CHAPTER II

SUPPLY AND DEMAND, AND THE VALUE OF MONEY

The theory of the value of money is a special case of the general theory of economic value. To the layman, this would seem to go without saying. To the student of the literature of the subject, however, who has noticed the wide divergence between the method of approach to the general problem of value and the method of approach to the problem of the value of money, in most treatises which include both these topics, the proposition will sound unusual if not heretical. Most text-books in English to-day will offer the marginal utility theory as the general theory of value. The same books commonly present the quantity theory of the value of money. Whether or not the two theories are consistent may wait for later discussion, but that the quantity theory of money is a _deduction from_ the utility theory of value, and a _special case_ of the utility theory of value, will not, I believe, be contended by anyone. Certainly in its origin, the quantity theory is much the older theory. The same is true for those writers who seek to explain value in general on the basis of cost of production, and who at the same time offer the quantity theory to explain the value of money. The two theories may or may not be consistent, but in any case, they are logically and historically independent, neither being a deduction from the other. Older writers (as Walker and Mill), whose treatment of the general theory of value runs in terms of "supply and demand," have stated that the quantity theory is merely a special case of the law of supply and demand, and the statement is occasionally met in present-day writings, though one of the most recent and best known of the expositions of the quantity theory, Professor Fisher's _Purchasing Power of Money_, very explicitly repudiates this doctrine.[41] But it may be easily shown, and will be shown later, that the quantity theory, and the present-day formulation of the law of supply and demand, are in no way logically dependent upon each other. This lack of connection between two bodies of doctrine which should be in a most intimate and essential way related to each other, may well throw suspicion on the current treatments of both topics. In any case the lack of connection raises a problem, and calls for explanation.

Part of the explanation may be sought in the fact that the writers who have developed the general theory of value have not been, in general, the writers who have most elaborated the theory of the value of money. The theory of money has been for a long time a more or less isolated discipline. In Ricardo, we have an elaboration of the labor theory of value, and we also have the quantity theory of money. But it is not clear that Ricardo added anything to the quantity theory. He found it, in much the form in which he used it, in the writings of predecessors, among them Locke and Hume. Ricardo makes large use of the quantity theory as a premise, but apparently feels the theory to be so self-evident that it needs little exposition or defence at his hands. John Stuart Mill is a clear exception to the general statement. Cairnes, likewise, did treat both topics in considerable detail, but while his interest in the general theory of value was that of the theorist, his treatment of money was primarily in the spirit of the publicist, and his interest was less in the justification of the theory--which he again seems to feel needs little defence--as in its application. A similar statement may be made with reference to Jevons. He worked out his general theory of value for its own sake; his utterances on the theory of the value of money must be sought scattered through his practical writings on money. Alfred Marshall's _Principles_ (Vol. I) says almost nothing about the theory of money; his opinions on that subject are to be found in some _ex cathedra_ replies to questions from a Parliamentary Commission. The most important discussions in England of the value of money are to be found in the long polemic between the Currency and the Banking Schools, by writers who would not be listed among the makers of the general theory of value. In the United States to-day, with the exceptions of Professors Fisher and Taussig, the writers who have been interested in the general field of economic theory have done comparatively little with the value of money (_e. g._, Professors Clark and Fetter), and the writers who have been most interested in the value of money have usually not written largely on the general theory of value (_e. g._, Professors Laughlin, Scott, Kinley). Professor Kemmerer might well be included as an illustration of this last statement. His primary interest is in money, rather than general theory, even though he does precede his theory of the value of money with an exposition of the utility theory of value. In German, a similar situation obtains. Boehm-Bawerk has touched the theory of money scarcely at all. Menger has written an important article on "Geld" in the _Handwoerterbuch der Staatswissenschaften_, but the important thing about this article is the theory of the origin of money, and the reader will find little on the problem of the value of money. Wieser has recently taken up the value of money (in articles published in 1904 and 1909), but no trace of his views has as yet manifested itself in the English literature on money, and the writer may here express the opinion that Wieser's contributions to the theory of money are not likely to be very influential, or to add to his reputation.[42] Austrian writers on the value of money, as Wieser and von Mises, have recognized more clearly than anyone in America or England, the essential dependence of the theory of the value of money on the general theory of value. The German writer on money who has attracted most attention recently, however, G. F. Knapp, troubles himself about the general theory of value not at all.

