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Monetary theory is discussed in the first two articles under this entry and in Liquidity preferenceand Interest. For monetary policy and institutions, see the last article under this entry and Banking; Banking, central; Credit; Financial intermediaries; and Monetary policy. Related material is covered in Inflation and deflation. For the international aspects of money, seeInternational monetary economics.

I. GENERALAlbert Gailord Hart









The term “money” has accumulated such a wealth of connotations and variant uses that it is perhaps more serviceable as an adjective rather than as a noun. The most useful definition of the term as a noun seems to be an extremely liquid asset, measured in a standard unit of account and capable with certainty of discharging debts expressed in that unit. As applied to the United States at the present time, this definition includes in money the circulating stock of metallic small change, Federal Reserve Notes and other paper currency, and also the stock of commercial bank deposits with checking privileges.

Since the definition just proposed makes “moneyness” a matter of degree (because of the relativity inherent in the terms “extremely liquid” and “with certainty”), it may be construed either to include or to exclude from the stock of money in the United States such liquid claims as certificates of deposit issued by commercial banks, Treasury bills, savings deposits, and “shares” in savings and loan associations. Wherever the frontier between money and what the International Monetary Fund in its compilations calls “quasi money,” we must always expect to find some types of quasi money which rank almost at the monetary extreme of the relativistic scales of “extremely liquid” and “capable with certainty of discharging debts.”

The proposed definition implies differences in the list of things which constitute money—between different societies and through time within a given society. In rare cases where there are unusually sharp cleavages in attitudes and expectations within a given society, it may even imply different moneys for different groups within that society.

The underlying concepts “unit of account,” “debt,” and “liquid asset” obviously have to be interpreted to put content into the proposed definition of money. Unit of account means a unit (such as the U.S. dollar) which by convention (whether with or without supporting pressure from government) is accepted in a society to value commodities and services sold, to compute costs, to reckon wealth, and to state debts. Such units have been used to facilitate thinking about economic matters through much of human history. In Biblical annals, for example, we find as early as Genesis 23 an account of Abraham buying a field “for the full price … [of] four hundred shekels of silver according to the weights current among the merchants”; and the New Testament pictures Jesus as taking it for granted that the unsophisticated people to whom he addressed his parables could readily think in monetary units. As may be seen from the fact that the more venerable units of account (shekels, pounds, and the like) correspond to units of weight, most societies until recently have thought of their units of account as expressing the value of a stated weight of gold or silver; but since paper money came into general use in the nineteenth century, units of account have become more and more abstract. It should be noted that a society at a given time may be using one or more units of account.

A debt is an obligation on the part of one economic unit (person, firm, or government body) to another, expressed in a standard unit of account. For the debtor, a debt is negative wealth—but expressed in the unit of account, whereas other types of negative wealth (such as a contract to deliver 1,000 bushels of wheat next month) are expressed in physical units. Since every debt obligation is two-sided, the obverse of each debt payable is a claim receivable, which constitutes an asset (wealth) for the creditor. Money in most presentday societies consists chiefly of claims upon debtors who are central governments, central or commercial banks, or other credit institutions.

For an asset to be liquid, it must be either money or else something which quickly and with a high degree of certainty can be converted into a known amount of money. Since “quickly” and “with a high degree of certainty” are both relative expressions, assets can evidently be more or less liquid. The concept of a “liquid asset,” furthermore, is subjective; it is defined from the point of view of the holder—the creditor, if the asset is a debt claim. In rating assets as more or less liquid, therefore, we should not ask whether all units of such a unit could in fact be converted into money, but whether each unit can be so converted in the opinion of its holder. This view admits of a shift * of opinion through time. Such a shift may be quite sudden, with holders today viewing as illiquid assets which a short time ago they viewed as highly liquid. It seems clear that there were such sudden shifts in the liquidity attributed to deposits in individual banks during the great epidemic of bank failures in the United States in 1930-1933. There may also have been such a sudden shift in the liquidity attributed to government securities at the time of the “monetary accord” of 1951, which terminated the rigid support of government securities prices by the Federal Reserve.

Most liquid assets in the United States consist of short-term claims upon the national government, upon the Federal Reserve banks, upon commercial banks, or upon “nonbank credit institutions”—particularly mutual savings banks, savings and loan associations, and, in the view of some analysts, also credit unions and life insurance companies. For some holders and upon some occasions, liquid assets may include inventories of commodities, short-term claims upon firms which are not credit institutions, longer-term government securities, and even listed stocks. For holders in small countries, a large part of the stock of liquid assets may consist of claims upon banks, government bodies, etc., outside the country in question. Such use of foreign claims may or may not involve the use of foreign units of account in domestic dealings and calculations.

The meaning of money may be illuminated further by reference to two other terms, not used in the proposed definition. Legal tender is that which is established by governmental rules as a satisfactory medium for settling debts in case of dispute. Anything that is legal tender must be money; but often (as with checking deposits in the United States) large parts of the money stock may be excluded from legal tender. But one might paraphrase the definition of money as “that which is by custom treated like legal tender.”

A monetary standard may be defined as a fixed relation between the unit of account and the standard commodity. Such a standard is, in the inspired definition of D. H. Robertson, an arrangement by which “a country keeps the value of its monetary unit and the value of a defined weight of gold [or other standard commodity] at an equality with each other” (1922, p. 134). In a “full” gold or silver standard, such as existed in many countries before World War i, this equality of value was maintained through the free convertibility of monetary metal, metal coins, and paper money. Such an arrangement based on gold (or possibly on a bimetallic standard with both gold and silver coins of full weight) was regarded as normal for a developed industrial economy. With the disappearance of gold coins, the restriction in most centers of dealings in monetary gold bars to “official” dealers, and the fading of the tradition of permanence in monetary arrangements, the standard has been modified. The United States today may be described as operating a “limited, provisional, gold-bullion standard,” and similar descriptions would apply to the other major industrial countries. Many countries choose to treat the currency units of other countries as their “standard commodities” and may be described as on a “sterling-exchange standard” or a “dollar-exchange standard.” [SeeInternational monetary economics, article oninternational monetary organization.]

It should be noted that many economists prefer to define money more informally than is proposed above: simply as “that which constitutes means of payment.” This is an easy and useful way to convey a correct general impression. But it is hard to give a precise meaning to “means of payment.” Strictly, the immediate means of payment for most goods and services sold is the establishment of “book credit”: the buyer recognizes a debt to the seller for merchandise supplied or for services rendered. (In the broad sweep of economic operations, “cash and carry” transactions are exceptional.) But no economist finds it convenient to regard book credit as the primary form of money. To adopt the means-of-payment definition without regarding book credit as money involves casuistry to the effect that goods are not “really” paid for until the book credit in question has been settled by check or by a transfer of paper currency.

Another often-proposed simple definition of money is “that which a seller will accept from a buyer whose credit standing is unknown.” This may be a very useful formulation in countries where payments are normally made by Giro (a payments system used in parts of Europe). But it has the defect of ruling out checking deposits as a form of money—a defect which is fatal for analysis of the economy of the United States and a number of other advanced countries.

Analytical role of money in economics

One of the key problems of present-day economics is the role of money and other liquid assets in the structure of economic decisions—particularly in the decisions of firms and households to save and to invest in durable real assets, such as factories, machinery, houses, and vehicles. Broadly speaking, the funds available to a firm or household for investment within a stated period consist of its saving during the period (taking saving gross, to include depreciation charges and the like), plus its net borrowing, plus any reduction it may make in its holdings of liquid assets. In any stated situation, there is usually something to be gained for the firm or household by investing more, something to be gained by reducing rather than increasing debt, and also something to be gained (in the form of increased consumption, or of increased distribution of a firm’s profits to its owners) by saving less. Given the size of current income, the more ample the stock of liquid assets, the more it is possible to realize all these benefits simultaneously. The scarcer the liquid assets, the more it is necessary to choose to forgo one benefit in order to reap another. Thus, adequacy of liquid assets in the possession of a firm or household is viewed as an incentive to invest, while inadequacy of liquid assets is viewed as an incentive to save and to curtail investment.

It is plain from experience that a “spendthrift” response to the possession of money and other liquid assets—that is, a course of management which outspends receipts so heavily as to bring liquid holdings down rapidly to a crisis point—is very rare. In most societies, the firms, households, and governments which account for the bulk of wealth holdings and of economic operations feel a need to maintain substantial holdings of money and other liquid assets. If we measure money by the sum of hand-to-hand currency plus checking deposits (which, as we saw at the outset, is a measurement which conforms fairly well to the proposed definition), the private sector of the U.S. economy in recent years has held a money stock roughly equivalent to a quarter-year’s gross national product and, in addition, has held other liquid assets equivalent roughly to a half-year’s product.

Motives for holding money. Monetary economists have developed an interesting array of hypotheses about the motives for holding money. Prior to the great depression of the 1930s, emphasis was placed primarily on the transactions motive—the need to hold a stock of money so as to smooth out the irregularities of inflow and outflow and to carry the holder past a foreseen trough in his money holdings. During the 1930s, under the leadership of John Maynard Keynes, emphasis shifted to the speculative motive—the benefit of holding money while one waits for an expected fall in the price of some alternative asset one may be interested in buying. Some such element in monetary theory was clearly needed to interpret the sharp fall during the 1930s of the “velocity of circulation of money”—the ratio of money payments to money stock—which would have to remain fairly constant if the transactions motive were dominant. Without abandoning either of these previously emphasized motives, monetary economists in recent years have put increasing emphasis on the precautionary motive—the benefit of holding money to mitigate uncertainty. An attractive explanation of the benefit derived from keeping a margin of safety in one’s money holdings is the principle of linkage of risk. If a firm or household lacks such a margin, an un-expected unfavorable development is likely to create a crisis that will bring on further unfavorable events. But if the adverse effect of the first event can be taken in stride, the linkage of risk is weakened, and the further unfavorable events may be averted.

