Most economists are in agree­ment t

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

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

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

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

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

The Origin of Money Value

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

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

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

On Demand and Supply

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

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

Variation on the Side of Goods

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

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

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

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

Factors on the Side of Money

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

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

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