Front Page Titles (by Subject) CHAPTER 3: COMMODITY MONEY AND THE QUANTITY THEORY - Economics, vol. 2: Modern Economic Problems
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CHAPTER 3: COMMODITY MONEY AND THE QUANTITY THEORY - Frank A. Fetter, Economics, vol. 2: Modern Economic Problems 
Economics, vol. 2: Modern Economic Problems, 2nd edition, revised (New York: The Century Co., 1923).
Part of: Economics, 2 vols.
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COMMODITY MONEY AND THE QUANTITY THEORY
§ 1. Coinage and seigniorage. § 2. Technical features of coinage. § 3. Coined commodity money. § 4. Concept of the individual monetary demand. § 5. Factors influencing individual monetary demand. § 6. Concept of the community’s monetary demand. § 7. Quantity of money and prices. § 8. The quantity theory of money. § 9. Interpretation of the quantity theory. § 10. Practical application of the quantity theory.
§ 1. Coinage and seigniorage. Very early it became the practice of governments to shape and stamp pieces of metal to be used as money, so as to indicate their weight and fineness. The act of shaping and marking metal for this purpose is called coinage.1 The coinage by government had notable advantages in giving to the monetary units uniformity of size, fineness, and value, with the stamp that was readily recognized. But in its simplest form coinage in no way changed the value of the money, and any other mark equally plain put upon it would have served equally well, if only it had carried with it equal assurance of the quality and weight of the metal.
Coinage, as practised by early governments and rulers, came to be a function of great importance politically as well as economically. The right to issue money came to be one of the most essential prerogatives of sovereignty. The prince, king, or emperor stamped his own device or portrait upon the coin; hence the term seigniorage from seignior (meaning lord or ruler). Seigniorage meant primarily the right the ruler, or the estate, has to charge for coinage, and hence it has come to mean also the charge made for coinage, and often, in a still broader sense, the profit made by the government in issuing any kind of money with a value higher than that of the materials (whether metal or paper) composing it. Coinage is rarely without charge, and often has been a source of revenue to the ruler. In antiquity and in the Middle Ages this right was frequently exercised by princes for their selfish advantage to the injury and unsettling of trade. This introduced a very great problem of value into the use of money.
The coinage is said to be gratuitous when no charge is made for coinage. Coinage is said to be free if the subject or citizen may take bullion to the mint whenever he pleases, paying the usual seigniorage. Coinage is limited if the government or ruler determines when coinage is to take place. Thus, coinage may be both free and gratuitous, when citizens are allowed to bring bullion whenever they please and have it converted into coins without charge or deduction. But coinage is free without being gratuitous when any citizen may bring metal to the mint, whenever he chooses, to be coined subject to the seigniorage charge.
§ 2. Technical features of coinage. For each kind of metal money there is an established ratio of fineness for the more precious material, which is mixed with baser metals used as alloys. In the United States all gold and silver coins are made nine tenths fine; in Great Britain, eleven twelfths. The established weight of the gold dollar in the United States is 25.8 grains of standard gold which contain 23.22 grains of fine gold. The limit of tolerance is the variation either above or below the standard weight or fineness that a coin is allowed to have when it leaves the mint. This is different for each of the principal coins, being about one fifth of one per cent on a gold eagle. The par of exchange between standard coins of different countries is the expression of the ratio of fine metal in them. Thus the par of exchange between the American dollar and the English sovereign (the “pound”) is 4.866; that is, that number of dollars contains the same amount of fine gold as an English gold sovereign. The embossed design is to make the coins easily recognizable and difficult to counterfeit; and milled or lettered edges are to prevent clipping and otherwise abstracting metal from coins.
§ 3. Coined commodity money. When coinage is free and gratuitous the standard money is a commodity. Such coinage is essentially but the stamp and certificate that the coin contains a certain weight and fineness of metal. Where coinage is free and gratuitous2 each coin will be worth the same as the bullion that is in it, as far as the citizens exercise their choice. They will not long keep uncoined metal in their possession when it is worth more in the form of money, nor will they long keep money from the melting-pot when it is worth more as bullion. Yet there may be a slight disparity between the bullion value and the monetary value before the metal is converted into coin or the coin melted down into metal.
