The Purchasing Power of Money

Fisher, Irving
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First Pub. Date
New York: The Macmillan Co.
Pub. Date
2nd edition. Harry G. Brown, assistant.
11 of 27


§ 1


THUS far we have considered the level of prices as affected by the volume of trade, by the velocities of circulation of money and of deposits, and by the quantities of money and of deposits. These are the only influences which can directly affect the level of prices. Any other influences on prices must act through these five. There are myriads of such influences (outside of the equation of exchange) that affect prices through these five. It is our purpose in this chapter to note the chief among them, excepting those that affect the volume of money (M); the latter will be examined in the two following chapters.


We shall first consider the outside influences that affect the volume of trade and, through it, the price level. The conditions which determine the extent of trade are numerous and technical. The most important may be classified as follows:—

1. Conditions affecting producers.
(a) Geographical differences in natural resources.
(b) The division of labor.
(c) Knowledge of the technique of production.
(d) The accumulation of capital.
2. Conditions affecting consumers.
(a) The extent and variety of human wants.
3. Conditions connecting producers and consumers.
(a) Facilities for transportation.
(b) Relative freedom of trade.
(c) Character of monetary and banking systems.
(d) Business confidence.


1 (a). It is evident that if all localities were exactly alike in their natural resources and in their comparative costs of production little or no trade would be set up between them. It is equally true that the greater the difference in the costs of production of different articles in different localities, the more likely is there to be trade between them and the greater the amount of that trade. Primitive trade had its raison d'être in the fact that the regions of this earth are unlike in their products. The traders were travelers between distant countries. Changes in commercial geography still produce changes in the distribution and volume of trade. The exhaustion of gold and silver mines in Nevada and of lumber in Michigan have tended to reduce the volume of trade of these regions, both external and internal. Contrariwise, cattle raising in Texas, the production of coal in Pennsylvania, of oranges in Florida, and of apples in Oregon have increased the volume of trade for these communities respectively.


1 (b). Equally obvious is the influence of the division of labor. Division of labor is based in part on differences in comparative costs or efforts as between men,—corresponding to geographic differences as between countries. These two, combined, lead to local differentiation of labor, making, for example, the town of Sheffield famous for cutlery, Dresden for china, Venice for glass, Paterson for silks, and Pittsburg for steel.


1 (c). Besides local and personal differentiation, the state of knowledge of production will affect trade. The mines of Africa and Australia were left unworked for centuries by ignorant natives but were opened by white men possessing a knowledge of metallurgy. Vast coal fields in China await development, largely for lack of knowledge of how to extract and market the coal. Egypt awaits the advent of scientific agriculture, to usher in trade expansion. Nowadays, trade schools in Germany, England, and the United States are increasing and diffusing knowledge of productive technique.


1 (d). But knowledge, to be of use, must be applied; and its application usually requires the aid of capital. The greater and the more productive the stock or capital in any community, the more goods it can put into the currents of trade. A mill will make a town a center of trade. Docks, elevators, warehouses and railway terminals help to transform a harbor into a port of commerce.


Since increase in trade tends to decrease the general level of prices, anything which tends to increase trade likewise tends to decrease the general level of prices. We conclude, therefore, that among the causes tending to decrease prices are increasing geographical or personal specialization, improved productive technique, and the accumulation of capital. The history of commerce shows that all these causes have been increasingly operative during a long period including the last century. Consequently, there has been a constant tendency, from these sources at least, for prices to fall.


2 (a). Turning to the consumers' side, it is evident that their wants change from time to time. This is true even of so-called natural wants, but more conspicuously true of acquired or artificial wants.


Wants are, as it were, the mainsprings of economic activity which in the last analysis keep the economic world in motion. The desire to have clothes as fine as the clothes of others, or finer, or different, leads to the multiplicity of silks, satins, laces, etc.; and the same principle applies to furniture, amusements, books, works of art, and every other means of gratification.


The increase of wants, by leading to an increase in trade, tends to lower the price level. Historically, during recent times through invention, education, and the emulation coming from increased contact in centers of population, there has been a great intensification and diversification of human wants and therefore increased trade. Consequently, there has been from these causes a tendency of prices to fall.