But the main explanation of the hiatus between the two bodies of literature and doctrine is to be sought in something more fundamental. Neither utility nor costs nor supply and demand furnishes an adequate basis from which the quantity theory, or any other theory of the value of money can be deduced. The cost theory, and the supply and demand theory, in their present-day formulation, are really not theories of value at all, but are theories of _prices_, theories which presuppose _value_, and _money_, and a _fixed value of money_. And the utility theory, as usually presented, is either a theory of barter relations, or else (more commonly) speedily settles down into the grooves of supply and demand, leaping by means of a confusion of utility curves and demand-curves (or sometimes by a deliberate identification of them, _e. g._, Flux and Taussig[43]) to the treatment of market prices. I shall take up these points in order.

A historical summary of the development of the notions of supply and demand will aid the exposition. It may be noticed, first of all, that supply and demand is really a very superficial formula even though an exceedingly useful one. By virtue of its superficial character, it antagonizes few other theories, and it has been the common property of almost all schools of value theory. Cost theories and utility theories, labor theories, or social value theories, all find use for it, in one form or another. It is really quite neutral and colorless, so far as the ultimate questions of value-causation are concerned. The more fundamental causal factors offered by one theory or another are commonly supposed to operate _through_ supply or demand, in price-determination. Adam Smith seems to see this more clearly than does Ricardo. Ricardo, indeed, sometimes thought of demand and supply as forces antithetical to the forces of labor-costs which he was considering. In ch. xxx of his _Principles of Political Economy and Taxation_ (ed. McCulloch, pp. 232ff.) he holds that his natural value ultimately rules, except (p. 234) in the case of monopolized articles. Supply and demand govern the prices of monopolized articles and of all articles in the short run. I do not find in Ricardo any clear statement to the effect that cost of production operates _through_ influence on supply. Neither Adam Smith nor Ricardo felt the need of very much precision in the definition of supply and demand. Smith does, indeed, distinguish "effectual" from "absolute" demand, in a well-known passage (ed. Cannan, I, p. 58), defining effectual demand as the demand of the effectual demanders, _i. e._, these who are willing to pay the "natural price" of the commodity. The term "supply" he does not use in this passage, but speaks of the "quantity which is actually brought to market," and gives as the law of market price that it is determined by the "proportion" between this quantity and the effectual demand. That much is wanting in this analysis will be sufficiently clear when the views of J. S. Mill and Cairnes are considered. Ricardo offers even less than Smith in the way of definition. The reader may compare the pages in _Ricardo's Works_ cited above, and the discussion of the demand for labor on p. 241 in the same volume.

In J.S. Mill, a clean-cut notion first appears. The doctrine that price is determined by a ratio between effectual demand (_i. e._, the wish to possess combined with the power to purchase) and supply (_i. e._, the quantity available in the market), is sharply criticised. How have a ratio between two things not of the same denomination? "What ratio can there be between a quantity and a desire, or even a desire combined with a power?" To make supply and demand comparable, demand must be defined as "quantity demanded," and then the difficulty arises that the quantity demanded will vary with the price, which seems to present a case of circular reasoning if demand is to be a determinant of price. The solution which Mill develops for this difficulty really gives us our modern conception, virtually complete except that Mill does not present it in the useful diagrammatic form and does not whisper the magic word, "margin." There is a demand-schedule, which, plotted, would give a demand-curve. At such and such prices, such and such quantities are demanded, or will be purchased. There is a supply schedule, presenting a supply situation of similar character (though not so clearly indicated). The price reached is that price which _equalizes_ amount demanded and amount supplied. A higher price will lead to competition among sellers, forcing down the price, a lower price will lead to competition among buyers, forcing up the price. The notion of a _ratio_ between supply and demand is replaced by the notion of an _equation_ between them. The present writer wishes to remark, in this connection, that Boehm-Bawerk's elaborate analysis, with his "marginal pairs," etc., has not advanced one step beyond this conception of Mill's, that it is really less satisfactory than Mill's analysis, because of the impedimenta of pseudo-psychology it has to carry, and because of its confusion of utility schedules with demand schedules.[44] In our present-day expositions, as presented in the diagrams, we are accustomed to say that price is fixed when marginal supply-price and marginal demand-price are equal, putting the stress on the ordinate, rather than on the abscissa, on the identity of the dollars paid or received, rather than on the identity of the goods given or received. But this is merely another way of stating the same equilibrium which Mill perceived--when marginal demand and supply prices are equal, amount supplied and amount demanded will be equal, and conversely.

One point is to be added, making explicit what is implicit in the modern theory of supply and demand. Supply and demand doctrine assumes _money_, and a _fixed value_ of money. That there should be a given schedule of money-prices for varying quantities of a good, is possible only if there be a given value of the money-unit.