Except for very short-term aspects of the transactions motive, all these motives for holding money can be served at least moderately well by holding some type of nonmonetary liquid asset. Money as ordinarily defined consists of elements (paper currency and checking deposits ) which yield no money income, while nonmonetary liquid assets do yield such income. Hence, it pays the holder to substitute other liquid assets for money up to the point at which the next remaining unit of money has net advantages equal to the interest income forgone. A practical consequence of this fact is that the financial institutions whose liabilities constitute the public’s nonmonetary liquid assets have an incentive to design the claims they offer so as to present attractive combinations of liquidity and income. The working of this incentive to narrow the qualitative gap between money and money substitutes may be seen in the rapid development during the 1960s of “certificates of deposit” and “capital notes,” which are offered on the open market by commercial banks. A theoretical consequence of the same fact is that it becomes interesting to view the demand for money in opportunity-cost terms. Developing a Keynesian insight, many monetary economists center their analysis on a liquidity-preference function, which treats the stock of money the public will choose to hold as an inverse function of the interest rate which could be earned on alternative uses of funds [seeLiquidity Preference].

Creation of money

The processes which bring stocks of money into being, and which distribute them among various holders, are best seen in terms of transactions among various sectors of a country’s economy. In the first stage of analysis, it is convenient to recognize two sectors only. The first is called the “nonbank public”—made up of households, firms other than banks, and local governments; it is through effects upon incentives in this sector that monetary influences on saving and investment are supposed to work. The second sector is the “money-generating sector”—made up of the national government, the central bank (in the United States, the Federal Reserve System), and the commercial banks (those which include among their liabilities deposits that can be used in payment by check or Giro order). The stock of money constitutes an asset for the nonbank public and a liability for the money-generating sector.

A simple way to view the processes which generate money is to think of the flow of checks and its effect on the holdings of the nonbank public. Any check which is drawn by one member of the nonbank public and is payable to another member has a net effect of zero upon the total money stock. The payee enlarges his holding of money when he deposits the check, but the drawer’s account is necessarily reduced by an identical amount, so the total is unchanged. (Transitory nominal changes may arise from variations in the “float” of checks which have been drawn and not yet debited, since there is often a spread of several days between the dates on which withdrawals and deposits are entered in bank records and in the checkbooks of depositors.) But net effects on the money stock are not zero when the checks cross the boundary between the two sectors. For example, when a government employee deposits his paycheck, it will not be debited against the account of any other member of the nonbank public, so that the transaction is money-increasing. In the other direction, if a business firm draws a check to repay a bank loan, this check is not deposited in the account of any other member of the nonbank public, so that the transaction is money-decreasing. Transactions in both directions across the frontier between the nonbank public and the money-generating sector go on continuously, and the net change in the money stock depends on the net difference between the money-increasing flow and the money-decreasing flow.

It should be noted in passing that the situation is complicated by the presence of liabilities of the money-generating sector which are not treated as part of the money stock. The government employee, for example, might have deposited his paycheck in a savings account at his bank instead of in his checking account. To deal with this complication, one may, like Milton Friedman (see Friedman & Schwartz 1963), adopt a working definition of money which includes as money the time deposits of commercial banks. Or one may (like the International Monetary Fund) adopt a concept of “quasi money,” changes in which are viewed as an alternative use of “potential money” generated by net payments from the money-generating sector to the nonbank public.

Transactions in either direction between the two sectors may be on income account or on wealth-transfer account. The government paycheck referred to above is an income-account transaction; so is a check to pay for current products of the private sector which are bought for government use, or a dividend check to a bank stockholder. In the other direction, checks to pay taxes or to pay interest on bank loans may be regarded as income-account payments from the nonbank public to the money-generating sector. Wealth-transfer transactions may be represented by checks drawn by members of the nonbank public to pay for their subscriptions to newly issued government securities or, in the other direction, by checks drawn to pay for open-market purchases of government securities by the Federal Reserve from nonbank sellers. With minor exceptions, income-account transactions which affect the stock of money are transactions that figure in the social accounts among the receipts and expenditures of the central government and come into the domain of fiscal policy, while wealth-transfer transactions which affect the stock of money are bank-loan or government-debt transactions that clearly lie within the domain of monetary policy. A basic point of dispute between economists who think largely in terms of fiscal policy and those who are sometimes called “monetary monists” is whether the effect of an increment of money stock will be different according to whether it originates in an income-account or in a wealth-transfer-account transaction.

Theories of the supply of money

Theories of the supply of money center upon wealth-transfer transactions carried on by commercial banks. income-account transactions of the government are seen as by-products of fiscal policy, and wealth-transfer transactions by the treasury and central bank are viewed in terms of policy decisions rather than of the more or less impersonal response mechanisms attributed to the banking subsector.

Particularly in the United States, with its wide dispersion of activity among unit banks, one must view the creation of money by bank activity as a mass phenomenon directed by incentives and restrictions, rather than as a simple decision of high policy like, for example, a cut in federal income tax rates. For this part of our analysis, we must look inside the “money-generating sector” and distinguish the commercial banks from the “bank-reserve-generating subsector” made up of the national government and the central bank. Commercial banks have a continuous incentive to carry out money-increasing transactions—that is, to expand their loans and investments—because their income arises as interest on these assets. Further-more, there is ordinarily an available supply of such assets—for loans, a “fringe of unsatisfied borrowers”; for investments, a mass of bonds suitable for bank ownership that are held by the nonbank public and can be bought on the open market. Banks are free to respond to this incentive only insofar as they have a margin over reserve requirements in their holdings of reserve balances at Federal Reserve banks (plus their vault cash) or as they are willing to borrow reserves by discount at the Federal Reserve banks in the face of various deterrents [seeBanking, CENTRAL].

The central bank is able to facilitate the expansion of bank assets, and thus of the money stock, or to apply pressure toward contraction. The Federal Reserve System has authority within wide limits to vary legal reserve requirements. Furthermore, the total mass of reserves can be increased by Federal Reserve open-market purchases of government securities or decreased by open-market sales. The deterrents to discounting can be altered by varying the official discount rate or by official “moral suasion.” True, there are certain forces out-side central bank control which change the bank-reserve position—notably changes in the flow of international payments which expand or contract the reserve funds of commercial banks as well as the international-liquidity position of the country as a whole, and flows of hand-to-hand currency in and out of circulation. But on the whole, these forces can be offset or reinforced by measures at the disposal of the central bank.

For any individual commercial bank, the limits on its expansion of loans and investments within any short period are determined by its initial reserve position (the excess over requirements of the reserves it holds, plus the amount it is willing to borrow), plus the amount of additional deposits it can attract within the period, less the reserves required against those additional deposits. But if we shift our attention from the individual bank to the commercial banking system as a whole, the limits on expansion become less than one might think at first glance, because for the system as a whole the amount of additional deposits which can be “attracted” will be almost the same as the amount “created” by transactions which increase earning assets for the banks as a whole. (The only major difference between the amount created and the amount that can be attracted is the part of any increment in its total holding of money—hand-to-hand money plus commercial bank deposits—which the public will insist on taking in hand-to-hand currency.) The system as a whole can go on expanding so long as there are still commercial banks which have excess reserves or are willing to increase their discounts at the Federal Reserve. According to the assumptions one makes about the division of the increment into hand-to-hand money, checking (“demand”) deposits, and time deposits, the unused lending power implied by a given amount of initial excess reserves may be calculated as anywhere between three and five times the initial excess reserves.

For any other class of credit institutions, the limits on expansion of earning assets are more like those for the individual commercial bank than like those for commercial banks as a whole. An acceleration of mortgage lending by savings and loan associations, for example, does very little to increase the amount of funds which savers hold at such associations. If these associations obtain a million dollars of excess reserves (for example, through discounts at a Federal Home Loan bank), the additional amount they can lend is increased by almost exactly a million dollars. Thus, the initiative in nonbank credit expansion comes largely from savers who decide to entrust their funds to these institutions—although of course the institutions have some scope for making themselves attractive to savers.

To the extent that society reorganizes itself to make more use of such financial intermediaries, liquid assets expand relative to activity. For example, suppose that a group of savers have been in the habit of using their flow of saving from year to year to erect apartment houses and rent flats to newly married couples. If these savers now decide to place their funds with savings-and-loan associations, which in turn lend to newly married couples who buy new houses, the amount of real activity in housing investment may be unaltered. But the savers (who have acquired savings-and-loan “shares” redeemable on short notice instead of the ownership of apartment houses) will have their assets in more liquid form, while the liquidity of the new homeowners will not be more impaired by the prospect of paying amortization and interest on their mortgages than it would have been by the prospect of paying corresponding apartment rent. Accordingly, the economy will be more liquid at the end of a period in which savings-and-loan mortgage financing is substituted for direct investment by savers in new buildings. The argument is similar for other kinds of credit-institution expansion. [SeeFinancial intermediaries.]

The economic impact of money

Monetary economics offers a wide range of competing views about the impact of monetary forces on prices and economic activity. In good part, differences of view relate to the interpretation of somewhat ambiguous historical and statistical evidence. In principle, the adherents of each of today’s monetary schools admit the conceivability of a world in which the other schools’ favorite channel of monetary influence would be of the highest importance, but each school tends to argue that realistically and quantitatively its favorite channel of influence is the most important by a decisive margin. Furthermore, the different schools disagree sharply at the level of monetary policy. Hence, a correct impression can probably be given by contrasting several distinct types of theory—disregarding the minor concessions made by each school to the others.

