The Value of Money

At the time that Mises wrote his book, die dominant theory believed to account for the purchasing power of money was the Quantity Theory. Originating in sixteenth-century empirical observations and die insights of Bodin and Davanzati, the theory had had its ups and downs in professional opinion. By the start of the twentieth century the theory was fairly widely upheld, but the term "Quantity Theory of Money" had become quite elastic, covering a number of rather different versions.2 As we shall see, Mises recognized die kernel of truth in these various versions of the Quantity Theory (and indeed defended the theory against a number of the objections of its critics). But his own positive theory explaining die way in which die purchasing power (the "value") of money is determined must be understood against the background of the Fisherine version of the Quantity Theory, a version which he vigorously attacked for what he considered its "mechanical" character (tmc, 144).3 Mises was referring especially to Irving Fisher's 1911 book (with H. G. Brown), The Purchasing Power of Money. (Schumpeter remarked that ever since the publication of that book "Fisher has been dassed as a sponsor of a particularly rigid form of quantity theory.")4 The nub of this "mechanical," "rigid" version of the theory was, in Mises' words, its "conclusion that variations in the ratio between the quantity of money and the demand for it lead to proportionate variations in the objective exchange-value of money" (tmc, 144). Mises devoted considerable space to refuting this condusion; he found it difficult to understand how economists familiar with the subjective theory of value could have fallen into die error it represented. The only explanation he could put forward had to do with their failure to integrate monetary theory with economic theory generally (a failure the correction of which was, as we have noted, a principle objective of Mises' book). "One thing only can explain how Fisher is able to maintain his mechanical Quantity Theory.

To him the Quantity Theory seems a doctrine peculiar to the value of money; in fact, he contrasts it outright with the laws of value of other economic goods" (tmc, 144).

The challenge which Mises set for himself was in fact to show that the theoretical explanation for the value of money is, in principle, exacdy the same explanation (i.e., the subjective theory of value) that economists (at least since the marginal utility revolution of the early 187c») used to account for all commodity market values. Mises recognized that he faced a formidable challenge. Until the appearance of his own work, he observed, "die subjective school" (by which he meant in particular the Atistrians) had not succeeded in "developing a complete theory of the value of money on the basis of the subjective theory of value and its peculiar doctrine of marginal utility" (tmc, 114).

Perhaps die best known argument which had hitherto been advanced in order to claim that the standard marginal utility theory of value could not be used to account for the value of money was the "circularity" argument. Mises cited Helfferich (author of a well-known, German-language 1903 monetary treatise) on this point. Helfferich noted that marginal utility theory explains the exchange-value (i.e., die market prices) of goods by reference to the degree of utility that potential consumers attach to these goods. A similar explanation for the exchange-value (i.e., the purchasing power) of a unit of money would then have to proceed by reference to the degree of utility that potential users of money attach to that unit. But the utility attached to a unit of money is nothing else but "the amount of consumable goods that can be obtained in exchange for it The marginal utility of money.. .presupposes a certain exchange-value of the money; so the latter cannot be derived from the former" (tmc, 119-20; emphasis supplied). The marginal utility of a loaf of bread is independent of the price of bread. The marginal utility of a dollar is meaningful only in terms of the purchasing power of die dollar. To explain the purchasing power of the dollar by reference to its marginal utility is to fall into a circularity trap.

Now this circularity argument has been totally dismissed by some modem writers (notably by Don Patinkin, an eminent midcentury monetary theorist).5 Mises, however, took the argument seriously and developed what came to be a well-known solution to the circularity problem. For purposes of present discussion it is not really important to explain what Patinkins reasoning for his dismissal was, and why Mises would not have accepted that reasoning. (This is all the more so since this would involve us in "Austrian" considerations basically unrelated to Mises' contributions to monetary theory.)6 For us, it is sufficient to note that, at the time Mises wrote his book, the circularity argument was treated with great respect. Mises, in advancing his own solution (his "regression theorem") for this prob lem, was addressing an important issue in the monetary-theoretic debates of his time. For Mises, perhaps the even more important implication of his regression theorem was his ability, with the use of this theorem, to integrate die theory of the value of money into the main body of value theory as developed by the subjective economics of the Austrian School.

Mises'Regression Theorem

Mises' solution to the circularity problem proceeded by distinguishing sharply between (a) the purchasing power of money as it enters into the marginal utility considerations of prospective demandera of money, and (b) die purchasing power of money (emerging out of the marginal-utility-driven choices of such prospective demanders) that we are seeking to explain. The circularity problem exists only if one fails to recognize this distinction (so that a marginal utility explanation of the purchasing power of money would appear to involve a circularity). "The difficulty is, however, merely apparent. The purchasing power which we explain...is not the same purchasing power the height of which determines...demand. The problem is...the determination of the purchasing power of the immediate future For the solution of this problem we refer to the purchasing power of the immediate past These are two distinct magnitudes. It is erroneous to object to our theorem...that it moves in a vicious cirde" (ha, 408 f).

The purchasing power that informs the decisions of potential individual demanders of money is the purchasing power that they expect to reside in units of money that they may acquire. Mises postulated that this expected purchasing power will generally be assumed to be what it has in fact been in the immediate past. As a result of the interaction between innumerable individual market participants, each basing his marginal utility calculations on the past purchasing power of money, the market generates—at each moment—a new market value for money—that is, a new purchasing power of money, which may well be (but of course need not be) at a different level than that of the past purchasing power which informed the individual calculations.

Mises recognized, of course, that this seems to push us back into an endless historical regression. Each days purchasing power of money is determined, it would seem, by that of the preceding day. This would seem to be an endless sequence of "explanations,'' and thus a sequence unable to provide us with an independent starting point to serve as an explanatory element. But Mises maintained that this historical regression was not endless. Building on Menger's theory of how the institution of money can be understood to have emerged spontaneously out of prehistoric barter markets (tmc, 30-34), Mises points out that the historical regression which he has outlined for us need (and can) proceed back only to die moment when the mon etary commodity first came to be valued, to some extent at least, as a common medium of exchange. Up until that point in time the market value of this commodity was determined entirely by marginal utility considerations that did not include (and were thus entirely independent of) purchasing power considerations. "At this point yesterday's exchange value is exclusively determined by the non-monetary...demand which is displayed only by those who want to use this good for other employments than that of a medium of exchange" (ha, 409).

Mises had thus succeeded in using the Austrian School's marginal utility theory of value to explain the determination of the value of money. And it is here that Mises found a place for what he considered the kernel of truth in the Quantity Theory of the value of money. "[T]he idea that a connexion exists between the variations in the value of money on the one hand and variations in die relations between the demand for money and the supply of it on the other hand,...constitutes the core of truth in the [Quantity] theory..." (tmc, 130). His main objections to the more mechanical versions of the Quantity Theory were closely related to his objections to widespread views concerning the desirability and possibility of "neutral" money.

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