CHAPTER VI

THE QUANTITY THEORY OF PRICES. INTRODUCTION

The quantity theory, in its usual formulations, is a theory, not of the value of money, in the absolute sense of value, but of the general price-level, the average price of goods exchanged for money. It is not a psychological theory. It does not deal with psychological quantities, or psychological forces. It is a mechanical theory, concerned simply with quantities, and the relations between them. The essence of the quantity theory comes out in the following brief statement: given a number of units of money; given a number of units of goods to be exchanged; assume these two numbers to be independent[105] of each other; assume all the goods to be exchanged for all the money; then the average price will be a simple function of the quantities of goods and of money respectively, such that an increase in the amount of money will increase the average price per unit of goods proportionately, if goods remain unchanged in amount, or an increase in goods will lower the price per unit proportionately, money being assumed to remain unchanged in amount. The qualification is commonly added that if goods have to be exchanged more than once, the effect is the same on prices as if there were an added number of goods equal to the added number of exchanges, and that if money is used more than once in exchanging a given number of goods, the effect is the same as if there were proportionately more money. Both quantity of goods and quantity of money are commonly defined as actual quantity multiplied by "rapidity of circulation." Rapidity of circulation, however, for both money and goods, is commonly thought of as a constant, so that the original formula remains unaffected by the qualification, so far as a prediction as to the effect of increase or decrease of money or goods on prices is concerned. Involved in the quantity theory, and explicitly stated by many writers, is the doctrine that the substance of which money is made is irrelevant, that it is the number, and not the quality or size of the money-units that counts. "In short, the quantity theory asserts that (provided velocity of circulation and volume of trade are unchanged) if we increase the _number_ of dollars, whether by renaming coins, or by debasing coins, or by increasing coinage, or by any other means, prices will be increased in the same proportion. It is the number, and not the weight, that is essential. This fact needs great emphasis. It is a fact which differentiates money from all other goods and explains the peculiar manner in which its purchasing power is related to other goods. Sugar, for instance, has a specific desirability dependent on its quantity in pounds. Money has no such quality. The value of sugar depends on its _actual quantity_. If the quantity of sugar is changed from 1,000,000 pounds to 1,000,000 hundredweight, it does not follow that a hundredweight will have the value previously possessed by a pound. But if money in circulation is changed from 1,000,000 units of one weight to 1,000,000 units of another weight, the value of each unit will remain unchanged." (Irving Fisher, _Purchasing Power of Money_, pp. 31-32.) To the same effect is Nicholson's exposition, in which the money is assumed to consist of dodo-bones, the most useless substance that Nicholson could think of. For the quantity theory, prices are determined by the _numbers_ of goods and dollars that are to be exchanged for one another, and not by the _values_ of the goods and dollars;--indeed, for the quantity theory, "value" commonly has no meaning apart from the prices which are supposed to be adequately explained by the mechanical relations of numbers.

In the critical study which follows, virtually every doctrine and every assumption of this preliminary statement will be challenged. I shall deny, first, that the quantity of goods to be exchanged and the quantity of money to be exchanged for the goods, are independent quantities, maintaining, rather, that an increase in either of them tends normally to be accompanied by an increase in the other. Quantity of goods and quantity of money _exchanged_ are not simple physical stocks, given data. Rather, they are consequences of human choices and human relationships, and vary from a large number of highly complex psychological causes, many of which are common to both. I shall deny, second, that "rapidity of circulation," either of goods or of money, is a simple constant, independent of quantity of goods or of quantity of money. I shall maintain, rather, that rapidity of circulation of money is a phenomenon which calls for psychological explanation: that the rapidity of money really means the _activities of men_; that these activities are complex, and obey no simple law; that instead of being an independent factor, constant, in the situation, the rapidity of circulation of money is bound up with the quantity of money, the quantity of goods to be exchanged, the rapidity of circulation of goods, and the prices of the goods, and that the rapidity of circulation of goods is likewise causally dependent on the factors named--or better, on the causes which control them; that rapidity of circulation, whether of money or of goods, is not a causal factor independent of prices, but rather in part depends on prices. In the third place, I deny the doctrine that the question as to _what_ the money-unit is made of is irrelevant. On the contrary, I shall maintain that the _quality_ of money, rather than its quantity, is the determining factor. I shall not maintain that only money made of or redeemable in valuable bullion can circulate, nor shall I maintain that the value of money depends wholly on the value of its bullion content when money is made of valuable metal. I recognize that value can come from other sources. But I shall maintain that value from some source other than the monetary employment is an essential precondition of the monetary employment, even though recognizing that that monetary employment may, in a way later to be analyzed, add to the original value of the money. The doctrine that only physical quantities, or abstract numbers, of goods are relevant I shall challenge especially, maintaining, on the contrary, that the psychological significances, the values, of goods are the really important thing, so that an increase in the number of one sort of goods may have a very different effect on the average of prices from an increase of the same number of units of some other good, and so that an increase in the number of goods exchanged under one set of conditions may have a very different effect on prices--or may be accompanied by a very different movement in prices, for the question of causal relations is a complicated one--from the change in prices that might accompany the same increase in the amount exchanged of same goods under other circumstances. Finally, the doctrine of the quantity theory that the price-level is a passive result of the other factors named: quantities of goods and money, and their respective velocities; that prices cannot initiate a change in the situation, will also be challenged. I shall undertake to show that the first change in the situation may appear in prices themselves, and that the quantities of goods exchanged, and of money, and their velocities, may then be altered to correspond with the change in prices.