That the modern doctrine of supply and demand necessarily involves the assumptions of value, of money, and of a fixed value of money, may be proved by the following considerations:

Supply-situation, represented by the supply-curve, and demand-situation, represented by the demand-curve, are conceived of as antithetical and independent causal forces, whose equilibrium determines both "supply and demand" (in the sense of quantities supplied and demanded) and price. Mill's doctrine that supply and demand determine price gets out of the circle that demand (amount demanded) is itself dependent on price, only by making both demand in this sense and price _results_, rather than causes, and by putting the causation back into the more complex factors which I call "supply-situation" and "demand-situation." The two independent causes, then, are summed up in the supply-curve and the demand-curve. But, first, these curves are expressed in money. And second, a change in the value of money would affect _both_ of them proportionately. But a theory which is concerned with supply and demand as independent and antithetical must abstract from factors which give them a _common_ movement, without modifying their _relation_ to each other. A change in the value of money would lead the supply-curve to move to the right, and the demand-curve to move to the left, the change in each being proportionate, and the amount supplied, and amount demanded, would remain unchanged. Changes in the value of money must, therefore, be abstracted from.

Again, we must precise the notion of an _increase_ in demand, or of supply. Increase in demand may mean mere increase in amount demanded, consequent upon a lower price, consequent, _i. e._, upon a lowering of the supply schedule. In this sense, increase in demand is a passive fact, a result rather than a cause. On the other hand, if the increase in demand is an increase in the amount demanded at the _same_ price, if it means a change in the demand-situation, represented by the moving to the right of the demand-curve, we have a causal factor in increase in demand, a factor which raises the price and compels new supply to come into the market. We may distinguish these two meanings as increase in demand in the active and in the passive senses. _Mutatis mutandis_, we may speak of increase of supply in the active and passive senses. These distinctions have been made before, but it has not been clearly seen that these distinctions, and the connected doctrines, involve the assumption of a fixed value of money. But consider: it is the current doctrine that increase in demand in the active sense, the demanding of a greater amount at the same price, the moving of the demand-curve to the right, not only raises the price, but also tends to _increase the supply_. But this is true only if the _cause_ of the increase in demand is not a cause which simultaneously works on supply, neutralizing that tendency. If the increase in amount demanded at a given price be due to a lowered value of money, then the same lowered value of money will reduce the supply available at that price _pro tanto_, and the new equilibrium, _caeteris paribus_, will be at a higher price, to be sure, but with the same amount supplied and demanded. "Demand" is a term which carries the connotation of motivating power in economic theory. Through demand run the forces which regulate production and supply. The function of increased demand is to induce increased supply. But the value concept, and the assumption of a fixed value of money, are needed to preserve this part of the doctrine. Without them we have no way of distinguishing a _real_ increase in demand in the active sense, which does modify the adjustments in production, and alter the proportions of different supplies, from a _nominal_ increase in demand in the active sense, which merely raises a money-price, without affecting supply.[45]

Another approach will lead to the same conclusion. Demand and supply-curves are not to be understood merely in terms of brute, physical quantities. They are rather curves expressing economic _significances_, manifesting _psychological_ forces which lie behind them. No considerations of mere physical quantity will explain why one demand-curve should be "elastic" and another inelastic,--each curve has its own peculiarities, which are not mechanical in their nature. Demand-curves express the diminishing economic significance of goods as their quantity is increased. How economic significance is to be interpreted need not be argued here. I have elsewhere undertaken to show that the utility theory of value does not explain the economic significance which demand-curves express--that demand-curves are not utility curves. My own theory is that demand-curves are to be explained only in terms of a social psychology, that demand-curves are social-value curves. But my argument at this point does not rest on the particular type of causal theory of value one chooses. It is enough that the demand-curve be recognized as expressing economic significance, and diminishing economic significance.[46] But for the demand-curve to express variation in economic significance of a good, there is need for a unit in which to express that variation. That unit is the economic significance of the dollar, itself assumed to be invariable--as all measures must be assumed to be invariable if measurement is to mean anything. If the unit chosen vary in the course of a given investigation, the curve tells you nothing at all.

Another way of reaching the same conclusion is to say that an increase in demand in the active sense will lead to an increase in supply only if there be no corresponding increase in demand for the alternative employments of the sources of that supply, that, _e. g._, an increased demand for wheat will lead to increased production of wheat only if there be not a corresponding increase in the demands for corn and other crops which can be raised on land and with labor and capital that would otherwise produce wheat. This is only another phase of the argument that went before, that an increase in demand due to a falling value of money would lead to a corresponding shift in the supply-curve. It is not quite the same argument, however, because that was an argument concerned with short run tendencies, resting on the assumption that the holders of supply would immediately react to a change in the value of money, whereas the argument just presented rests on the longer adjustments, based on the law of costs, as worked out by the Austrians. This point will be made clearer in the next chapter.