§ 2


3 (a). Anything which facilitates intercourse tends to increase trade. Anything that interferes with intercourse tends to decrease trade. First of all, there are the mechanical facilities for transport. As Macaulay said, with the exception of the alphabet and the printing press, no set of inventions has tended to alter civilization so much as those which abridge distance,—such as the railway, the steamship, the telephone, the telegraph, and that conveyer of information and advertisements, the newspaper. These all tend, therefore, to decrease prices.


3 (b). Trade barriers are not only physical but legal. A tariff between countries has the same influence in decreasing trade as a chain of mountains. The freer the trade, the more of it there will be. In France, many communities have a local tariff (octroi) which tends to interfere with local trade. In the United States trade is free within the country itself, but between the United States and other countries there is a high protective tariff. The very fact of increasing facilities for transportation, lowering or removing physical barriers, has stimulated nations and communities to erect legal barriers in their place. Tariffs not only tend to decrease the frequency of exchanges, but to the extent that they prevent international or interlocal division of labor and make countries more alike as well as less productive, they also tend to decrease the amounts of goods which can be exchanged. The ultimate effect is thus to raise prices.


3 (c). The development of efficient monetary and banking systems tends to increase trade. There have been times in the history of the world when money was in so uncertain a state that people hesitated to make many trade contracts because of the lack of knowledge of what would be required of them when the contract should be fulfilled. In the same way, when people cannot depend on the good faith or stability of banks, they will hesitate to use deposits and checks.


3 (d). Confidence, not only in banks in particular, but in business in general, is truly said to be "the soul of trade." Without this confidence there cannot be a great volume of contracts. Anything that tends to increase this confidence tends to increase trade. In South America there are many places waiting to be developed simply because capitalists do not feel any security in contracts there. They are fearful that by hook or by crook the fruit of any investments they may make will be taken from them.


We see, then, that prices will tend to fall through increase in trade, which may in turn be brought about by improved transportation, by increased freedom of trade, by improved monetary and banking systems, and by business confidence. Historically, during recent years, all of these causes have tended to grow in power, except freedom of trade. Tariff barriers, however, have only partly offset the removal of physical barriers. The net effect has been a progressive lowering of trade restrictions, and therefore the tendency, so far as this group of causes goes, has been for prices to fall.

§ 3


Having examined those causes outside the equation which affect the volume of trade, our next task is to consider the outside causes that affect the velocities of circulation of money and of deposits. For the most part, the causes affecting one of these velocities affect the other also. These causes may be classified as follows:—

1. Habits of the individual.
(a) As to thrift and hoarding.
(b) As to book credit.
(c) As to the use of checks.
2. Systems of payments in the community.
(a) As to frequency of receipts and of disbursements.
(b) As to regularity of receipts and disbursements.
(c) As to correspondence between times and amounts of receipts and disbursements.
3. General Causes.
(a) Density of population.
(b) Rapidity of transportation.


1 (a). Taking these up in order, we may first consider what influence thrift has on the velocity of circulation. Velocity of circulation of money is the same thing as its rate of turnover. It is found by dividing the total payments effected by money in a year by the amount of money in circulation in that year. It depends upon the rates of turnover of the individuals who compose the society. This velocity of circulation or rapidity of turnover of money is the greater for each individual the more he spends, with a given average amount of cash on hand; or the less average cash he keeps, with a given yearly expenditure.


The velocity of circulation of a spendthrift may be presumed to be greater than the average.*53 He is always apt to be "short" of funds,—to have a small average balance on hand. But his thrifty neighbor takes care to provide himself with cash enough to meet all contingencies. The latter tends to hoard and lay by his money, and will, therefore, have a slower velocity of circulation. When, as used to be the custom in France, people put money away in stockings and kept it there for months, the velocity of circulation must have been extremely slow. The same principle applies to deposits. In a certain university town the banks often refuse to take deposits from students of spending habits because the average balances of the latter are so low; or insist on a special stipulation that the balance shall never fall below $100.