I shall further maintain, as against the whole spirit of the quantity theory, that it does not seize hold of essentials in the causes lying behind prices. I shall contend that the factors with which it deals, instead of being independent _foci_ to which converge the causes governing the price-level, and through which causation flows in one direction, are really not true "factors" at all, but rather are blanket names for highly complex and heterogeneous groups of facts concerning which few general statements are possible. Quantity of goods exchanged, for example, may be in some of its parts caused by rising prices, in others of its parts may be causing falling prices and is chiefly caused by _fluctuating_ prices. The net change in prices in this case is not the result of any one movement from "quantity of goods" as a whole. Changes in the price-level are not one result, but rather, are the mathematician's average of many changes, due to a host of causes, in many individual prices. The quantity theory is an effort to simplify phenomena highly complex. Of course, the simplification of complex phenomena in thought is a laudable scientific goal, but when the simplification goes so far as to group things only superficially related, and to leave out the really vital elements, it is worthless. Value theory, with all the value left out, is like Hamlet with no actor for the title role. Simplification in the explanation of general prices has gone as far as we can legitimately take it when we seek to summarize all the factors involved in the _foci_ of, on the one hand, the value of money, and, on the other hand, the values of the particular goods. The general price-level is an average of many concrete prices. Each of these individual prices has a concrete causal explanation. The _general_ price-level has, not a few simple causes, but an infinite host of causes. Indeed, the general price-level has no real existence. It is a convenient mathematical concept, by means of which we may summarize the multitude of concrete facts. It is useful as a device for measuring changes in the value of money, on the assumption that changes in the values of goods neutralize one another. This assumption is never strictly true, and often is demonstrably false. The general price-level is neither a cause nor a result. Particular prices, in general, are results of two causes, namely, the value of money and the value of the good in question, and particular prices may then become causes, changing the quantity of money involved in a given set of exchanges. Neither quantity of money, nor quantity of goods exchanged, nor rapidity of circulation, nor general price-level is a simple, homogeneous quantity, obeying definite laws.

I shall also undertake to show that in many important cases the quantity theory leads to conclusions regarding the price-level which contradict other laws of prices, notably the capitalization theory, the cost of production doctrine, and the law of supply and demand. I have previously pointed out that these three doctrines are inapplicable to the problem of the value of money itself. On the assumption of a value of money, however,--using value in the absolute sense--they are applicable to the problem of prices, and, since the price-level is merely an average of particular prices, they should be applicable to the problem of the price-level also. It will be shown, in the course of the criticism which follows, first that the quantity theory contradicts each of these doctrines, in certain situations, and second, that in these cases, the conclusions based on the cost theory, the supply and demand theory, and the capitalization theory are right, and the conclusions based on the quantity theory are wrong. It has been maintained by certain writers, as Knut Wicksell[106] and Irving Fisher,[107] that cost of production and supply and demand are inapplicable to the problem of the general price-level. I shall maintain the contrary, holding that while these doctrines are inapplicable to the problem of the _value_ of money, they _are_ applicable to the problem of general prices, on the assumption of a fixed value of money. By the value of money I mean its absolute[108] value, and not--what the quantity theorists commonly mean--its "purchasing power," or the "reciprocal of the price-level."

I shall undertake to show that no sound conclusion reached on the basis of quantity theory reasoning is the peculiar property of the quantity theory school; that every valid conclusion which may be based on the quantity theory may also be deduced from the theory maintained in this book, and, indeed, that most of them may be deduced from several other theories of money, notably the commodity or bullionist theory. I shall show a number of false and misleading doctrines which logically spring from the quantity theory, and shall undertake to show that the quantity theory fails to give an adequate basis for several important parts of the theory of money, among them Gresham's Law, the theory of international gold movements, and the theory of elastic bank-notes and deposit-currency.

So much for the theses to be maintained. The detailed proof of these contentions will best be given in connection with a critical account of various versions of quantity theory doctrine. Attention will be given in this summary to the expositions of Nicholson, Mill, Taussig, and Kemmerer, and very special attention to I. Fisher, though some other writers will also be taken into account.