To clear the ground, we may examine briefly several discredited theories—held in the past by influential economists but without professional support today. A common element of these discredited theories, which today’s monetary economists are at one in repudiating, is the view (stated explicitly by many of the older theorists and implied by the others) that the real volume of economic activity is governed entirely by nonmonetary forces, that the role of monetary analysis is solely to explain changes in the “purchasing power of money” (that is, the reciprocal of some broad index number of prices). Each of the discredited theories has in addition at least one other major element that today’s monetary economists all find unacceptable. Statist theories viewed the value of money as determined by an act of will on the part of government, whereas observation suggests that changes in the price level ordinarily occur against the will of government. Commodity theories viewed the value of money as transferred from commodity markets for gold and silver, which could be interpreted by means of a supply-and-demand analysis essentially similar to that applicable to iron or cotton. In view of the increasingly abstract character of money and of peculiarities of the gold market which stem precisely from the monetary role of gold, it seems more reasonable to describe the commodity aspect of gold as dominated by the monetary aspect. The classical quantity theory of money (as it flourished before 1929) took the velocity of circulation as a constant. Today all schools, including the modern quantity theorists, regard velocity as a variable whose behavior must be explained by monetary theory.

While each of the foregoing theories must be regarded as discredited as a general theory of money, present-day economists make much use of special-purpose theories which contain important elements of these older theories. For example, there is some affinity with statist theories in the widely used models which assume price levels to be constant or which take some key element of the price structure (for example, the level of wages) as a policy variable. In considering the probable long-run effects of suggestions that international monetary relations should be “reformed” along lines closer to the traditional gold standard, today’s economists are not such purists as to refuse to take into account the costs of producing gold, as well as the speculative attitudes of private and governmental holders of gold. In taking these factors into account, they use market analysis techniques similar to those used for other durable commodities. The classical quantity theory can still be applied with confidence to situations in which changes in the money stock are of enormous magnitude. If, as sometimes happens, a country’s money stock is multiplied by 10 or by 100 within a few years, monetary economists predict a change in the price level of the same order of magnitude—although many monetary economists would not be much surprised if some tenfold increases in the money stock were accompanied by fivefold increases in prices and others by twentyfold increases.

Present-day schools of monetary economics may be sorted out fairly well by their preferences in devising models that explain the general course of economic activity and prices in a market economy. At one extreme stands the “modern quantity theory” school, typified by Milton Friedman. It pictures changes in the stock of money as the dominant force in any explanation of the course of money payments and draws the policy inference that the sovereign prescription for steady growth without inflation is to engineer a steady growth rate for the money stock about equal to the growth of the economy’s productive potential. In this theory, velocity is treated neither as a constant nor as an exogenous variable but, rather, as endogenous to the system of interrelations used in the theory. Nevertheless, the forces that govern velocity are not pictured as lending themselves to any sort of policy intervention which might usefully supplement the regulation of the quantity of money.

At the other extreme from quantity-theory models stand models that analyze the behavior of economic activity and the price level without including any variable that corresponds to the stock of money. It would be hard to name any economists who would make it a matter of principle to go to this extreme. But the stress, in teaching and in popularized statements about economic policy, on investment as an exogenous variable, and on the determination of activity by investment (mediated by a “propensity to consume”), is so heavy that this extreme view is likely to be taken as the sum of academic wisdom about macroeconomics by a large proportion of those who have been exposed to economic pedagogy or advice. The associated view of economic policy is that fiscal policy is all-sufficient and monetary policy is inconsequential.

Much more representative of professional opinion as the academic monetary economists would like it to be understood is what may be called the interest rate school. On the theoretical side, the models typical of this view present “the” rate of interest as a major influence on investment and, through investment, on economic activity. In policy terms, this school treats the interest rate as the monetary influence on activity par excellence and does not concern itself with any direct influence of the stock of money on activity. (In relation to fiscal policy, the position of this school is likely to be eclectic, looking to an interaction of interest rate policy with such fiscal-policy variables as public expenditure and tax rates.) In the analytical models of this school, a peripheral liquidity-preference function expresses a relation between the money stock and the interest rate. The policy implication drawn may be that the interest rate can be regulated through the stock of money, or that if an appropriate rate of interest is adopted, the stock of money can be allowed to adapt itself to this rate without disturbing other aspects of the economy.

Some variants of the interest-rate approach pay a good deal of attention to possible changes within the structure of interest rates: for example, possibilities of relative changes between the interest rates on home mortgages and those on foreign funds invested in treasury bills in New York. This view merges into another position, which in principle is quite distinct from the interest-rate school: that of the credit-availability school The credit-availability doctrine is implicit in many official statements by the monetary authorities of the United States and other countries and has been usefully made explicit by Robert Roosa (1951). This view is that various types of investment may be powerfully influenced by the amount of funds the credit machinery makes available to finance home construction, inventory holding, exports, etc. Relative movements of interest rates may be useful indicators of the forces at work but will not themselves be the effective variable. The stock of money as such does not figure in explanations of activity along these lines, but changes in the stock of money will be by-products of transactions called for to carry out appropriate financing. The size of the monetary expansion that accompanies a given course of economic activity and prices, in this view, may vary substantially according to the financing of the economic activity.

Despite the lively controversy among schools, it is hard to see their views as philosophically irreconcilable. “Pure” models of one or another of the types just sketched illuminate the implications of various hypotheses, can help guide the search for evidence, and may offer useful special-purpose models for work on economic diagnosis and economic policy. But advocacy of any of these views as all-sufficient can be seriously misleading. This is particularly true, in the judgment of the author, of the “monetary monism” shown by advocates of the modern quantity theory approach and of some variants of the interest-structure approach—advocates who try to explain the flow of payments and economic activity without reference to such variables as taxes, accelerator effects of activity upon investment, changes in the impact of the “rest of the world,” and so forth. A certain healthy eclecticism, with willingness to be guided by the evidence in the choice of theoretical simplifications, would seem appropriate in the present stage of monetary economics.

Albert Gailord Hart


Friedman, Milton; and Schwartz, Anna J. 1963 A Monetary History of the United States: 1867-1960. National Bureau of Economic Research, Studies in Business Cycles, No. 12. Princeton Univ. Press.

Keynes, John Maynard (1930) 1958-1960 A Treatise on Money. 2 vols. London: Macmillan. → Volume 1: The Pure Theory of Money. Volume 2: The Applied Theory of Money.

Keynes, John Maynard 1936 The General Theory of Employment, Interest and Money. London: Macmillan. → A paperback edition was published in 1965 by Harcourt.

Nussbaum, Arthur (1939) 1950 Money in the Law. 2d ed. Chicago: Foundation Press.

Patinkin, Don (1956) 1965 Money, Interest, and Prices: An Integration of Monetary and Value Theory. 2d ed. New York: Harper.

Robertson, D. H. (1922) 1959 Money. Rev. ed. Univ. of Chicago Press.

Roosa, Robert V. 1951 Interest Rates and the Central Bank. Pages 270-295 in Money, Trade and Economic Growth: In Honor of John Henry Williams. New York: Macmillan.


Since men first began to write systematically about economic matters they have devoted special attention to the wide movements in the general level of prices that have intermittently occurred. Two alternative explanations have usually been offered. One has attributed the changes in prices to changes in the quantity of money. The other has attributed the changes in prices to war or to profiteers or to rises in wages or to some other special circumstance of the particular time and place and has regarded any accompanying change in the quantity of money as a common consequence of the same special circumstance. The first explanation has generally been referred to as the quantity theory of money, although that designation conceals the variety of forms the explanation has taken, the different levels of sophistication on which it has been developed, and the wide range of the claims that have been made for its applicability.

The broad outlines of the quantity theory of money were fully developed by the eighteenth century. The contemporary economist can still read David Hume’s essay “Of Money” (1752) with pleasure and profit and find few if any errors of commission. Reasonably satisfactory attempts at mathematical formulation have been traced back to the eighteenth century (see the references in Marget 1938). And certainly the mathematical formulation given by Simon Newcomb, the eminent astronomer, in 1886 is entirely modern, excepting only the particular symbols used. Knut Wicksell published a highly sophisticated analysis in 1898 that, because it was written in German, had less influence than its excellence justified. The two formulations of the quantity theory that have most influenced modern thinking both date from the end of the nineteenth century (although the dates of their publication are later): Irving Fisher’s transactions version (1911) and the Cambridge cash-balances version, attributed to Alfred Marshall (1923) and Arthur C. Pigou (1917). After some introductory remarks, this article discusses these two versions and then examines the Keynesian attack on the quantity theory, the post-Keynesian reformulation, empirical evidence bearing on the quantity theory, and finally some policy implications of the quantity theory.

In its most rigid and unqualified form the quantity theory asserts strict proportionality between the quantity of what is regarded as money and the level of prices. Hardly anyone has held the theory in that form, although statements capable of being so interpreted have often been made in the heat of argument or for expository simplicity. Virtually every quantity theorist has recognized that changes in the quantity of money that correspond to changes in the volume of trade or of output have no tendency to produce changes in prices. Nearly as many have recognized also that changes in the willingness of the community to hold money can occur for a variety of reasons and can introduce disparities between changes in the quantity of money per unit of trade or of output and changes in prices. What quantity theorists have held in common is the belief that these qualifications are of secondary importance for substantial changes in either prices or the quantity of money, so that the one will not in fact occur without the other.

The quantity theory in all its versions rests on a distinction between the nominal quantity of money and the real quantity of money. The nominal quantity of money is the quantity expressed in whatever units are used to designate money—talents, shekels, pounds, francs, lire, drachmas, dollars, and so on. The real quantity of money is the quantity expressed in terms of the volume of goods and services that the money will purchase.

There is no unique way to express the real quantity of money. One way of expressing it, one that is widely used, is in terms of some specified standard basket of goods and services. That is what is implicitly done when the real quantity of money is calculated by dividing the nominal quantity by a price index. The standard basket is then the basket whose components are used as weights in computing the price index—generally the basket purchased by some reference group in a base year.

Another way of expressing the real quantity of money is in terms of the time duration of the flows of goods and services the money could purchase. For a household, for example, the real quantity of money can be expressed in terms of the number of weeks of the household’s average level of consumption that it could finance with its money balances or, alternatively, in terms of the number of weeks of its average income to which its money balances are equal. For a business enterprise, the real quantity of money it holds can be expressed in terms of the number of weeks of its average purchases or of its average sales or of its average expenditures on final productive services (net value added) to which its money balances are equal. For the community as a whole, the real quantity of money can be expressed in terms of the number of weeks of aggregate transactions of the community or aggregate net output of the community to which it is equal.

