Broken Capitalism, Lecture 5

David GordonMises Academy

July 15, 2013

Money and Wealth

• Money is different from other goods and services.

• Imagine that wasn’t any money. We are living in a barter economy. If I want something that I haven’t produced, I have to trade to get it.

• What I own has two kinds of value: its direct use to me and how much other people want it.

More Money?

• Money in a free market is a commodity, like gold and silver.

• It has some direct use as a commodity. E.g., gold is used for jewelry.

• Almost all of the value of money is its exchange value. If you have money, how much of other goods can you get for it?

Still More Money

• How much is a unit of money worth? This depends on its purchasing power, i.e., what you can buy with it.

• Is it true that the more units of money you have, e.g. more dollars, the better off you are?

• Not necessarily. It depends how much each dollar is worth.

The Value Of Money

• What determines the value of a dollar?• Just like other goods, the value depends on

demand and supply.• The supply consists of the number of

monetary units. • The demand depends on how much people

want to hold money

Value of Money Continued

• Suppose that people don’t want to increase their holding of money. If the number of money units goes up, the purchasing power of money will decrease.

• Each dollar will buy less.

Optimal Amount of Money

• Any amount of money is sufficient to perform the services of money in the free market.

• With a given stock of money, people can satisfy whatever demand they have to hold money. Purchasing power will adjust to changes in demand.

• It is not true that as the economy grows, more units of money have to be issued.

More Optimal

• One way to express this point is that any amount of money is optimal.

• This statement can be misunderstood.• The correct reading is the one we have already

discussed: any amount of money is sufficient.• The incorrect reading is: If x is the amount of

money at time t, then any change in x is sub-optimal, so long as demand to hold money stays the same.

Inflation

• People very often don’t realize that an increase in the supply of money doesn’t make everybody better off.

• Many economic cranks think that making money or credit more readily available will result in prosperity.

• Hazlitt mentions the Social Credit movement as an example.

Effects of Inflation

• You might think from what we have said so far than increasing the supply of money wouldn’t have any effect, so long as the demand to hold money hasn’t changed.

• Suppose all prices, wages, etc., instantly doubled. What would change?

• The Austrians define inflation as an increase in the money supply, rather than the price rise that often accompanies this rise.

Effects Continued

• In most cases, inflation does have effects.• When the state increases the supply of

money, the money usually doesn’t get to everybody at the same time.

• Suppose the state increases purchases of armaments and finances this by printing money. Then, the armaments makers have the money to spend.

Spreading Money

• When they spend their money, this will drive up the prices of what they spend it on.

• The makers of these products will have new money to spend. This will in turn drive up the prices of other goods.

• Price increases will gradually spread through the economy.

Cantillon Effects

• In the initial stages of the spread of money, people will have extra money but most prices haven’t risen yet.

• People in the initial stages thus benefit from the increase.

• Those in the later stages find that prices rise before they get more money. They lose out.

More Cantillon

• The way in which an increase in the money supply spreads through the economy is called Cantillon effects. These were named after the 18th century economist Richard Cantillon.

• The relation between an increase in the money supply and price rises has to be traced in detail.

Quantity of Money

• There isn’t a mechanical relation between an increase in the quantity of money and an increase in prices.

• E.g., it isn’t the case that doubling the supply of money automatically doubles the money supply.

Bank Credit Expansion

• One kind of inflation is important for the business cycle. This is an expansion of bank credit.

• The expansion of bank credit lowers the rate of interest on loans.

Rate of Interest

• In the Austrian view, the rate of interest is not primarily determined by the demand and supply of money.

• Rather, interest depends on time preference.• This is the rate at which people prefer present

satisfactions to equivalent future satisfactions.

Interest and Production

• In the economy, some resources are devoted to making consumption goods, i.e., goods that people directly use.

• Other resources are devoted to making production goods. These are goods used to produce other goods.

• We also have goods that are used to produce goods that are used to produce these production goods, etc.

Interest and Production Continued

• In other words, we have different stages of production. A stage depends on how many steps it takes to get to consumer goods.

• What determines how resources are distributed among the stages of production and also how many stages there are?

• The answer is the rate of time preference. Because people prefer goods in the present to goods in the future, the structure of production will be limited in extent.

Back To Bank Credit

• We can now return to the expansion of bank credit.

• When the bank expands credit, this will lower the money rate of interest.

• Entrepreneurs will be able to invest in higher stages of production than before. Before the credit expansion, investing in these stages wouldn’t have been profitable.

Collapse

• Now the big problem comes up.• The rate of interest is fundamentally

determined by the rate of time preference, not by the supply and demand of loanable funds.

• After the credit expansion stops, the rate of interest will go up again.

More Collapse

• The businesses that expanded will no longer be able to get money to continue their activity.

• These businesses will then collapse. Resources need to be shifted to lower stages of production, to correspond with the rate of time preference.

• This collapse and resource transfer is the depression.