Hoarded money is sometimes said to be withdrawn from circulation. But this is only another way of saying that hoarding tends to decrease the velocity of circulation.


A man who is thrifty is usually, to some extent, a hoarder either of money*54 or of bank deposits. Laborers who save usually keep their savings in the form of money until enough is accumulated to be deposited in a savings bank. Those who have bank accounts will likewise accumulate considerable deposits when preparing to make an investment. Banks whose depositors are "rapidly making money" and periodically investing the same, have, it is said, less active accounts than banks whose depositors "live up to their incomes."


1 (b). The habit of "charging," i.e. using book credit, tends to increase the velocity of circulation of money, because the man who gets things "charged" does not need to keep on hand as much money as he would if he made all payments in cash. A man who pays cash daily needs to keep cash for daily contingencies. The system of cash payments, unlike the system of book credit, requires that money shall be kept on hand in advance of purchases. Evidently, if money must be provided in advance, it must be provided in larger quantities than when merely required to liquidate past debts. This is true for two reasons: First, in advance of purchases, there is always uncertainty as to when money will be needed and how much, while after bills are incurred, the exact sum needed is known. Secondly, and as a consequence of the first circumstance, money held in advance must be held a longer time than money received after a use for it has been contracted for. In short, to keep money in advance requires (a) a larger margin for unforeseen contingencies and (b) a longer period before being disbursed during which the money is idle. In the system of cash payments, a man must keep money idle in advance lest he be caught in the embarrassing position of lacking it when he most needs it. With book credit, he knows that even if he should be caught without a cent in his pocket, he can still get supplies on credit. These he can pay for when money comes to hand. Moreover, this money need not lie long in his pocket. Immediately it is received, there is a use awaiting it to pay debts accumulated. Now, to shorten the period of waiting evidently decreases the average balance carried, even if in the end the same sums are received and disbursed. For instance, a laborer receiving and spending $7 a week, if he cannot "charge," must make his week's wages last through the week. If he spends $1 a day, his weekly cycle must show on successive days at least as much as $7, $6, $5, $4, $3, $2, and $1, at which time another $7 comes in. This makes an average of at least $4. But if he can charge everything and then wait until pay day to meet the resulting obligations, he need keep nothing through the week, paying out his $7 when it comes in. His weekly cycle need show no higher balances than $7, $0, $0, $0, $0, $0, $0, the average of which is only $1.


Through book credit, therefore, the average amount of money or bank deposits which each person must keep at hand to meet a given expenditure is made less. This means that the rate of turnover is increased; for if people spend the same amounts as before, but keep smaller amounts on hand, the quotient of the amount spent divided by the amount on hand must increase.


But we have seen that to increase the rate of turnover will tend to increase the price level. Therefore, book credit tends to increase the price*55 level. Moreover, a community can to some extent cover the relative scarcity of money of a period when business is large with the relative surplus of a period when fewer demands are made on its supply of money. Otherwise, to maintain the same general level of prices, there would have to be considerably more money when business was large; and this money, unless it were some form of elastic bank currency which could be canceled and retired, would lie idle during those seasons when business was slack.


In short, book credit economizes money (M) even though it may not economize money payments (E) and therefore increases the velocity of circulation of money (E/M).


1 (c). The habit of using checks rather than money will also affect the velocity of circulation; because a depositor's surplus money will immediately be put into the bank in return for a right to draw by check.


Banks thus offer an outlet for any surplus pocket money or surplus till money, and tend to prevent the existence of idle hoards. In like manner surplus deposits may be converted into cash—that is, exchanged for cash—as desired. In short, those who make use both of cash and deposits have the opportunity, by adjusting the two, to prevent either from being idle.


We see, then, that three habits—spendthrift habits, the habit of charging, and the habit of using checks—all tend to raise the level of prices through their effects on the velocity of circulation of money, or of deposits. It is believed that these habits (except probably the first) have been increasing rapidly during modern times.

