Irving Fisher (1914); Why is Dollar Shrinking: A Study in High Cost of Living; The Macmillan Company, New York
The purchasing power of money, or its reciprocal, the level of prices, depends exclusively on five definite factors: (1) the Volume of Money; (2) its velocity in circulation; (3) the volume of bank deposits subject to check; (4) its velocity; and (5) the volume of trade.
Money is the most exchangeable form of wealth; it can bring uniformity of measurement out of diversity. In other words, it is not only a medium of exchange, but it can be used as a measure of value. However, it is not the only true measure of wealth. In fact, measuring wealth by its monetary value is often misleading.
Property: To own wealth is to have a right to its benefits …. The ultimate object for which wealth exists is the benefits which it confers on its beholder.
Benefits rendered by human beings are usually called services or work done. When rendered by other than persons, benefits are usually called uses.
Opposed to the benefits of wealth are its costs. Cost may be called negative benefits …. For instance, one cannot enjoy the benefits of a dwelling without incurring the cost of taking care of it.
Costs may, of course, be measured just as benefits are measured – by numbers, by time or by other appropriate unit; and costs when thus measured may, by price and value, be translated into terms of money precisely, like the opposite items – benefits.
INTEREST IS NOT ONLY THE PRICE OF MONEY BUT ALSO PRICE IN MONEY.
Purchasing power of money is simply the reciprocal of the general level of prices. To say that prices have doubled is the same thing as to say that the purchasing power of money has been cut in half.
Money is primarily defined as wealth generally acceptable in exchange. This definition may be refined to include all goods generally acceptable in exchange for other goods. The certificates of property rights are also included in this definition of money.
Real money is what a payee accepts without question, because he is induced to do so either by legal tender laws or by a well-established custom or both.
Real money is of two kinds: (1) Primary and Fiduciary, e.g., gold coins are primary money. Fiduciary money, the value of which depends partly or wholly on the owner’s confidence that he can exchange it for primary money, or at any rate for other goods.
The qualities of primary money which make it exchangeable are numerous, including portability, durability, and divisibility. The chief quality of fiduciary money is its redeemability in primary money, or else its imposed character of “legal tender.”
THE QUANTITATIVE THEORY OF MONEY
MV=pQ+p1Q1+ p2Q2+p3Q3+…..etc.
MV = summation of pQ
Where M stands for money in circulation;
V, its velocity of circulation;
P, p1, p2, p3….. the prices of various goods; and
Q, Q1, Q2, Q3 …. the quantities of goods sold
MV=PT (T for trade)
Where P is the average of all p’s and T is the sum of all Q’s, the trading commodities.
The quantity theory of money rests ultimately upon the fundamental peculiarity which many of the goods possess – the fact that it has no definite relation to the satisfaction of human wants, but only the power to purchase things which do have such satisfying power.
So, the certificates or checks would circulate in place of money among various depositors in the bank. What really changes or circulates as ownership in such cases is the deposits, i.e., the rights to draw money. The check is merely certain evidence of this right.
We have a three-fold classification of goods: first, actual money, second, rights to draw money (deposits), and third, all other goods. Among these, then, there are six possible types of exchanges:
(a) Money against money;
(b) Deposits against deposits;
(c) Goods against goods;
(d)Money against deposits;
(e) Money against goods; and
(f) Deposits against goods.
Only the last two types of exchanges constitute the circulation of circulating media.
We shall now use M1 to express the total deposit subject to the transfer of check, and V1 to express the average velocity of their circulation …. The equation of exchange now becomes:
MV+ M1V1= Summation of pQ= PT
A fairly definite ratio is fixed between M and M1. If the ratio is disturbed, temporarily, there will come a tendency to restore it. Individuals will deposit surplus cash, or they will cash surplus deposits. Hence, both money in circulation and money in reserve tend to maintain a fixed ratio to deposits.
SUMMARY
(1) Banks supply two kinds of currency, viz., bank notes – which are money; and bank deposits (right to draw)- which are not money.
(2) A bank check is merely presumptive evidence of a right to draw.
(3) Behind the claims of depositors and note holders stand, not simply the cash reserve, but all the assets of the bank.
(4) Deposit banking is a device by which wealth, incapable of direct circulation, may be made the basis of the circulation of rights to draw.
(5) The basis of such circulating rights to draw or deposits must consist in part of actual money, and it should consist in part also of quick assets readily exchangeable to money.
(6) Six sorts of exchanges exist among the three classes of goods: money, deposits and goods. … The most important for our present purposes are the exchanges of money and deposits against other goods. (\
(7) The extended equation stands
MV+ M1V1= Summation of pQ= PT
(8) Bank deposits (M1) tend to keep a normal ratio to bank reserves and to the quantity of money (M); because, in the first place, ash reserves are necessary to support bank deposits… and in the second place, business convenience dictates that the circulating medium or currency shall be apportioned between deposit and money in a certain more or less definite, even though elastic ratio.
MONEY, PRICE, AND TRADE CYCLE
An increase in the quantity of money will cause a rise in prices. The businessman’s profit will rise much more than the increase in price because many expenses (e.g., payment to creditors, interest on loans, rent, and salaries) will not initially rise. He will be encouraged to expand his business by increasing his borrowings. Deposit currency (M1) will increase in relation to money (M).
This rise in prices culminates in a crisis. An enterprise that is started by borrowing is expected to continue borrowing. But loans become harder to get, and their terms become stricter. There is a lack of cash when and where it is most needed.
The sequence of events is now the opposite:
· Prices fall;
· Profits fall as expenses increase;
· Borrowings of the enterprises are discouraged;
· Deposit currency (M1) contracts relative to money (M);
· Phenomenon (1) repeats; prices further fall
There is a depression of trade (T).
The upward and downward movement taken together constitute a complete trade cycle which resembles forward and backward movement of a pendulum.…In most cases the time occupied by the swing of the commercial pendulum, to and fro, is about ten years.
RATE OF INTEREST
Most people want the rate of interest to be always low, and they blame banks if it rises. But the truth is that the banks are usually to blame for not raising it early enough to prevent the crisis. The crises may be averted by increasing and decreasing the rate of interest. There is a need to remove the existing prejudice against raising the rate of interest. We still inherit the old idea that interest is usury or robbery …. We should get rid of this prejudice.
[It is worth noting that Irving Fisher, the author, had earlier too in his book, The Rate of Interest: Its Nature, Determination and Relation to Economic Phenomenon (1907)], expressed the opinion that the inhibition regarding the rate of interest being a sin is required to be done away with.]
GRESHAM’S LAW
” Bad money drives out good money.”
Irving Fisher restated the law as under:
“The cheaper money tends to drive out the dearer.”
The reason why the cheaper of the two moneys always prevails is that the choice of the use of money rests chiefly with the man who gives it in exchange, not with the man who receives it. The dearer money is hoarded, or it goes into the melting-pot, or goes abroad. Abroad because, where foreign trade is involved, it is the foreigner who receives the money, rather than ourselves giving it, who dictates what kind of money shall be accepted.