Money and Its Purchasing Power

foundationsofeconomicsIn Chapter 12 of Foundations of Economics, Shawn Ritenour inally gives us a detailed discussion of “what makes the world go round.” For something that is universally used, it seems as though the understanding of money in our society is pretty poor, so I thought this was a very valuable chapter.

Early on Ritenour explains the often-used phrase “purchasing power of money” (PPM). Just as the price of a good is expressed in how much money it takes to buy it, money’s purchasing power is expressed is how much of a particular good a unit of money will buy. For example, if gasoline is $4.00 per gallon, the purchasing power of a dollar is 1/4 gallon of gasoline. The PPM is determined by two things: the quantity of money in circulation, and the demand for money (or the demand to hold money in cash balances). As the quantity of money in circulation increases (inflation), the PPM falls ceteris paribus, and prices increase. As the demand for money increases, so does the PPM because money is withheld from circulation in people’s cash balances. In a free market, the PPM will be determined by supply and demand in the same fashion as every other good or service.

Marginal utility and the other laws of human action apply to money just as much as they do to other things. This insight is one thing that distinguishes the Austrian school of economics from the mainstream, which often attempts to treat money as a “king’s X” to which ordinary economic laws don’t apply.

Of course, money is unique in that it has no use subjective value as money apart from its exchange value. No one will want it if they don’t believe they can exchange it for other things. How then did money acquire its exchange value in the first place? Here Ritenour explains the regression theorem of Ludwig von Mises. Mises demonstrated that we must factor in the time component of the value of money; there must have been a point in time where money was valued for its use, and this usefulness is what gave rise to its exchange value. In other words, money could not have originated by fiat; it must have been a commodity valuable in its own right.

Ritenour also explains how the stock of money in society can increase. Here he explains the nature of fractional-reserve banking and how banks engage in the practice of allowing multiple claims to exist for each unit of money they hold in their vaults. These claims (in the form of bank notes or checking accounts) circulate as money themselves and thus increase the quantity of money in circulation.

My discussion of this chapter hasn’t been as detailed as most of my other summaries have been; my excuse is that I am putting in a prodigious amount of work this weekend to get a couple of online courses ready to roll out next week. Still there’s more to come; I must finish this book in the next ten days!

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About Dr. J

I am an Associate Professor and head of the Department of Humanities at Faulkner University. I am also Associate Editor of the Journal of Faith and the Academy.
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2 Responses to Money and Its Purchasing Power

  1. Rick says:

    Dr. J, I am participant at liberty classroom, where I both enjoy and appreciate your work.
    Question: Didn’t the PPM of the dollar rise about 3 percent from about 1800 to about 1900 as commodity based money as compared with about a 96 percent decline in PPM from 1913 or 1933 to 2012 as as a debt based fiat money? Shouldn’t it be obvious that this benefits only those who create the money at interest?

    Thanks,
    Rick

    • Dr. J says:

      Hi, Rick. I don’t have the precise figures at hand, but yours sound about right. As Rothbard argued, in a free market the PPM ought to increase gradually over time as productivity increases ceteris paribus. So we should not be surprised to see it rise in the 19th century under a gold standard and fall dramatically since we left that standard (1913, 1933, or 1971, depending on how you count it). I agree that it should be obvious to anyone informed on the issue that the fiat standard has been a bad deal for ordinary people. You can look forward to more posts on this topic as I get deeper into the “Reading Economic Project” I’ve outlined on the blog here.

      Thanks for your comment and your involvement with Liberty Classroom!

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