Let us take a case where gold is in general use as money, and where for some time there has been no noticeable change in the amount of business and in methods of trade. What would happen when new gold-mines were found that were much easier to operate, and gold began to be produced at a much more rapid rate than formerly? The amount of gold as compared with other forms of wealth evidently would be increased. If all the increased amount went into the industrial arts, the value of gold in its industrial uses would fall below its value in monetary uses. Then a part of the increased amount must be diverted to monetary uses. When any man, by reason of the increasing gold supplies, gets a larger stock of money than he had before, the proportion formerly existing between his use for money and his monetary stock is altered. He has more money than meets his monetary demand at the existing prices. As he seeks to reduce his stock of money to due proportions by buying more goods, he thereby distributes a part of the excess of money to others. This bids up the price of goods further until the total value of goods exchanged again bears the same ratio as before to the average monetary demand of each individual.
§ 4. Concept of the individual monetary demand. Let us now seek to get in mind the idea of an individual monetary demand, as that amount of money which at any time is required by an individual to make his purchases in expending his income. Every man may be thought of as having an average monetary demand, or his average individual cash reserve, throughout a period. A man with a salary of $50 a month paid monthly has ordinarily a maximum monetary demand of $50. If his expenditures are made in two equal parts, the one on pay-day, the other thirty days later, his average monetary demand during the month is a little over $25. If most of his purchasing is done in the first week of the month, his average monetary demand may be perhaps $10. Many a workman purchases on credit, running accounts at the stores for a month. Then on pay-day he spends his entire month’s wages the day he receives it, and goes without money for the rest of the month. His average monetary demand throughout the month would then be about equal to one day’s wages. Evidently any person’s cash reserve may be expressed as that proportion of his income that is to him of more value retained in money form for any period than if at once expended.
Every moment beyond the average time that any one keeps money increases his monetary demand. If he delays a day, a week, or a month in spending the money, waiting until he can buy in some other market or until a better time to buy, he thus increases insomuch the amount of money needed to make the trade (on that scale of prices). It requires more slow dollars than swift dollars to make a given volume of purchases.
§ 5. Factors influencing individual monetary demand. In this conception of the individual monetary demand must, however, be included not merely the demands of retail purchasers, made by themselves, but also those of all agencies, such as merchants, bankers, and transportation companies, serving the needs of ultimate consumers of goods. The use of money may be necessary several times before a commodity completes its journey from producer to consumer.
Of two persons whose expenditures of money are of the same kind and made at the same rate, the one having the larger amount of purchases to make has the larger monetary demand. But the amount of purchases does not always vary directly with the amount of real income;3 for example, a farmer and a village mechanic may have at their disposal incomes equal in the quantities of goods, such as food, fuel, clothing, and house-uses (worth, let us say, $1000 for each), but the farmer would be getting a larger part of his goods directly from his farm and by his own labor, while the mechanic would be getting first a money income to be expended afterward for food, clothing, and rent. The mechanic would in this case have an average monetary demand much larger than the farmer.
We see thus that the individual monetary demand at any time is that amount of money which rests in his possession as the necessary condition to making his purchases as he desires. Individual monetary demand varies in proportion directly to the delay, and inversely to the rapidity with which the individual passes the money on; and directly to the amount of the person’s income that is received and expended in monetary form.
§ 6. Concept of the community’s monetary demand. The monetary demand of a community at a given time is the sum of the monetary demands of the various individuals and enterprises. It is that stock of money which is necessarily present to effect the exchanges of the community in the prevailing manner at any given level of prices. A single dollar as it circulates helps to supply the monetary demand of many individuals in turn: the more quickly each person spends the piece of money he receives, the greater its rapidity of circulation. Let us suppose that every piece of money passed from one person to another once each day. Then a dollar would, in the course of a business year (about 300 days), serve to buy (and at the same time to sell) $300 worth of goods. If the average purchases of each individual amounted to $1000 a year, the average monetary demand of each would be about $3.33⅓.