For the community, attention has generally centered not on the real quantity of money but on a velocity of circulation—which can be regarded as the reciprocal of a particular expression of the real quantity of money. The ratio, for example, of the aggregate annual transactions of a community to its stock of money is termed the “transactions velocity of circulation of money,” since it gives the number of times the stock of money would have to “turn over” in a year to accomplish all transactions; similarly, the ratio of annual income to the stock of money is termed “income velocity.” In every case the calculation of the real quantity of money or of velocity is made at the set of prices prevailing at the date to which the calculation refers. These prices are the bridge between the nominal and the real quantity of money.

The quantity theory takes for granted that what ultimately matters to holders of money is the real quantity rather than the nominal quantity of money they hold and that there is some fairly definite real quantity of money that people wish to hold under any given circumstances. Suppose the nominal quantity that people hold happens to correspond at current prices to a real quantity larger than that which they wish to hold. Individuals will then seek to dispose of what they regard as their excess money balances; they will try to pay out a larger sum for the purchase of securities, goods, and services, for the repayment of debts, and as gifts than they are receiving from the corresponding sources. However, one man’s expenditures are another’s receipts. One man can reduce his nominal money balances only by persuading someone else to increase his. The community as a whole cannot in general spend more than it receives.

The community’s attempt to do so will nonetheless have important effects. If prices and income are free to change, the attempt to spend more will raise the nominal volume of expenditures and receipts, which will lead to a bidding up of prices and perhaps also to an increase in output. If prices are fixed by custom or by government edict, the attempt to spend more either will be matched by an increase in goods and services or will produce “shortages” and “queues.” These in turn will raise the effective prices and are likely sooner or later to force changes in official prices. The initial excess of money balances will therefore tend to be eliminated, even though there is no change in the nominal quantity, by either a reduction in the real quantity held through price rises or an increase in the real quantity desired through output increases. Conversely, if nominal balances happen to correspond to a smaller real quantity at current prices than people wish to hold, people will seek to spend less than they are receiving. They cannot in the aggregate do so. But their attempt will in the process lower nominal expenditures and receipts, driving down prices or output and either raising the real balances held or lowering the real balances desired.

It is clear from this discussion that changes in prices and nominal income can be produced either by changes in the real balances that people wish to hold or by changes in the nominal balances available for them to hold. Indeed it is a tautology, summarized in the famous quantity equation (to which we shall return) that all changes in nominal income can be attributed to one or the other—just as a change in the price of any good can always be attributed to a change in either demand or supply. The quantity theory is not, however, this tautology. It is, rather, the empirical generalization that changes in desired real balances (in the demand for money) tend to proceed slowly and gradually or to be the result of events set in train by prior changes in supply, whereas, in contrast, substantial changes in the supply of nominal balances can and frequently do occur independently of any changes in demand. The conclusion is that substantial changes in prices or nominal income are almost invariably the result of changes in the nominal supply of money.

Variants of the quantity theory of money are distinguished by the variables that are regarded as most important in determining the real quantity of money that people desire to hold and by the analysis of the process whereby any discrepancy between actual and desired real balances works itself out. The chief issues that have occasioned controversy and conflict are perhaps the definition of money, the importance of transactions motives versus asset motives in the holding of money, the importance of substitution between money and other assets expressed in nominal terms as compared with substitution between money and real goods and services, and the speed and character of the dynamic process of adjustment. We shall have occasion to comment on these below.

Fisher’s transactions approach

The quantity equation in transactions form

Every payment made by one economic unit in an economy—household, business enterprise, or governmental organization—to another can be regarded as the product of a price and a quantity: wage per week times number of weeks, price of a good times number of units of the good, dividend per share times number of shares, and so on. The total volume of transactions during a period of time can thus be regarded as equal to the sum of a large number of such products, say ∑piti, where pi is the price and ti the quantity for the i th transaction. Let P be a suitably chosen average of the prices, and let T be a suitably chosen aggregate of the quantities. We then have

(1) Total volume of transactions = PT =∑ piti.

The total volume of transactions can also be viewed in terms of the medium of exchange used to effectuate them. Let M be the total quantity of money in the economy and V the average number of times each unit of money is used to effectuate a transaction during the year (the transactions velocity). We then have

(2) Total volume of transactions = MV,

or, putting (1) and (2) together, the famous quantity equation

(3) MV = PT.

Each side of this equation can be broken into subcategories: the right-hand side into different categories of transactions and the left-hand side into payments in different form. Fisher and later writers emphasized in particular the subdivision of the left-hand side into two categories of payments, those effected by the transfer of hand-to-hand currency (including coin) and those effected by the transfer of deposits. Let M stand solely for the volume of currency and V for the velocity of currency, M′ for the volume of deposits and V′ for the velocity of deposits. We then can write

(4) MV + M′V′ = PT.

One reason for the emphasis on this division was the persistent dispute about whether the term “money” should include only currency or deposits as well—this dispute was at the center of the banking school-currency school controversy that raged in England in the nineteenth century. Another reason was the direct availability of figures on M′V′ from bank records of clearings or of debits to accounts so that it was and is possible to calculate V′ in a way that it is not possible to calculate V.

As they stand, equations (3) and (4) are identities: The V of (3) or the V and V′ of (4) are defined as the numbers having the property that they render the equations correct. If P changes from one time period to the next, then so must one or more of the other terms in the equations. That is an arithmetic necessity, not an economic proposition. The identities are useful for economic analysis because they offer a useful classification of the factors at work, a classification into categories each of which contains factors largely independent of those in the other categories.

The categories in the quantity equation

Consider the fourfold classification in equation (3).

Transactions. The physical volume of transactions is denoted by T. It is determined by the resources available to the economy, the efficiency with which they are used, the degree of integration or disintegration of the economy (which determines the number of transactions involved in the production and sale of final goods), and so on. These are the basic physical and operational characteristics of the economy. All quantity theorists, at least since Hume, have recognized that changes in the stock of money may have transitional effects on T. However, they have generally regarded the average level of T and long-run changes in T as largely independent of the quantity of money, although not of the existence of a money economy.

Price level. The price level, which is the object of investigation, is denoted by P. It has generally been regarded as the resultant of other forces rather than as itself having any important element of autonomy. Cost-push or profit-push theories of inflation treat it as being to some extent independently determined. Under a regime of widespread government price fixing, it clearly does have some measure of autonomy.

Stock of money. The stock of money in nominal units is denoted by M. Its precise definition, as noted before, has been the subject of much controversy. The transactions approach makes it seem natural to define money in terms of its function as a medium of exchange and to include only those means of payments generally acceptable in discharge of debts. Under a gold standard, specie was regarded as money par excellence, and questions were raised about extending the definition to include paper money and then demand deposits transferable by check. Today these would generally be included in the definitions, but there is much controversy about the treatment of other deposits, such as time deposits and savings deposits. On transactions lines, it is argued that such deposits cannot be used to discharge debts without first being converted into either currency or demand deposits. One answer to this argument is that it is also true of some items that all are willing to regard as money. For example, in the United States, $10,000 is the largest denomination of currency. Such a currency note can be used to effectuate few transactions without first being converted into smaller denominations. No issue of principle is involved. However M is defined, equation (3) remains valid, provided V is appropriately defined. The issue is one of the usefulness of one or another definition: what definition of M will have the empirical property of rendering the forces determining the other symbols in the equation as nearly independent as possible of those determining M?

Whatever the precise definition of M, the factors determining it depend critically on the monetary system and are largely independent of the forces determining T. Two main cases should be distinguished: a commodity standard, of which a gold standard is the most important historical example, and a fiduciary standard.

Under a gold standard the amount of money in the gold standard world is determined by the total existing amount of gold, the fraction used as money, and the institutional arrangements determining the superstructure of claims to gold, in the form of currency or deposits, that can be erected on any given stock of gold. Changes in the amount of money depend on costs of producing various quantities of gold, the demand for gold for non-monetary purposes, and the financial arrangements for issuing fiduciary claims to gold. For any one country the situation is somewhat different: the quantity of money is a dependent rather than an independent variable. It must be whatever quantity is consistent with levels of prices and incomes that will maintain balance in its international payments. Gold inflows or outflows tend to keep it at that quantity.

Under a fiduciary standard the amount of money is ultimately under the control of the monetary authorities. In practice these authorities have always been governmental agencies. Although they have had the power to control the stock of money, they frequently have not stated their objectives in these terms but have let the stock of money be whatever was consistent with some alternative objective (e.g., given exchange rates or given interest rates).

Under either the gold or the fiduciary standard the factors determining M are connected only loosely, if at all, with those we have considered as affecting directly either P or T. It is precisely this clearly perceived independence of the factors determining the quantity of money that has rendered the quantity theory so attractive to economists.

Velocity of circulation. We now come to V, the velocity of circulation. This is the core of the quantity theory. It is determined by whatever factors affect, on the one hand, the amount of money people want to hold and, on the other, their ability to make their actual money balances equal their desired balances.

The transactions approach makes it natural to emphasize payment practices: the frequency with which people are paid, the irregularity of receipts and payments, and so on. However, such payment practices themselves seem to be largely explained by the willingness of people to hold money. For example, during periods of rapid inflation, when it is costly to hold money, pay periods consistently tend to become more frequent.

It is convenient to postpone a fuller consideration of the factors determining velocity until we discuss the post-Keynesian formulation in terms of the demand for money. Here it suffices to point out that Fisher and other earlier quantity theorists explicitly recognized that velocity would be affected by, among other factors, the rate of interest and also the rate of change of prices. They recognized that both high rates of interest and rapidly rising prices would give people an incentive to economize on money balances and so tend to raise velocity and that low rates of interest and falling prices would have the opposite effect. They were never guilty of the crude fallacy—with which critics have often charged them—of regarding velocity as something of a natural constant.

