Austrian theory of money

Austrian theory of money
See also
Money emission Austrian business cycle theory Neoclassical economics Fiduciary money Monetarism David Ricardo Nominal exchange rate Macroeconomic equilibrium Price

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.

See also:

• Global demand

Examples of Austrian theory of money

• Austrian theory of money suggests that the purchasing power of money is determined by the supply and demand of money, and not by the government or central bank. This means that if more money is created and injected into the economy, the value of the currency will decrease, leading to inflation.
• Austrian theory of money also states that inflation is caused by an increase in the money supply, not by an increase in prices. This means that central banks and governments cannot control the price level by increasing the money supply.
• Austrian economists suggest that central banks should focus on maintaining a stable money supply, as this will help keep prices stable and prevent inflation. This is in contrast to the Keynesian view which suggests that the government should be able to use fiscal and monetary policies to manage the economy and inflation.
• Austrian economists also emphasize the importance of savings and investment in the economy. They argue that savings should be invested in productive activities in order to create economic growth, rather than simply printing more money and creating inflation.

Advantages of Austrian theory of money

Austrian theory of money offers a comprehensive approach to understanding money and credit, which has been highly influential in the field of economics. It offers a number of advantages, such as:

• It emphasizes the importance of understanding money in terms of its impact on the economy, rather than solely as a medium of exchange. This focus on the economic effects of money helps to explain why certain monetary policies can be beneficial or detrimental.
• It emphasizes the role of money in facilitating economic transactions, and the importance of credit markets in providing liquidity to the economy.
• It views money as an economic good, and one that is subject to changes in its purchasing power due to changes in demand and supply.
• It recognizes the need for sound money and the importance of money as an intermediary between production and consumption.
• It takes into account the impact of the banking system on money creation and the economy as a whole.
• It recognizes the importance of understanding the dynamics of money and credit over the long-term, rather than just focusing on short-term changes.

Limitations of Austrian theory of money

Austrian theory of money has some limitations. These include:

• An inability to explain the behavior of money demand over time, as it assumes money demand is always equal to the total money supply.
• It does not explain how liquidity preference affects the supply of money and its relationship with the interest rate.
• It does not take into account the effects of fractional reserve banking, which can increase or decrease the money supply.
• It does not account for the effects of inflation or deflation on the money supply.
• It does not account for government intervention in the economy or other external influences on the money supply.
• It does not account for the effects of financial innovations, such as the development of derivatives and digital currencies, on the money supply.

Other approaches related to Austrian theory of money

One-sentence introduction: Other approaches to the Austrian theory of money include the following:

• The quantity theory of money, which is based on the idea that an increase in the money supply will lead to an increase in prices, was developed by the early-modern economists such as David Hume and John Stuart Mill.
• The real bills doctrine, which was developed by the Scottish economist, David Hume, postulates that a large increase in the money supply would lead to an increase in inflation if it is not matched by an increase in real output.
• The banking school, which was developed by the British economist, Henry Thornton, argued that the supply of money should be regulated by the banking system and that the money supply should be adjusted to the needs of the economy.
• The Chicago school of economics, which was popularized by Milton Friedman and others, suggests that monetary policy should be based on the quantity of money and that the money supply should be allowed to increase or decrease with the needs of the economy.

In summary, other approaches to the Austrian theory of money include the quantity theory of money, the real bills doctrine, the banking school, and the Chicago school of economics.

References

• Mises von, L., (1971) The Theory of Money and Credit, The Foundation for Economic Education, Inc., Irvington-on-Hudson, New York
• Rothbard, M. N. (1976). The Austrian Theory of Money. The Foundations of Modern Austrian Economics, 160-184.
• Rothbard, M. N. (1978). Austrian definitions of the supply of money. New Directions in Austrian Economics, 143-56.
• Ludwig von Mises @ Wikipedia
• Mises Institute webpage.

Author: Bartosz Cioch