The times of maximum monetary demand of the different individuals do not coincide; often they alternate with each other, and the community’s total monetary demand at a given time is a composite of the many individual variations. The amount of money that will remain in circulation in a community depends on several factors, the chief among them being the amount of goods to exchange, the methods of exchange, and the value of the commodity material in other uses. The amount of goods to be exchanged may change even when the amount produced is unaltered (e. g., a change from agricultural to industrial conditions). The methods of exchange may alter so as to require either more money (e. g., cash instead of credit business) or less money (e. g., use of bank checks displacing use of money by individuals). Or, apart from the other factors, the scale of prices may change as the conditions of commodity money production are altered.
§ 7. Quantity of money and prices. Consider the effect of a large and rapid increase in the production of gold in a community where the gold dollar is the standard commodity money. At first some few men, the miners, may have far more dollars than before, while most men have nearly the same number as before. But those nearest the miners and selling to them will get more dollars, which they will pass on to others, and thus, in ever-widening circles, the increased supply of gold will spread until a new equilibrium of the monetary value is attained, when every one will have got his due proportion of the new supplies. If the number of dollars has been doubled, every one will, in the long run, and “other things being equal,” have twice as many dollars as before.
Now, prices of goods cannot remain the same as before; for if they did there would be twice as many pieces of money available to effect the same number of trades at the same prices. There is no reason why each person should tie up twice as large a proportion of his income in the form of money. If, however, there is a concerted movement to spend the surplus money, there results a general bidding down of the value of money, a general bidding up of the prices of goods and of services. At what point will this movement stop? The rational conclusion must be that, other things being equal, the new equilibrium will be established when the ratio between the value of money and the price of the goods that each individual is purchasing becomes the same as before. The money in a community being doubled, prices must be doubled, and proportionally for any other change in the quantity.
§ 8. The quantity theory of money. This explanation of the effect of changes in the quantity of money in a country upon prices (the general scale of prices) is known as the quantity theory of money. This theory has, for a century, been very generally accepted by competent students of the money problem. It may be summed up thus: other things being equal, the value of the monetary unit, expressed in terms of all other commodities, falls as the quantity of money increases, and vice versa. That is, prices rise and fall in direct proportion to changes in the total quantity. This is a simple explanation of a complex and difficult set of conditions. The phrase, “other things being equal,” betokens the statement of a tendency where there are several factors. The quantity theory explains what happens when there is a change in one of the factors—the number of pieces of money. There are three large sets of facts to be brought into relationship with each other in the quantity theory: (1) the amount of business, or the number of trades effected; (2) the rapidity of circulation, depending on the methods by which business is done; (3) the amount of money available. According to the quantity theory, we must expect that, when conditions (1) and (2) remain fixed, prices (the general price level) will vary directly, and the value of money will vary inversely as the quantity of money. This quantity theory may be expressed in the formula P = when P is the symbol for price, or the general price level, N is (1) above, R is (2), and M is (3). P, therefore, changes directly with either M or R, or inversely with N.4
§ 9. Interpretation of the quantity theory. The quantity theory must be carefully interpreted to avoid various misunderstandings of it that have appeared again and again in economic discussion.
(1) It does not mean that the price level changes with the absolute quantity of money, independently of growth of population and of the corresponding growth in the volume of exchanges.