Yet another, and perhaps simpler, approach to the same conclusion is by pointing out that an individual, deciding to buy, must take account of the prices of other things in his budget--that individual demand-schedules would be different if market prices of other things--which depend on the value of money--were different.

The doctrine that supply and demand (and cost of production, the capitalization theory, and other elements in the current price-analysis) presuppose a fixed value of money, must be sharply distinguished from the doctrine of Professor Fisher (_Purchasing Power of Money_, ch. 8), and others, that a fixed _general price level_ is assumed by supply and demand, etc. I should deny that a fixed general price level is assumed. The point rests in the distinction between value as _absolute_ and value as _relative_. For my theory, it is perfectly possible for the general price level to rise, with the value of money constant, because of a rise in the values of _goods_. In a later chapter, on "The Passiveness of Prices," I shall examine the doctrine of Professor Fisher more closely, and set these two views in clearer contrast. For the present, it is enough to point out one vital difference between a rise in prices due to a fall in the value of money and a rise in prices due to a rise in the values of goods, with the absolute value of money unchanged: in the latter case, there is an increase in the psychological stimulus to industry, an increase in economic power in motivation, which energizes and increases production. In the latter case, especially when the fall in the value of money is rapid, and the rise in prices is clearly due to that cause (as in the case of Confederate paper, or the French _Assignats_), we find a reverse effect on industry. Intermediate cases, where money is falling in value, but where goods are also rising, give us intermediate results.

In what follows, I shall from time to time refer to this distinction. In my own exposition, I shall always use "value of money" in the absolute sense, as distinguished from the mere "reciprocal of the price level,"--a practice which I have sought to justify in the chapter on "Value," and in other places there referred to.[47]

The modern theory of supply and demand, then, assumes money, and a fixed value of money. It is, therefore, obviously unfitted as an instrument to solve the problem of the value of money. If supply and demand concepts are to be applied to this problem, they must be of a different sort. This was pointed out by Cairnes[48] who criticised Mill's formulation, and pointed out that Mill departed from it in three capital doctrines: in the theory of the value of money, in the theory of wages, and in the theory of international values. By the demand for money, Mill means, not the amount of _money_ demanded, but the quantity of goods offered against money--a very different conception. (Mill, _Principles_, Bk. III, ch. viii, par. 2.) In what sense a quantity of goods can equal a quantity of money, or in what sense there can be a ratio between goods and money, (to recur to Mill's former problem as to the ratio between things not of the same denomination) Mill does not make clear, nor is it defensible to speak of either a ratio or an equation on the basis of Mill's system, since Mill had no absolute value concept. Cairnes seeks to reconstruct the notion of supply and demand, in such fashion as to make it possible to apply it universally, and takes up the question of the comparability of supply conceived as a quantity of goods, and demand, conceived, not as a quantity of goods, but as desire combined with the ability to pay. He concludes that in both supply and demand there is a physical, as well as a mental, element. Demand he defines as the desire for a commodity backed by general purchasing power; supply as the desire for general purchasing power, backed by the offer of a commodity. Thus he thinks he has made the two of the same denomination, so that comparison may be instituted between them, and the ideas of equation, ratio, and proportion made legitimate. By "general purchasing power," Cairnes seems to mean money and the representatives of money. It is not an abstract power, since it is the "physical" element in demand, comparable with, and of the same denomination with, the physical element in supply, a commodity. Cairnes' solution of Mill's difficulty seems to me to be merely verbal, however. First, in what way is the desire for general purchasing power in the mind of one man comparable with the desire for a commodity in the mind of another man? I pass over the supposed difficulty that knowledge of other men's emotions is impossible,[49] and emphasize simply the point that price offer, either by demander or supplier, is no test of the intensity of desire where there are inequalities in the distribution of wealth. But second: in what sense is general purchasing power, money and money-funds, of the same denomination as a commodity? Cairnes emphasizes the physical character of both. But surely they are not comparable on the basis of any physical attributes--weight, bulk, etc. Certainly if we look at the concept of demand here given, the physical aspect is simply irrelevant--gold money goes by weight, but what of paper money and credit instruments? And in what sense is even gold money physically of the same denomination with, say, wheat, or hay or base-ball tickets? Not physical quantities, but economic quantities, are relevant here; not weight or bulk, but _value_. By means of a concept of value, as the homogeneous quality of wealth, present in each piece of wealth in definite, quantitative degree, could Cairnes bring about comparability between the "physical" elements in supply and demand. But not otherwise. Only significances, values, are relevant here. Supply and demand presuppose value.

