Austrian theory of money

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Austrian theory of money
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Austrian theory of money was presented in Ludwig von Mises's work The Theory of Money and Credit, which was published in 1912. In the treatise Mises applies laws of marginal utility, which determine market prices, to the monetary theory. Austrian money theory is considered heterodox to the main stream economics.

Supply and Demand according to austrian theory of money

When analysing supply and demand for money, Mises uses a concept proposed by Philip Wicksteed: supply of money is the total stock of money at given moment in time. Demand for money is the total demand to hold cash balances at given moment in time, which is derived from subjective valuations of individuals, regarding marginal utility of monetary units (which compete in individual's scale of values against other goods and services). This means, that individual will keep accumulating monetary units as long as their marginal utility against other goods is higher.

Demand for money comes from the fact, that it can be exchanged in the future for something else, as it is a generally accepted mean of exchange. Purchasing power of money can be therefore described as an array of quantities of all other goods and services that can be exchanged for a given amount of money.

What is money

In the Austrian theory, money is perceived as a commodity with some unique attributes, such as aforementioned function as a mean of exchange, and the fact that unlike any other commodity- increase in the supply of money does not benefit the society. The latter fact is not so obvious under the gold standard (since gold can be used for other purposes- jewellery, industry), but it refers only to the general stock of gold used for monetary purposes. Under fiat money system, situation is clear- increase in the supply of paper money does not create any additional value to the society, it just dilutes the value of all monetary units already in circulation. Additionally, it causes redistribution of wealth in the society, since those who are first to receive new money can spend it with yet unchanged price structure.

Criticism of the general price level concept

Austrian school is very critical of attempts to analyse monetary phenomena in an aggregated perspective. Austrians claim, that monetarist approach, which assumes that increase in the supply of money will affect general price level in the economy is way too simplified, and causes economists to miss some very important effects of changes in the money supply. According to Austrian economists, newly created money doesn't just "appear" in the economy, changing all prices simultaneously. Instead, it "pours" into the systems by many different channels, which causes price structure to change and in effect can cause business cycle to appear.

For example: new money, created by the banking system in the process of credit expansion is never distributed equally among all entities in the economy. Rather than that, new credit is granted to some specific sectors and enterprises, which later use newly acquired money for their purposes, disturbing current economic environment.

Regression theorem

One of the most notable concepts of Mises's theory is so-called regression theorem. It answers one of the fundamental issues of the monetary theory- the origin of money. Mises argues, that the fact that people attribute utility to monetary units, and demand it, thus- allowing money to have value (determined also by the supply of money) in present time (period X) comes from the previous period (X-1), when money also had a determined value. The same with value in period X-1, which comes from X-2. This chain of interactions between periods can be tracked to the very first time when given commodity became money, but this means that the commodity chosen to be money must have had value in the barter system.

For example: for the majority of time, human race has been using precious metals, especially gold, as money. But gold could have become money only because it functioned in the barter era as something valuable (it was used in jewellery).

Consequences of above reasoning are that it is impossible to assume that money can emerge as a result of a government decree or some kind of "social agreement". If a commodity is to become money, it has to have some intrinsic value in the previous period. The same applies to modern monetary systems- all currencies, even newly created (for example when new countries come into existence and introduce their currencies) derive their value from some other functioning monetary system.

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Author: Bartosz Cioch