20

Monetary theory

deficient or excessive or just right? Rather it is: what determines whether or

not the market process of exchange and coordination in an economy of decentralized decisionmaking works smoothly? Or, how can monetary disequilibrium
impede exchanges of goods against goods, the mobilization of scattered
knowledge, and the coordination of decentralized activities?
These questions have policy implications. The question about aggregate
demand invites attempts to fine-tune the macroeconomy. Questions about
exchange and coordination direct attention, instead, to what background of
economic institutions and policies can best help market processes work. For
money is potentially a loose joint (Hayek, 1941, p. 408) between decisions
to produce and sell things on the one hand and decisions to buy things on the
other hand. Elaborating on this point will occupy us at length in this book.
The close affinity between the goods-against-goods approach and moneysupply-and-demand analysis is represented by the long dashed line in Figure 1.2.
Goods exchange against goods through the intermediary of money, and whether
or not moneys supply and demand are in equilibrium has much to do with
whether this exchange proceeds smoothly or meets obstacles. Focusing on the
monetary lubricant invites attention to a familiar but nevertheless momentous
fact. Money as the medium of exchange is the one thing routinely traded on all
markets, yet its supply and demand do not confront each other on one particular
market and are not equilibrated with each other through adjustment of one
particular price. This circumstance helps explain how monetary disequilibrium
can produce painful consequences that last months and even years. The implications of this circumstance require much attention.
Keynes believed in real obstacles to reaching full employment, real obstacles
to fully filling a supposed saving gap with investment, obstacles more serious
for rich than poor communities. He saw a deep-seated real problem of deficiency
of demand and did not interpret the problem as a merely monetary disorder.13
Yet Says Law expresses a profound truth: no real obstacles bar achieving
sufficient demand for output as long as nothing else impairs the process of
exchange. Says Law goes wrong in neglecting the full implications of the fact
that some outputs constitute demand for other outputs not directly but only
through the intermediary of money.

NOTES
1. Friedman (1993) provides empirical evidence supporting the plucking model. In a much-cited
article on asymmetry, Cover (1992) finds that negative money supply shocks have a greater
effect on output than positive shocks. Kim and Nelson (1999) formally test Friedmans model.
Their results support it and find no role for symmetric cycles.
2. Some new Keynesian economists conceive of long-run hysteresis effects in which potential
output itself would change following a major shock to the economy.

Money in macroeconomics

21

3. The translation test is so named in a broader context by Flew (1971, p. 359), who quotes
Thomas Hobbess advocacy of it in Leviathan, Chapters 8 and 46.
4. Strictly speaking, k is not precisely the reciprocal of V. As becomes clear from the text that
follows, k pertains to money at an instant of time, V to money over an interval of time.
5. Chapter 3 presents the Wicksell Process and the closely related fundamental proposition of
monetary theory. The latter presupposes a closed economy or one with a freely floating
exchange rate. Things are different, as explained in Chapters 3 and 9, in an economy open to
international transactions at a fixed exchange rate.
6. Here and elsewhere, confronting errors can be an expository device. The purpose is not simply
to flog dead horses, blow down straw men, or discredit other economists. Errors can be instructive by revealing points requiring clearer or fuller exposition and by making the correct
doctrines stand out in contrast.
7. The words in brackets are not Tobins but Meiers.
8. We realize that velocity became unstable for a period in the 1970s and then from the early
1980s onward. Chapter 2 investigates these phenomena.
9. Hicks (1935 [1967]) recognizes the subjective nature of money demand. Indeed, he argues
(p. 63) that money must have a marginal utility. However, he later (1967, especially pp. 14,
16) repudiates that analysis and argues that no transactions demand for money could be
analyzed with marginal utility theory. However, he does recognize a subjective precautionary and speculative demand for money.
10. Fisher (1911, 1922) pays predominant attention to mechanical determinants of velocity of
the sorts mentioned in the text, but he does not deny or ignore the subjective determinants,
as is evident from his surveys among Yale students and professors (1922, pp. 37982).
11. See references to Kuenne and Schumpeter on pages 2630 below. Chapter 2 elaborates on this
paragraph.
12. The words in brackets were a footnote. Clark Warburton in an unpublished book-length
manuscript argues that this passage does not fully describe Says view. Warburton quotes
other passages in which, according to his interpretation, Say recognizes that money can have
an important influence on business conditions.
13. For documentation, see Yeager (1973, 1985, 1986, 1988, 1991 [1997]).

2. The services of money

INTRODUCTION
This chapter investigates (1) how money promotes economic coordination; (2)
how ill-functioning money can impair coordination and (3) what services individuals derive from their holdings of money. The third topic is fundamental to
understanding the demand for money and to the money-supply-and-demand
analysis of total spending.