It will be interesting to consider the effort to solve the problem of the value of money by means of supply and demand on the lines employed by Mill, where demand for money is defined as quantity of goods to be exchanged, and supply of money as quantity of money times rapidity of circulation, and where physical quantities are treated as the relevant factor, no value concept of the sort here contended for being presupposed. This is, essentially, Mill's method. There is, in this conception, first the difficulty that "quantity of goods to be exchanged" is not a true quantity at all, but is a mere collection of things of different denominations, dozens of eggs, pounds of butter, gallons of milk, etc., incapable of being funded into a quantity.[50] There is, second, the difficulty that increasing the amount of any one of the items in this heterogeneous composite need not increase the "demand" for money, in the sense that it increases the "pull" on money, or tends to increase the supply of money. Yet, under the general doctrine of supply and demand, an increase in demand should be a stimulus to increase in supply. Indeed, it is easy to construct a case where an increase in the quantity of one of the items in this composite, the others remaining unchanged, would actually tend to _repel_ money, to reduce the _supply_ of money. Suppose that one item in America's stock of goods, say cotton, is much increased in quantity, and suppose that cotton has a highly inelastic demand-curve, so that the increased quantity sells for less money than the original quantity.[51] Suppose, too, that cotton is our chief article of export, and that the bulk of our cotton is exported. Would not the "balance of trade" tend to turn against us, so that gold would tend to leave the country, and the supply of money be reduced? There is nothing in the situation assumed to raise the prices of other goods,[52] so that they could exert a counteracting "pull" on money. Europeans, to be sure, having less to pay for cotton, could demand more of other things, and Americans paying less for cotton could demand more of other things. But, on the other hand, American producers of cotton, receiving less for their cotton--receiving precisely as much less as the others had more--could then demand less of other things, exactly as much less as the others are able to demand more. The original tendency for gold to leave the country, and the tendency for gold to leave the money-form and be used in the arts, would remain unneutralized. An "increase of demand for money," in Mill's sense, would in this case present the remarkable phenomenon of driving money away. Physical quantities are irrelevant. Psychological significances are what count.

It is interesting to note, in this connection, that some striking contradictions in quantity theory reasoning on any formulation, whether connected with the notions of supply and demand or not, are involved in this hypothesis. The illustration above gives a case where a lowered price level leads money to flow away from your country. But, on the quantity theory explanation of foreign exchange, it is _rising_ price levels which drive gold away, and _falling_ price levels which attract gold![53]

Mill's effort to apply the notion of demand and supply to the value of money is, then, (1) not an application of his formal doctrine of supply and demand, and (2), is a failure, leads to results contradictory to the general law of supply and demand, as soon as we take account of the peculiarities of individual commodities, and cease to look at commodities in one huge lump. Psychological forces, rather than physical quantities, are what count. Whether or not the supply and demand notion of Cairnes, reinterpreted by putting a quantitative value concept into it, could serve as a means of approach to the value of money, I shall not here argue. No one so far as I know has attempted to do the thing that way, and my own theory is best developed by another method. It is interesting to note, however, another somewhat different effort to apply the supply and demand formula. General Walker does so, including among the factors determining the demand for money, not only the quantity of goods to be exchanged, but also the _prices_[54] prevailing. Since by value of money Walker means merely the reciprocal of the price-level, this is the clearest possible case of a vicious circle. It would be a circle even if he were trying to explain the absolute value of money, as distinguished from the reciprocal of the price-level, since the former is one of the determinants of the latter. Value of money and values of goods determine prices; prices and quantity of goods determine demand for money; demand and supply of money determine value of money,--a hopeless circle.

I know no sense in which the terms, demand and supply of money, can have relevance to the problem of the value of money. There is one sense in which the terms can be used which fits in with the modern supply and demand-curves, and that is the sense in which they are used in the money market. Demand for money comes from borrowers; supply of money from lenders. The price paid is a money-price, the curves express the short time money-rates, the rental of money, in terms of money, for stated periods of time. There is a relation, later to be investigated, between the rental of money, the money-rate, and the value of money, but the two are in no sense the same. It should be noted, too, that we are here concerned with "money-funds" rather than with money in the strict sense,--distinctions and relations in this connection properly belong at another stage of our inquiry. Whenever the terms, demand and supply of money, appear in the following pages, they will be used in the sense developed in this paragraph.

Demand and supply are superficial formulae. They cannot touch a problem so fundamental as that of the value of money.