The quantity equation in income form

One difficulty with equations (3) and (4) is that the magnitudes designated “transactions” and the associated “general price level” proved conceptually ambiguous and difficult to measure with available data. Despite the large amount of empirical work done on these equations, notably by Fisher and Carl Snyder, these ambiguities and deficiencies of data have never been satisfactorily resolved. Should capital transfers, such as purchases and sales of real estate and securities, be included? What about gifts? Money-changing transactions? What is the relevant price and quantity in these transactions?

As noted before, the data on volume of transactions have been satisfactory only for transactions effected by check. For these, debits to bank accounts (or bank clearings) provide a statistically reliable total, although even then there are problems involved in separating out money-changing transactions. Average deposits give a statistically reliable estimate of M′, so that estimates of V′ can be and are readily calculated for frequent time intervals and for many different geographical areas. However, even for check transactions, there is no satisfactory way to break down the other side of the equation into price and quantity components.

With the development of national or social accounting, which has stressed income transactions rather than gross transactions and which has explicitly and satisfactorily dealt with the conceptual and statistical problems of distinguishing between changes in prices and changes in quantities, there has been a tendency to express the quantity equation in terms of income rather than of transactions. Let Y be money national income, P the price index implicit in estimating national income at constant prices, and y national income in constant prices, so that

(5) Y = Py.

Let M represent, as before, the stock of money, but define V as the average number of times per year that the money stock is used in making income transactions (that is, payments for final productive services) rather than all transactions. We then can write the quantity equation in income form as

(6) MV =Py. Although the symbols P and V are used both in eqs. (5) and (6) and in eqs. (1) through (4), they stand for different concepts in each group.

Equation (6) is both conceptually and empirically more satisfactory than equation (3). Nonetheless, the earlier discussion of the fourfold classification implicit in the quantity equation applies, except for changes that are nearly self-evident, such as the very different relevance for y than for T of the degree of integration or disintegration of industry. Equation (6) is also closer in conception to the Cambridge approach, to which we now turn.

The Cambridge cash-balances approach

The essential feature of a money economy is that it enables the act of purchase to be separated from the act of sale. An individual who has something to exchange need not seek out the double coincidence—someone who both wants what he has and offers in exchange what he wants. He need only find someone who wants what he has, sell it to him for general purchasing power, and then find someone else who has what he wants and buy it with general purchasing power.

In order for the act of purchase to be separated from the act of sale, there must be something which can serve as a temporary abode of purchasing power in the interim. It is this aspect of money which is emphasized in the cash-balances approach.

How much money will people or enterprises want to hold for this purpose? As a first approximation we may suppose that the amount one wants to hold bears some relation to one’s income, since that determines the volume of purchases and sales in which one is engaged. We then add up the cash balances held by all holders of money in the community and express the total as a fraction of their total income. We can then write

(7) M =kPy,

where M, P, and y are defined as in equation (6) and k is the ratio of the money stock to income. We can regard k either as a constant so calculated as to make (7) an identity, or as the “desired” ratio, so that M is the “desired” amount of money, which need not be equal to the actual amount. In either case, k is clearly equal numerically to the reciprocal of the V of equation (6), the V in one case being interpreted as measured velocity and in the other as desired velocity.

Formally the Cambridge equation (7) is simply a transformation of Fisher’s equation (6). Most writers who have used one of the two approaches regarded them in this way and tended to cover much the same ground. Yet to a far greater extent than is reflected in the writings of the early expositors, the two approaches stress different aspects of money, make different definitions of money seem natural, and lead to emphasis being placed on different variables and analytical techniques.

Consider the definition of money. The transactions approach makes it natural to define money in terms of whatever serves as the medium of exchange in discharging obligations. By stressing the function of money as a temporary abode of purchasing power the cash-balances approach makes it seem entirely appropriate to include also such stores of value as demand and time deposits not transferable by check, although it clearly does not require their inclusion.

Similarly, the transactions approach leads to stress being placed on such variables as payments practices, the financial and economic arrangements for effecting transactions, and the speed of communication and transportation as it affects the time required to make a payment—essentially, that is, to emphasis on the mechanical aspects of the payments process. The cash-balances approach, on the other hand, leads to stress being placed on variables affecting the usefulness of money as an asset: the costs and returns from holding money instead of other assets, the uncertainty of the future, and so on.

Stress on the first set of variables led most early writers—both those using the Fisher equation and those using the Cambridge equation—to predict that velocity would increase over time as a result of technological improvements in transportation and communication, which would facilitate the payments process. In fact, velocity has shown no tendency to rise over time. If anything it has rather tended to decline in economically progressive countries along with rises in real income, although this tendency is less pronounced when money is defined narrowly than when it is defined to include some deposits not transferable by check. The tendency for velocity to decline, along with the very size of money balances (equal in 1960 in the United States to about one month’s income for currency outside banks alone, to nearly five months’ income for currency plus adjusted demand deposits, and to about seven months’ income for currency and all deposits at commercial banks) has contributed to a shift of emphasis from the function of money as a medium of exchange to its function as a temporary abode of purchasing power.

Finally, with regard to analytical techniques, the cash-balances approach fits in much more readily with the general Marshallian demand–supply apparatus than the transactions approach does. Equation (7) can be regarded as a demand function for money, with P and y on the right-hand side being two of the variables on which demand for money depends, and with k symbolizing all the other variables, so that k is to be regarded not as a numerical constant but as itself a function of still other variables. For completion the analysis requires another equation showing the supply of money as a function of other variables. The price level is then the resultant of the interaction of the demand and supply functions. From this point of view the quantity theory of money as embodied in equation (7) is a theory of the demand for money, not a theory of the price level or of money income.

The Keynesian attack

The Keynesian income–expenditure analysis developed in the General Theory of Employment, Interest and Money (1936) offered an alternative approach to the interpretation of changes in money income that emphasized the relation between money income and investment or autonomous expenditures rather than the relation between money income and the stock of money. The success of the Keynesian revolution in economic thought led to a temporary eclipse of the quantity theory of money and to perhaps an all-time low in the amount of economic research and writing devoted to monetary theory and analysis, narrowly interpreted. It became a widely accepted view that money does not matter, or, at any rate, that it does not matter very much, and that policy and theory alike should concentrate on investment, government fiscal policy, and the relation between consumer expenditures and income.

Keynes did not, of course, deny the validity of the quantity equation. What he did was something very different. He argued that under conditions of underemployment equilibrium the V in equation (6) and the k in equation (7) were highly unstable and would, for the most part, passively adapt to whatever changes independently occurred in money income or the stock of money. Hence, under such conditions these equations, although entirely valid, were largely useless for policy or prediction. Moreover, he regarded such conditions as prevailing much, if not most, of the time.

Keynes reached this conclusion by giving a highly specific form to equation (7). The quantity of money demanded, he argued, could be treated as if it were divided into two parts, one part, M1, “held to satisfy the transactions- and precautionary-motives,” the other, M2, “held to satisfy the speculative-motive” (1936, p. 199). He regarded M1 as a roughly constant fraction of income. He regarded the demand for M2 as arising from “uncertainty as to the future course of the rate of interest” and the amount demanded as depending on the relation between current rates of interest and the rates of interest expected to prevail in the future. (Keynes, of course, emphasized that there was a whole complex of interest rates. However, for simplicity, he spoke in terms of “the rate of interest,” usually meaning by that the rate on long-term securities that were fixed in nominal value and that involved minimal risks of default—for example, government bonds.) In a “given state of expectations,” the higher the current rate of interest, the lower would be the (real) amount of money people would want to hold for speculative motives for two reasons: first, the greater would be the cost in terms of current earnings sacrificed by holding money instead of securities, and, second, the more likely it would be that interest rates would fall, and hence bond prices rise, and so the greater would be the cost in terms of capital gains sacrificed by holding money instead of securities.

Although expectations are given great prominence in developing the liquidity function expressing the demand for M2 , they do not enter explicitly into that function. For the most part, Keynes and his followers in practice treated the amount of M2 demanded simply as a function of the current interest rate, the emphasis on expectations serving only as a reason for their attribution of instability to the liquidity function.

Except for somewhat different language, the analysis up to this point differs from that of earlier quantity theorists, such as Fisher, only by its subtle analysis of the role of expectations about future interest rates and its greater emphasis on current interest rates and by restricting more narrowly the variables explicitly considered as affecting the amount of money demanded.

Keynes’s special twist concerned the empirical form of the liquidity-preference function at the low interest rates that he believed would prevail under conditions of underemployment equilibrium. Let the interest rate fall sufficiently low, he argued, and money and bonds would become perfect substitutes for one another; liquidity preference, as he put it, would become absolute. The liquidity-preference function, expressing the quantity of M2 demanded as a function of the rate of interest, would become horizontal at some low but finite rate of interest. Under such circumstances, he held, if the amount of money is increased by whatever means, the holders of money might seek to convert the additional cash balances into bonds. This would, however, tend to lower the rate of return on bonds. Even the slightest lowering would, he argued, lead holders of money to desist from trying to convert it into bonds. The result would simply be that people would be willing to hold the increased quantity of money;k would be higher and V lower. Conversely, if the amount of money were decreased, holders of bonds would seek to convert them into money, but this would tend to raise the rate of interest, and even the slightest rise would reconcile them to holding the bonds instead of the money. Or, again, suppose there is an increase in money income for whatever reason. That will require an increase in M1, which can come out of M2, without any further effects. Conversely, any decline in M1, can be added to M2, without any further effects. The conclusion is that under circumstances of absolute liquidity preference income can change without a change in M and M can change without a change in income. The holders of money are in metastable equilibrium, like a tumbler on its side on a flat surface; they will be satisfied with what-ever the amount of money happens to be.