§ 4


2 (a). The more frequently money or checks are received and disbursed, the shorter is the average interval between the receipt and the expenditure of money or checks and the more rapid is the velocity of circulation.


This may best be seen from an example. A change from monthly to weekly wage payments tends to increase the velocity of circulation of money. If a laborer is paid weekly $7 and reduces this evenly each day, ending each week empty-handed, his average cash, as we have seen, would be a little over half of $7 or about $4. This makes his turnover nearly twice a week. Under monthly payments the laborer who receives and spends an average of $1 a day will have to spread the $30 more or less evenly over the following 30 days. If, at the next pay day, he comes out empty-handed, his average money during the month has been about $15. This makes his turnover about twice a month. Thus the rate of turnover is more rapid under weekly than under monthly payments.


The same result would hold if we assumed that, instead of ending the cycle empty-handed, he ended it with a given fraction—say half—of his wages unspent. Under weekly payments, he would begin with $10.50, and end with $3.50, averaging about $7. Under monthly payments he would thus begin with an average of $45, and end with $15, averaging about $30. In the former case his average velocity of circulation would be once a week and in the latter once a month. The turnover will thus still be about four times as rapid under weekly as under monthly payment. Thus if the distribution of expenditure over the two cycles should have exactly the same "time shape"*56 (distribution in time), weekly payments would accelerate the velocity of circulation in the same ratio which a month bears to a week. As a matter of history, however, it is not likely that the substitution of weekly payments for monthly payments has increased the rapidity of circulation of money among workingmen fourfold, because the change in another element, book credit, would be likely to cause a some-what compensatory decrease. Book credit is less likely to be used under weekly than under monthly payments. Where this book-credit habit or habit of "charging" is prevalent, the great bulk of money is spent on pay day. It is probable that the substitution of weekly for monthly payments, when it has taken place, has enabled many workingmen, who formerly found it necessary to trade on credit, to make their own payments in cash, thus tending to decrease the velocity of turnover of money.


Frequency of disbursements evidently has an effect similar to the effect of frequency of receipts; i.e. it tends to accelerate the velocity of turnover, or circulation.


2 (b). Regularity of payment also facilitates the turnover. When the workingman can be fairly certain of both his receipts and expenditures, he can, by close calculation, adjust them so precisely as safely to end each payment cycle with an empty pocket. This habit is extremely common among certain classes of city laborers. On the other hand, if the receipts and expenditures are irregular, either in amount or in time, prudence requires the worker to keep a larger sum on hand, to insure against mishaps.*57 Even when fore-known with certainty, irregular receipts require a larger average sum to be kept on hand. This statement holds, at least, if we assume that the frequency of payments per year is the same as in the case of regular payments, and that the "time shape" of expenditures between receipts is also the same. Thus, suppose that a workman spends at the rate of $1 a day and receives at the average rate of $1 a day. The average amount that he will require to keep on hand will be less if his receipts occur once every fortnight than if they occur at intervals of three weeks and one week respectively in alternation. For, supposing he tries to come out empty-handed just before each payment, in the former case he will evidently need an average sum each fortnight of $7; but in the latter case, he will need for the first period of three weeks, or twentyone days, $10.50, and in the second period $3.50, the average of which—remembering that the $10.50 applies for three weeks and the $3.50 for one week—will be $8.75. We may, therefore, conclude that regularity, both of receipts and of payments, tends to increase velocity of circulation.


2 (c). Next, consider the synchronizing of receipts and disbursements, i.e. making payments at the same intervals as obtaining receipts. Where payments such as rent, interest, insurance and taxes occur at periods irrespective of the times of receipts of money, it is often necessary to accumulate money or deposits in advance, thus increasing the average on hand, withdrawing money from use for a time, and decreasing the velocity of circulation. This result may, however, be obviated if the individual is willing and able to borrow in order to meet his tax or other special expense, repaying the loan later at his convenience. This is one of the ways in which banking, as already explained, through loans and deposits, serves the convenience of the public and increases the velocity of circulation of money and deposits. Similarly book credit may obviate the inconveniences arising from the disharmony between the times of receipt and disbursement; for we have already seen that it is a great convenience to the spender of money or of deposits, if dealers to whom he is in debt will allow him to postpone payment until he has received his money or his bank deposit. This arrangement obviates the necessity of keeping much money or deposits on hand, and therefore increases their velocity of circulation.


