, has been continued by Sir George Paish in The Statist.
The first computations of this character in the United States were made under the direction of Dr. R. P. Falkner for the Senate Committee on Finance in 1891. The computations went back to 1860 for a base, and for a large number of articles, prices were obtained from 1840. Tho not continued directly this investigation was the basis for subsequent official publications of this nature. A few years later Dr. Falkner persuaded the Bureau of Labor Statistics to take up the matter again and, after an effort to complete the earlier figures under his direction, the Bureau established its own index number on the basis of the prices of years 1890-99. This has been continued to date.
Other index numbers have since been established. A full account of them is given in a recent bulletin of the Bureau of Labor Statistics (No. 173, July, 1915). In connecting its investigations with those of the Senate Finance Committee, the Bureau of Labor Statistics has reduced all figures to a base of 1914. The figures for certain years before 1900 and annually thereafter with results of The Economist and Sauerbeck appear on page 217.
In the course of prices as revealed in this table the thoughtful reader cannot fail to be struck by the co-incidence of rising prices following the discovery of gold in California and Australia, and that which has followed later increases in the output of gold.
15. Effects of changing prices.—When the changes in price are due to the changes in the value of money the economic effects which follow are very marked. Economists have pointed out that production and ex-change are adjusted to the price level, that there is no peculiar merit in high prices and no special disadvantage in low prices. It is not the level of prices, whether it be high or low, which causes either prosperity or distress. But changes in the price level bring out the need of many readjustments. They affect business chiefly thru the fact that money is a standard of deferred payments. Rising prices work to the advantage of the debtor, falling prices to that of the creditor.
In our analysis of credit it was seen that in the field of production the debtor is the active man of enter-prise who is willing to take risks, and who expects from the return from his enterprise to cancel his obligation. In periods of falling prices, interest payments and payments on account of principal absorb more and more of the product of his industry. In the long period of falling prices which preceded 1896 the public heard much of the plight of the farmer who had a mortgage on his farm. With every fall in the price of his wheat, a larger and larger number of bushels of wheat was necessary to meet his obligation. When, on the other hand, prices are rising the debtor finds it continually easier to meet his obligations.
Hence falling prices cause depression in business, and rising prices hopefulness and activity. Since business rests so largely upon credit, and credit rests upon confidence, it is easily understood how the general state of the public mind finds a reflection in the dulness or activity of business affairs.
What fixes the value of money?
How is the demand for money increased and how is it diminished?
What is the supply of money and how are changes in it effected in individual countries and in the world at large?
How is the value of money expressed?
What special and general conditions affect the prices of commodities?
How are changes in the general price level measured? How do changes in price level affect business?