Keynes regarded absolute liquidity preference as a strictly “limiting case” of which, though it “might become practically important in future,” he knew “of no example . . . hitherto” (1936, p. 207). But, since he regarded interest rates as frequently being not far above the level at which liquidity preference would become absolute, he treated velocity as if in practice its behavior frequently approximated that which would prevail in this limiting case.

Keynes’s disciples went much farther than Keynes himself. They were readier than he was to accept absolute liquidity preference as the actual state of affairs. More important, many argued that when liquidity preference was not absolute, changes in the quantity of money would affect only the interest rate on bonds and that changes in this interest rate in turn would have little further effect. They argued that both consumption expenditures and investment expenditures were nearly completely insensitive to changes in interest rates, so that a change in M would merely be offset by an opposite and compensatory change in V (or a change in the same direction in k), leaving P and y almost completely unaffected. In essence their argument consists in asserting that only paper securities are substitutes for money balances—that real assets never are (see Tobin 1961).

The issues raised for the quantity theory by the Keynesian analysis are clearly empirical rather than theoretical. Is it a fact that the quantity of money demanded is a function primarily of current income and of the rate of interest on fixed-money-value securities? Is it a fact that the amount demanded is highly elastic with respect to the rate of interest on such securities at a low but finite rate of interest? Is it a fact that expenditures are highly inelastic with respect to such a rate of interest? Or, to put the issue in an equivalent but more readily observable form, is it a fact that velocity is a highly unstable and unpredictable magnitude that generally varies in a direction opposite to that of the quantity of money?

The post-Keynesian reformulation

Experience with monetary policy after World War II very quickly produced a renewed interest in money and a renewed belief that money matters. Under the influence of Keynesian ideas, country after country followed an easy-money policy designed to keep interest rates low in order to stimulate, if only slightly, the investment regarded as needed to offset the shortage of demand that was universally feared. The result was an intensification of the strong inflationary pressure inherited from the war, a pressure that was brought under control only when countries undertook so-called orthodox measures to restrain the growth in the stock of money, as in Italy, beginning in August 1947, in Germany in June 1948, in the United States in March 1951, in Great Britain in November 1951, and in France in January 1960.

The effect of experience was reinforced by developments in economic theory, especially by the explicit analysis of the so-called real-balance effect as a channel through which changes in prices and in the quantity of money could affect income, even when investment and consumption were insensitive to changes in interest rates or when absolute liquidity preference prevented changes in interest rates (see Haberler 1937; Tobin 1947; Pigou 1943; 1947; Patinkin 1948).

Many economists continue to use Keynesian analysis but have revised their empirical presumptions. They grant that liquidity preference is not absolute and that investment does have a sizable elasticity with respect to interest rates. They continue, however, to regard analysis in terms of the quantity equation as less useful and meaningful than analysis in terms of autonomous expenditures and the multiplier, with monetary changes being taken into account as one factor among many that can affect these magnitudes.

The postwar period has also seen a return to analysis in terms of the quantity equation accompanied by a reformulation of the quantity theory that has been strongly affected by the Keynesian analysis of liquidity preference (Johnson 1962). The reformulation emphasizes the role of money as an asset and hence treats the demand for money as part of capital or wealth theory, concerned with the composition of the balance sheet or portfolio of assets.

From this point of view, it is important to distinguish between ultimate wealth-holders, to whom money is one form in which they choose to hold their wealth, and enterprises, to whom money is a producer’s good like machinery or inventories.

Demand by ultimate wealth-holders

For ultimate wealth-holders the demand for money, in real terms, may be expected to be a function of the following variables.

(a) Total wealth. This is the analogue of the budget constraint in the usual theory of consumer choice. It is the total that must be divided among various forms of assets. In practice, estimates of total wealth are seldom available. Instead, income may serve as an index of wealth. However, it should be recognized that income as measured by statisticians may be a defective index of wealth because it is subject to erratic year-to-year fluctuations and that a longer term concept, like the concept of permanent income developed in connection with the theory of consumption, may be more useful. (Friedman 1957; 1959, p. 7; Meltzer 1963; Brunner & Meltzer 1963).

The emphasis on income as a surrogate for wealth, rather than as a measure of the “work” to be done by money, is conceptually perhaps the basic difference between the reformulation and the earlier versions of quantity theory.

(b) The division of wealth between human and nonhuman forms. The major asset of most wealth-holders is their personal earning capacity, but the conversion of human into nonhuman wealth or the reverse is subject to narrow limits because of institutional constraints. It can be done by using current earnings to purchase nonhuman wealth or by using nonhuman wealth to finance the acquisition of skills but not by purchase or sale and to only a limited extent by borrowing on the collateral of earning power. Hence, the fraction of total wealth that is in the form of nonhuman wealth may be an additional important variable.

(c) The expected rates of return on money and other assets. This is the analogue of the prices of a commodity and its substitutes and complements in the usual theory of consumer demand. The nominal rate of return on money may be zero, as it generally is on currency, or negative, as it some-times is on demand deposits subject to net service charges, or positive, as it sometimes is on demand deposits on which interest is paid and generally is on time deposits. The nominal rate of return on other assets consists of two parts; first, any currently paid yield or cost, such as interest on bonds, dividends on equities, and storage costs on physical assets, and, second, changes in their nominal prices. The second part will, of course, be especially important under conditions of inflation or deflation.

(d) Other variables determining the utility attached to the services rendered by money relative to those rendered by other assets—in Keynesian terminology, determining the value attached to liquidity proper. One such variable may be one al-ready considered—namely, real wealth or income, since the services rendered by money may in principle be regarded by wealth-holders as a “necessity,” like bread, the consumption of which increases less than in proportion to any increase in income, or as a “luxury,” like recreation, the consumption of which increases more than in proportion to any increase in income.

Another variable, one that is likely to be important empirically, is the degree of economic stability expected to prevail in the future. Wealth-holders are likely to attach considerably more value to liquidity when they expect economic conditions to be unstable than when they expect them to be highly stable. This variable is likely to be difficult to express quantitatively even though the direction of change may be clear from qualitative information. For example, the outbreak of war clearly produces expectations of instability, which is one reason why war is often accompanied by a notable increase in real balances—that is, a notable decline in velocity.

We can symbolize this analysis in terms of the following demand function for money for an individual wealth-holder:

where M, P, and y have the same meaning as in equation (7) except that they relate to a single wealth-holder; w is the fraction of wealth in non-human form (or, alternatively, the fraction of income derived from property);rm is the expected rate of return on money;rb is the expected rate of return on fixed-value securities, including expected changes in their prices; re is the expected rate of return on equities, including expected changes in their prices; (1/P)(dP/dt) is the expected rate of change of prices of goods and hence the expected rate of return on real assets; and u is a portmanteau symbol standing for whatever variables other than income may affect the utility attached to the services of money. Each of the four rates of return stands, of course, for a set of rates of return, and for some purposes it may be important to classify assets still more finely—for example, to distinguish currency from deposits, long-term from short-term fixed-value securities, risky from relatively safe equities, and different kinds of physical assets from one another.

The usual problems of aggregation arise in passing from equation (8) to a corresponding equation for the economy as a whole—in particular, they arise from the possibility that the amount of money demanded may depend on the distribution of such variables as y and w and not merely on their aggregate or average value. If we neglect these distributional effects, (8) can be regarded as applying to the community as a whole, with M and y referring to per capita money holdings and per capita real income, respectively, and w to the fraction of aggregate wealth in nonhuman form.

The major problems that arise in practice in applying (8) are the precise definitions of y and w, the estimation of expected rates of return as contrasted with actual rates of return, and the quantitative specification of the variables designated by u.

Demand by business enterprises

Business enterprises are not subject to a constraint comparable to that imposed by the total wealth of the ultimate wealth-holder. The total amount of capital embodied in productive assets, including money, is a variable that can be determined by the enterprise to maximize returns, since it can acquire additional capital through the capital market. Hence, there is no reason on this ground to include total wealth, or y as a surrogate for total wealth, as a variable in their demand function for money.

It may, however, be desirable to include a some-what similar variable defining the “scale” of the enterprise on different grounds—namely, as an index of the productive value of different quantities of money to the enterprise. This is more nearly in line with the earlier transactions approach emphasizing the “work” to be done by money. It is by no means clear what the appropriate variable is: total transactions, net value added, net income, total capital in nonmoney form, or net worth. The lack of availability of data has meant that much less empirical work has been done on the business demand for money than on an aggregate demand curve encompassing both ultimate wealth-holders and business enterprises. As a result there are as yet only faint indications about the best variable to use.

The division of wealth between human and non-human form has no special relevance to business enterprises, since they are likely to buy the services of both forms on the market.

Rates of return on money and on alternative assets are, of course, highly relevant to business enterprises. These rates determine the net cost to them of holding the money balances. However, the particular rates that are relevant may be quite different from those that are relevant for ultimate wealth-holders. For example, rates charged by banks on loans are of minor importance for wealth-holders yet may be extremely important for businesses, since bank loans may be a way in which they can acquire the capital embodied in money balances.

The counterpart for business enterprises of the variable u in (8) is the set of variables other than scale affecting the productivity of money balances. At least one of these—namely, expectations about economic stability—is likely to be common to business enterprises and ultimate wealth-holders.

With these interpretations of the variables, equation (8), with w excluded, can be regarded as symbolizing the business demand for money and, as it stands, symbolizing aggregate demand for money, although with even more serious qualifications about the ambiguities introduced by aggregation.

The process of adjustment

Emphasis on the role of money as a component of wealth is important because of the variables to which it directs attention. It is important also for its implications about the process of adjustment to a difference between actual and desired stocks of money. Any such discrepancy is a disturbance in a balance sheet. As such it can be corrected in either of two ways: by a rearrangement of assets and liabilities through purchase, sale, borrowing, and lending or by the use of current flows of income and expenditure to add to or subtract from some assets and liabilities. The Keynesian liquidity-preference analysis stressed the first and, in its most rigid form, only one specific rearrangement: that between money and bonds. The earlier quantity theory stressed the second to the almost complete exclusion of the first. The reformulation enforces consideration of both.