We conclude, then, that synchronizing and regularity of payment, no less than frequency of payment, have tended to increase prices by increasing velocity of circulation.

§ 5


3 (a). The more densely populated a locality, the more rapid will be the velocity of circulation.*58


There is definite evidence that this is true of bank deposits. The following figures*59 give the velocities of circulation of deposits in ten cities, arranged in order of size:—

Paris 116 Lisbon 29
Berlin 161 Indianapolis 30
Brussels 123 New Haven 16
Madrid   14 Athens   4
Rome   43 Santa Barbara   1


Madrid is the only city seriously out of its order in respect to velocity of circulation.


3 (b). Again, the more extensive and the speedier the transportation in general, the more rapid the circulation of money.*60 Anything which makes it easier to pass money from one person to another will tend to increase the velocity of circulation. Railways have this effect. The telegraph has increased the velocity of circulation of deposits, since these can now be transferred thousands of miles in a few minutes. Mail and express, by facilitating the transmission of bank deposits and money, have likewise tended to increase their velocity of circulation.


We conclude, then, that density of population and rapidity of transportation have tended to increase prices by increasing velocities. Historically this concentration of population in cities has been an important factor in raising prices in the United States.


Ordinarily, the velocity of circulation of money and the velocity of circulation of deposits will be similarly influenced by similar causes. In time of panics, however, if the confidence of depositors is shaken, the tendency is for deposits to be withdrawn while money is hoarded. Hence, for a time, the two velocities may change in opposite directions, although there are no good statistics for verifying this supposition.

§ 6


Lastly, the chief specific outside influences on the volume of deposits subject to check are:—

(1) The system of banking and the habits of the people in utilizing that system.
(2) The habit of charging.


1. It goes without saying that a banking system must be devised and developed before it can be used. The invention of banking has made deposit currency possible, and its adoption has undoubtedly led to a great increase in deposits and consequent rise of prices. Even in the last decade the extension in the United States of deposit banking has been an exceedingly powerful influence in that direction. In Europe deposit banking is still in its infancy.


2. "Charging" is often a preliminary to payment by check, rather than by cash. If a customer did not have his obligations "charged," he would pay in money and not by check.*61 The ultimate effect of this practice, therefore, is to increase the ratio of check payments to cash payments (E' to E) and the ratio of deposits to money carried (M' to M), and therefore to increase the amount of credit currency which a given quantity of money can sustain.


This effect, the substitution of checks for cash payments, is probably by far the most important effect of "charging," and exerts a powerful influence toward raising prices.

Notes for this chapter

Cf. Jevons, Money and the Mechanism of Exchange, New York (Appleton), 1896, p. 336.
Cf. Harrison H. Brace, Gold Production and Future Prices, New York (Bankers' Publishing Co.), 1910, p. 122.
This indirect effect on the price level must not be confused with the direct effect sometimes claimed. See § 1 of Appendix to (this) Chapter V.
Compare Adolphe Landry, "La Rapidité de la Circulation Monétaire," Extrait de La Revue d'Économie politique, Février, 1905.
Compare Landry, ibid.
This is pointed out by Kinley, Money, New York (Macmillan), 1904, p. 156.
These figures are the medians of those of Pierre des Essars for European banks (Journal de la Société de Statistique de Paris, April, 1895) supplemented by data secured by me from a few American banks.
Cf. Jevons, Money and the Mechanism of Exchange, New York (Appleton), 1896, p. 336; also Kinley, Money, New York (Macmillan), 1904, pp. 156 and 157.
Andrew, "Credit and the Value of Money." Reprint from Papers and Proceedings of the Seventeenth Annual Meeting American Economic Association, December, 1904, p. 10.

Notes for Chapter VI

End of Notes

11 of 27

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