(2) It is not a mere per capita rule to be applied at a certain moment to different countries. For example, Mexico may have $9 per capita and the United States $35, while average prices may not differ in anything like that proportion. But in these two countries not only the amounts of exchanges per capita but the methods of exchange and the rapidity of the circulation of money differ greatly.5
(3) It cannot be applied as a per capita rule to the same country through a series of years, without taking account of the many changing factors. It is estimated that in 1800 the money stock was about $5 per capita in the United States, and in 1914 about $356 but average prices have not necessarily changed in the same ratio. In a period of years a country may change in a multitude of ways, in complexity of industry, modes of exchange, transportation, wealth, and income. These changes require some larger, others smaller, per capita amounts of money to maintain the same level of prices. For example, the substitution of cash payments for book-credit in retail trade is equivalent to increasing N in the formula; whereas an increased use of banks and checking accounts, by economizing the use of money, enables a smaller amount of money to maintain the same level, and may be considered as increasing R in the formula.7
(4) Tho applied originally to standard money, the quantity theory applies to all other kinds of money circulating side by side and at a parity of value, as far as these fulfil the definition of money and are not merely supplementary aids to money. These supplementary forms of money enable each standard dollar to do more work, to circulate more rapidly. If the standard money alone were doubled in quantity, while the various forms of fiduciary money (smaller coins, banknotes, government notes) remained unchanged, the quantity of money as a whole would not be doubled. Indeed, in such a case the method of exchange would be greatly altered. According to the quantity theory, therefore, prices would not be expected to double.
§ 10. Practical application of the quantity theory. Despite the number of changing factors affecting the methods of exchange and the amount of business, the quantity theory is a rule usable at any moment. These various factors change slowly, and the quantity theory answers the question: What general change occurs in prices as a result of the increase or decrease of the money in a given community at a given moment? Like the law of gravitation and the law of projectiles, the theory must be interpreted with relation to actual conditions.
The quantity theory makes intelligible the great and rapid changes in prices which have followed sudden changes in the quantity of money. Inductive demonstration of broadly stated economic principles is usually difficult, but there have been many “monetary experiments” to teach their lessons. Many inflations and contractions of the circulating medium have occurred, now in a single country, again in the whole world; and the local or general results have helped to exemplify richly the working of the quantity principle. With the scanty yield of silver- and gold-mines during the Middle Ages, prices were low. After the discovery of America, especially in the sixteenth century, quantities of silver flowed into Europe. The great rise of prices that occurred was explained by the keenest thinkers of that day along the essential lines of the quantity theory, tho there were many monetary fallacies current at that time. The experience in England during the Napoleonic wars, when the money of England was inflated (by the forced issue of large amounts of banknotes) and prices rose above those of the Continent, led to the modern formulation of the theory of Ricardo and others about 1810. The discovery of gold in California and Australia in 1848-50 greatly increased the gold supply, and gold prices rose throughout the world. Between 1870 and 1890 the production of gold fell off while its use as money increased greatly, and prices fell. A great increase of gold production has occurred in the period since 1890. The wave-like movements of prices since 1897 are explicable as the periodic up and down swings of confidence and credit, but in the main the general trend upward has been due to the stimulus of increasing gold supplies.8 These are but a few of many instances in monetary history, which, taken together, make an argument of probability in favor of the quantity theory so strong as to constitute practically an inductive proof.
[1 ]From the French coin, in turn from Latin cuneus, wedge, suggestive either of an earlier wedge-shaped piece, or of a wedge-shaped mark on the piece. The German word Münze is from the Latin moneta (as is the English mint, the place where coins are made), which meant money, that name being taken from the temple Juno, called Moneta, where coins are made.
[2 ]This means actually gratuitous, for any real difficulty in getting metal to or from the mint operates as a cost in the conversion of bullion into money, or vice versa; e.g., the gold may be in Australia and the mint in London.
[3 ]See on kinds of income, Vol. I, p. 26 ff.
[4 ]This formula is presented by E. W. Kemmerer in “Money and Prices” (2d ed., 1909), p. 15 ff.
[5 ]See table in ch. 2, § 7.
[7 ]On the function of deposits see ch. 7, § 11.
[8 ]Consult Figures 1 and 2 in chapter 5 for the graphic presentation of these and related facts.