The process of adjustment is important in particular for its implications about the time that readjustment may be expected to take. Balance-sheet adjustments can in general be expected to take considerable time, especially when they take the form of adjustments through alterations in flows and especially when they concern the money balance, M, whose function is precisely that of serving as a temporary abode of purchasing power, thereby permitting purchases to be separated from sales.

It is plausible that any widespread disturbance in money balances—through, say, an unanticipated increase or decrease in the quantity of money by the actions of monetary authorities—will initially be met by an attempted readjustment of assets and liabilities through purchase or sale. But such attempted readjustments will alter the prices of assets and liabilities, leading to the spread of the adjustment from one asset or liability to another. Such changes in prices will also alter the relative prices of capital items and the services they yield and so establish incentives to alter flows of receipts and expenditures. If the monetary change has altered the total nominal value of wealth, not simply its composition, this will introduce an additional reason to change flows. The effect of any monetary disturbance will thus spread in ever-widening ripples, and some of its most important effects may not be manifest for many months after the initial disturbance.

Empirical evidence

Empirical evidence about the relation between changes in the quantity of money and in prices, although it was sufficiently extensive to produce a widespread belief in the quantity theory, has seldom been systematically collated and organized. Until modern times, money was mostly metallic—copper, brass, silver, gold. The most notable changes in its nominal quantity under such circumstances were produced by sweating and clipping, by governmental edicts changing the nominal values attached to specified physical quantities of the metal, or by great discoveries of new sources of specie. Economic history is replete with examples of the first two and their coincidence with corresponding changes in nominal prices (see Cipolla 1956; Feavearyear 1931). The most important example of the third is the great specie discoveries in the New World in the sixteenth century. The association between this increase in the quantity of money and the price revolution of the sixteenth and seventeenth centuries has been well documented (see Hamilton 1934).

The nineteenth and early twentieth centuries offer another striking example, despite the much greater development of deposit money and paper money. The gold discoveries in Australia and the United States in the 1840s were followed by substantial price rises in the 1850s. When the rate of growth of the gold stock slowed down, and especially when country after country shifted from silver to gold (Germany in 1871-1873, the Latin Monetary Union in 1873, the Netherlands in 1875-1876) or returned to gold (the United States in 1879), world prices in terms of gold fell slowly but fairly steadily for about three decades. New gold discoveries in the 1880s and 1890s, powerfully rein-forced by the development of improved methods of mining and refining, particularly the development of commercially feasible methods of using the cyanide process to extract gold from low-grade ore, reversed the trend. The world gold stock started to grow at a much more rapid rate, and no additional important countries shifted to gold, so there was no increase in demand from this source. The price trend also reversed itself. From the mid-1890s to 1914, world prices in terms of gold rose by 25 to 50 per cent, depending on the index used.

Evidence from great inflations. The most dramatic evidence about the role of the quantity of money comes from periods of great monetary disturbances, and among these the most striking are the periods of extremely rapid price rise, such as the hyperinflations after World War I in Germany, Austria, and Russia, those after World War II in Hungary and Greece, and the rapid rises, if not hyperinflations, in many South American and some other countries both before and after World War II. These twentieth-century episodes have been rather more systematically studied than earlier ones. The studies demonstrate almost conclusively the critical role of changes in the quantity of money (the most important study is Cagan 1956).

These studies also enable us to sketch with considerable accuracy a rather typical profile of an inflation that follows a period of fairly stable prices. The inflation often has its start in a period of war, but it need not. What is important is that something, generally the financing of extraordinary governmental expenditures, produces a much more rapid rate of growth of the money stock. Prices start to rise, but at a slower pace than the money stock, so that for a time the real stock of money increases. The reason for this is twofold. First, it takes time for people to readjust their money balances. Second, initially there is a general expectation that what goes up will come down, that the rise in prices is temporary and will be followed by a decline. Such expectations make money seem to be a desirable form in which to hold assets, and therefore they lead to an increase in desired money balances in real terms.

As prices continue to rise, expectations are revised. People come to expect prices to continue to rise. Desired balances decline. People also take more active measures to eliminate the discrepancy between actual and desired balances. The result is that prices start to rise faster than the stock of money, and real balances start to decline (that is, velocity starts to rise). How far this process continues depends on the rate of rise in the stock of money. If it remains fairly stable, real balances settle down to a level that is lower than the initial level but roughly constant—for a constant expected rate of rise in prices there will be a roughly constant level of desired real balances; in this case, prices ultimately rise at the same rate as the stock of money. A decline in the rate of rise in the stock of money is followed by a decline in the rate of rise in prices, and this is followed in turn by an increase in actual and desired real balances as people readjust their expectations; the converse also holds. The result is that once the process is in full swing, changes in real balances follow with a lag changes in the rate of change of the stock of money. The lag reflects the fact that people apparently base their expectations of future rates of price change on an average of experience over the preceding several years, the period of averaging being shorter the more rapid the inflation.

In the extreme cases, those which have degenerated into hyperinflation and a complete breakdown of the medium of exchange, rates of price change have been so high and real balances have been driven down so low as to lead to the widespread introduction of substitute moneys, usually foreign currencies. At that point completely new monetary systems have had to be introduced.

A similar phenomenon has occurred when inflation has been effectively suppressed by price controls, so that there is a substantial gap between the prices that would prevail in the absence of controls and the legally permitted prices. This gap prevents money from functioning as an effective medium of exchange and also leads to the introduction of substitute moneys, sometimes rather bizarre ones like the cigarettes and cognac used in post-World War II Germany.

Evidence from the United States

Recent studies of the monetary history of the United States provide an especially full documentation of monetary relations (see especially Friedman & Schwartz 1963 a). Some of the salient findings may be summarized briefly.

(a) The real stock of money, expressed in terms of months of income, has risen from about 3½ months’ income at the end of the Civil War in 1865 to over 7 months’ income by 1960—that is, velocity has fallen (money is defined as currency held by the public plus all adjusted deposits in commercial banks, income is defined as net national product). One interpretation of this trend is that the rise in real balances reflects the contemporaneous rise in real income per capita. From the end of World War n to almost 1960, velocity rose rather than fell. It is not yet clear whether this was a temporary interruption or a change of trend.

(b) If allowance is made for the trend in velocity, there has been a very close connection between the stock of money per unit of output and prices. This is brought out clearly by Figure 1, which, to eliminate short-period fluctuations, plots the average stock of money per unit of output and average prices in successive reference-cycle phases.

(c) In the course of business cycles the stock of money has slowed up its rate of growth well before the date designated by National Bureau of Economic Research reference-cycle dates as the peak of the cycle and has increased its rate of growth well before the trough. In mild contractions these decelerations have generally produced not an absolute decline in the stock of money but only a lower rate of growth. Every severe contraction has been accompanied by an absolute decline in the stock of money, and the severity of the contraction

a. A phase is the trough-to-peak or peak-to-trough interval between reference-cycle turning points. (For a discussion of reference cycles, see Moore 1961.) Phase averages are computed by weighting initial and terminal years each at one-half and intervening years at unity. The trend lines are computed regressions based on phase-average values, 1882–1961.

b. The index of implicit prices is based on 1929 = 100. For the underlying figures, see Friedman and Schwartz (1963a, chart 62).

c. Stock of money per unit of output is the ratio of the money stock to real income, expressed as an index. For the underlying figures, see Friedman and Schwartz (1963a, table A-l, col. 8, and source notes to chart 62).

has been in roughly the same order as the size of the decline in the stock of money. Although changes in the rate of growth of the stock of money have to some extent reflected the contemporaneous course of business, on many occasions they have quite clearly been the result of independent forces, such as the deliberate decisions of monetary authorities. The clearest examples are probably the wartime increases and the decreases from 1920 to 1921, 1929 to 1933, and 1937 to 1938.

(d) Velocity as usually measured has tended to rise during business expansions and decline during business contractions. One explanation offered is that this pattern reflects the use of measured income in computing velocity rather than a longer term concept, such as permanent income (Friedman 1959). Another explanation offered is that it reflects the effect of interest rates.

(e) It is agreed that velocity is related to interest rates, higher interest rates being associated with higher velocity, and conversely, but there is wide disagreement about the magnitude and significance of the relation. One view is that changes in interest rates are either the primary or a major source of all cyclical and secular changes in velocity (Latané 1954; 1960; Brunner & Meltzer 1963). Another view is that changes in interest rates have been a minor factor, much less important than changes in real per capita income for secular changes in velocity and much less important than differences between measured and permanent income for cyclical changes (Friedman 1959; Friedman & Schwartz 1963 a).

Evidence from underdeveloped countries

A few scattered figures for some of the less developed countries may help to indicate the broad range of applicability of the quantity theory of money.

Real balances of currency. In less developed countries, currency is often a more meaningful total than currency plus deposits for two reasons. One is that deposits are often used to a very limited extent and by highly selected groups in the population. The other is that governmental monetary intervention is more frequent and more important with respect to deposits, so that an erratic element is introduced into the conditions of supply of deposits.

Table 1 gives estimates for a recent year of the stock of currency expressed in number of weeks of personal disposable income for less developed countries and, for comparison, for the United States. These figures are subject to very wide margins of error, particularly because of the unreliability of income estimates for the less developed countries. It is, therefore, all the more

Table 1 – International comparison of real balances
 YearNumber of weaks of personal disposable income held in currency
United States19604.3

striking that for countries for which methods of economic organization vary so greatly and for which real income per capita must vary over a range of something well in excess of 20 to 1, real balances vary over a range of decidedly less than 2 to 1. And much of that variation is readily explained by different degrees of financial development: deposits are least widely used in India, Greece, and Yugoslavia, most widely used in Israel and the United States, and used to an intermediate extent in Turkey. Clearly, money-holding propensities have a great degree of uniformity under a wide range of circumstances.