THE SERVICES AND FUNCTIONS OF MONEY

We gain insight into the damage monetary disorder does by reviewing what
services a well functioning monetary system renders to the community as a whole.
The traditional list includes moneys functions as: (1) medium of exchange; (2)
unit of account; (3) store of value and (4) standard of deferred payments.
Money overcomes the familiar difficulties of barter. It facilitates exchange
not only between people working in different lines of production but also over
time. By using money and claims denominated in it, people can arrange to
receive what other people produce either before or after delivering their own
outputs. Because people receive their incomes in generalized purchasing power
rather than in the specific goods they help to produce, they enjoy enhanced
freedom of choice and greater consumer sovereignty. Because money can be
stored more cheaply than the goods received as income under barter, consumers
have wider options about when as well as what to consume. By facilitating
exchange over time, money promotes the pooling and mobilization of savings
through financial intermediation and the securities markets. It thereby promotes
construction of capital-intensive and specialized production facilities, which,
like the division of labor, enhances productivity.
In our existing system, money is not only the medium of exchange but also
the unit of account. It reduces the number of value ratios to be considered. A
barter economy with n goods and services would have n (n 1)/2 ratios to
consider; money reduces the number to just n prices. Money as the measure of
value facilitates economic calculation and informed choices. The benefits
expected from various goods and the costs of acquiring or producing them can
22

The services of money

23

be estimated in money. Contributions of inputs to the value of various kinds of

output can similarly be estimated and compared. Accounting in terms of money
is almost essential to budgetary control in business firms and other organizations. Higher-level executives can apply profit-and-loss tests to their
subordinates in lieu of detailed bureaucratic supervision. In a way loosely
similar to business budgeting, consumers can also compare costs and benefits.
When the consumer compares the desirability of a contemplated purchase with
its price in money, he is at least subconsciously weighing the item against other
things known from experience to be obtainable for a similar sum of money.1
(Inflation hastens the obsolescence of this sort of information.) Efficient
allocation of resources and patterning of production would hardly be possible
in a highly developed economy unless firms had a unit available in which to
measure and compare revenues, costs and profits and unless firms, workers,
resource-owners and consumers had such a unit for comparing alternative
opportunities to buy and sell.
Money is almost essential to the signals with which a price system operates.
The price system permits decentralized decisionmaking decisions by the
man on the spot yet coordinates these decisions by conveying to each decisionmaker, in the form of prices, information about conditions in other parts of
the economy, together with incentives to take those conditions into account.
The decisionmaker does not need to know the details of those other conditions.
This is the message of F.A. Hayek (1945).
Supply and demand can rule markets more readily and traders can more
straightforwardly compare the terms offered by rival prospective trading
partners, which sharpens competition, when prices are quoted and payments
made in a homogeneous thing money. Money provides not only an economical
but also an impersonal mechanism for keeping track of and for balancing the
values of what each person (and his property) contributes to and draws from the
flows of goods and services throughout society. This point refers either to a
persons own productive contribution or to the contributions of other people
who have transferred to him, perhaps by gift, some of the entitlements received
for their own contributions. Here we are merely describing the process of
matching withdrawals and contributions and are not now judging whether
people ought to receive income in accordance with the marginal productivities
of themselves and their property.
With money, ties of personal interdependence are fewer and looser than in
a barter world, and the scope for extraneous personal discrimination is narrower.
With the clear-cut motive of profit in money at work, each consumers dollar
is as good as anyone elses. Money, especially hand-to-hand currency, also
contributes to anonymity and privacy. Pondering roughly the opposite arrangements helps make this last point clear. (See a review by Darby, 1973, pp.
87071, of a book whose author advocated replacing cash by one centralized

24

Monetary theory

credit card system, enabling the authorities to monitor all transactions, legal
as well as criminal.)
In short, money promotes efficient production responsive to peoples wants.
It does so by facilitating all of these: exchange and fine-grained specialization
in production; the credit system, financial markets and real capital formation;
the transmission and use of knowledge; and economic calculation and informed
choice through comparisons of revenues and expenses, of prospective profits
in different lines and scales of production, of costs and expected satisfactions,
and of the offers of rival potential trading partners. By helping make markets
work smoothly, money fosters impersonal cooperation among people unknown
to each other; it contributes to anonymity and privacy and so even to freedom.
To summarize in another way, money helps markets work by cutting transactions costs and information costs and requirements of many kinds (compare
Brunner and Meltzer, 1971 and Alchian, 1977). In indirect barter, for example,
information would be necessary about the qualities, values and marketability
of the intermediate goods that one accepted in exchange in hopes of being able
to trade them away for the goods really wanted. Using money as the universal
intermediate good avoids these extra information requirements and costs. These
cost and information aspects of money are reflected in the traditional list of
desirable characteristics of an ideal money material: portability, durability,
homogeneity, cognizability, divisibility and stability of value.
Moneys functions as store of value and standard of deferred payments seem
less fundamental than the first two, deriving from them. Many physical and
financial assets are stores of value, not just money, and money is not a good
store of value in times of inflation. Money could not serve as a medium of
exchange unless it could be stored between transactions. Being a standard of
deferred payments the unit in which debts and payments in long-term
contracts, such as leases, are expressed is part of the unit-of-account function.
The services of money to society as a whole, notably as an aid to economic
calculation, are emphasized by considering how inflation and other monetary
disorders undercut them.

THE ORIGIN OF MONEY

Considering how money probably evolved in the first place gives further
insight into its services (Menger 1871 [1981], Chapter VIII and Appendix J;
1892; compare George 1898 [1941], Book V). Mengers theory describes a
process that also characterizes the unplanned evolution of other social institutions such as language, the common law and the market economy itself.
Money and these other institutions are examples of what Hayek (1967, Chapter
6, following Ferguson, 1767, p. 187) has called the results of human action