Changes in quantity of money and in prices. If data like those in Table 1 are of questionable accuracy, year-to-year data are even more dubious for the underdeveloped countries. A recent study that was confined to the Middle East shows a variety of relations. In Egypt and Turkey the data for wholesale prices show the kind of close relationship between money supply and price changes that other experiences would lead one to expect. For the other countries the relation is loose or nonexistent (Penrose 1962). Rises in output may explain some part of the discrepancy. Much more likely explanations are the following: (a) The inclusion of rapidly expanding deposits whose significance is questionable. Currency figures alone show much less of a discrepancy, (b) Major defects in the price indexes. The countries have sought to suppress price increases, often have legal prices that are honored more in the breach than in the observance, and calculate price indexes in ways that understate the actual price rise. It is highly likely that revised and improved figures will remove much of the apparent discrepancy.

Stability of velocity and the multiplier

As pointed out above, the challenge to the quantity theory offered by Keynes rested entirely on differences in empirical presumptions, which can be summarized in terms of the stability attributed to the velocity of circulation, on the one hand, and the Keynesian multiplier (the ratio of changes in income to changes in autonomous expenditures), on the other.

A systematic comparison of the relative stability of velocity and the multiplier has been made for the United States from 1896 to 1958 (Friedman & Meiselman 1964a; 1964b; 1965). The results are striking: velocity is consistently more stable than the multiplier, These results have been challenged by other writers (Hester 1964; Ando & Modigliani 1965; DePrano & Mayer 1965), showing that this question is still far from settled.

Policy implications

On a very general level the implications of the quantity theory for economic policy are straightforward and clear. On a more precise and detailed level they are not.

Acceptance of the quantity theory clearly means that the stock of money is a key variable in policies directed at the control of the level of prices or of money income. Inflation can be prevented if and only if the stock of money per unit of output can be kept from increasing appreciably. Deflation can be prevented if and only if the stock of money per unit of output can be kept from decreasing appreciably. This implication is by no means a trivial one. Monetary authorities have more frequently than not taken conditions in the credit market—rates of interest, availability of loans, and so on—as criteria of policy and have paid little or no attention to the stock of money per se. This emphasis on credit as opposed to monetary policy accounts both for the great depression in the United States from 1929 to 1933, when the Federal Reserve System allowed the stock of money to decline by one-third, and for many of the post-World War n inflations.

The quantity theory has no such clear implication, even on this general level, about policies concerned with the growth of real income. Both inflation and deflation have proved consistent with growth, stagnation, or decline.

Passing from these general and vague statements to specific prescriptions for policy is difficult. It is tempting to conclude from the close average relation between changes in the stock of money and changes in money income that control over the stock of money can be used as a precision instrument for offsetting other forces making for instability in money income. Unfortunately there are many slips between this cup and this lip.

One slip is that a very close relationship on the average is consistent with much variation in the individual instance. A high correlation between changes relative to trend in the stock of money and in money income over many business cycles—involving, say, an average increase of 2 per cent in money income for every 1 per cent increase in money—is entirely consistent with the corresponding ratio varying in individual years or over single cycles from zero or a negative number to, say, 4 or 5. But for policy in a particular cycle, what is important is the relation in that cycle, not the relation on the average.

A second slip is the length of time it takes for changes in the stock of money to have their effect—this is one of the reasons for the variability that constitutes the first slip. A change in the stock of money today will have most of its effects some months from now, perhaps on the average as much as 12 to 15 months from now. A policy of using monetary changes to offset other forces making for instability therefore requires an ability to forecast a considerable time in advance what those forces will be—an ability that has so far been conspicuous by its absence. Moreover, the time it takes for monetary changes to be effective undoubtedly varies rather considerably. Hence it would also be necessary to forecast how long the lag would be in the specific instance.

These two slips mean that monetary changes in-tended to be stabilizing may in fact be destabilizing; they may introduce a random and erratic influence into economic affairs. It is a sobering thought that both the stock of money and economic activity displayed greater instability in the first two peacetime decades after the establishment of the Federal Reserve System (1919 to 1939) than in any other pair of decades in the whole of United States history. The blind, quasi-automatic forces that controlled monetary matters in earlier decades produced a higher degree of stability than a system specifically established to promote monetary and economic stability. The greater stability of prices and employment since the end of World War n may be a sign that we have learned how to avoid the mistakes of the interwar decades, but it is much too soon to have any confidence in that comfortable conclusion.

Other slips have to do with the indirect effects of methods used to control the stock of money; with possible conflicts between the objective of stable prices and such other objectives as stable exchange rates, stable employment at a high level, and low interest rates on government borrowing; and with the possible desire to use inflation as a means of imposing a tax on money balances.

One negative implication of the quantity theory, implicit in the above, is worth spelling out because of the continued widespread acceptance of the belief that fiscal policy is the key to control of the level of money income. The quantity theory implies that the effect of government deficits or surpluses depends critically on how they are financed. If a deficit is financed by borrowing from the public without an increase in the quantity of money, the direct expansionary effect of the excess of government spending over receipts will be offset to some extent, and possibly to a very great extent, by the indirect contractionary effect of the transfer of funds to the government through borrowing. Furthermore, the deficit will primarily affect income only while it lasts; a cessation of the deficit will mean a cessation of its effects. If a deficit is financed by printing money, there will be no offset, and the enlarged stock of money will continue to exert an effect after the deficit is terminated. What matters most is the behavior of the stock of money, and government deficits are expansionary primarily if they serve as the means of increasing the stock of money; other means of increasing the stock of money will have closely similar effects.

Milton Friedman

[See alsoLiquidity preference; Monetary policy].


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At least since the time of William Petty the velocity of circulation of money—known also as the rate of turnover, rate of use, frequency of use, rapidity of circulation, or efficiency—has been recognized as an important dimension of monetary analysis. A given quantity of money can finance any volume of spending, depending on how frequently, on the average, each unit is used. Moreover, a change in the quantity of money will alter aggregate demand for goods and services only if it is not offset by an opposite change in velocity. An understanding of the factors governing velocity obviously is crucial to the formulation of effective monetary policy.

Nevertheless, the velocity concept has been surrounded by controversies throughout its long history. The concept found greatest acceptance during the opening decades of the twentieth century—particularly in the United States, through the influence of Irving Fisher (1911). During the 1930s and 1940s it was abandoned by most economists in favor of the new conceptual framework fashioned by J. M. Keynes [seeLIQUIDITY PREFERENCE]. More recently, however, the older concept has been finding its way into monetary literature again.

The recent revival of interest in monetary velocity reflects a number of developments. It has be-come evident in the post-World War n period that the major behavior relations proposed in the New Economics are not as dependable as many Keynesian enthusiasts had hoped they would be. Mean-while, velocity analysis has been improved significantly. The concept of velocity has been refined in various ways, and it has been integrated at last into the main body of economic theory. In addition, the statistical resources for study of velocity have been extended greatly. This combination of conceptual breakthroughs and improved statistics has been accompanied by a number of attempts to explain particular velocity movements over time or cross-sectional differences, or to fashion general theories of velocity.

The early history of thought relating to velocity has been traced quite fully elsewhere, particularly by Holtrop (1929) and Marget (1938). This article is confined to a review of fundamentals, along with a discussion of more recent developments in velocity theory.

Types of velocities

The concept of the velocity of circulation of money is clearly and easily defined in general terms. It is the average number of times that each unit of money is spent during any time period. From the equation of exchange,

MV = PT,

where M is the average stock of money in existence during the period, P the average price of items pur-chased, and T the number of items purchased, it is evident that velocity is the volume of spending per unit of money:

V = PT/M.

However, the definition does not uniquely define velocity, since it fails to specify the meaning of “spending” and “money.” Actually, economists have worked with several broad types of velocities, and with countless minor variations thereof.

Fisher’s approach was to include in spending all exchanges of money against goods, services, and securities throughout an economy during a period such as a year and to restrict money to actual means of payment (i.e., privately held demand de-posits and currency). The resulting spending-money ratio can be called aggregate transactions velocity, Vt. For several reasons this velocity concept is not very useful, except for purposes of classroom exposition. In the first place, reliable measures of total spending in any economy—even for a single year—do not exist and would be extremely difficult to construct. Second, while study of Vt might help us to understand changes in total spending, the general price level (P), and the volume of transactions (T), these concepts have little interest from a welfare or policy point of view. Finally, the use of V, could be defended, apart from its immeasurability, only if money were regarded mainly as a “medium of exchange”; the demand for money would then be sensitive to the volume of spending, and Vt would tend to be fairly stable. Most economists now emphasize the “store of wealth” function of money, and consequently they see no advantage in relating the stock of money to total spending, as Vt does.

A second approach, pioneered in the United States by the Federal Reserve System, is to focus on the velocity of demand deposits alone, in which case spending means “spending by check.” This velocity is known as deposit turnover, Vd . Monthly estimates of Vd, based on data from a large sample of banks, are available for the United States since 1919 and are published each month in the Federal Reserve Bulletin. Although these estimates are a valued part of our monetary statistics, Vd , like Vt , does not directly relate to important policy variables such as the level of wholesale prices or the level of national income. And, like Vt, it assumes implicitly that the volume of spending is the major determinant of the demand for money.

Recognition of the shortcomings of Vt and Vd has led modern economists, beginning with Pigou (1927), to develop a third index of money use, income velocity, Vy. Since Vy is merely the ratio of spending for currently produced goods and services (i.e., gross or net national product) to the total money stock, it can be computed quite simply. Annual time series of Vy in the United States since 1867 have been constructed by Friedman and Schwartz (1963). Moreover, with the world-wide development of national income statistics, Vy estimates can now be made for a large number of other countries. Quarterly Vy series are also available for the United States since 1946.

In addition to its measurability, Vy has the important advantage of relating the money stock to national product, a concept of major interest to economists. Similarly, an index of the prices of final goods and services is much more meaningful than a general price index which includes prices of stocks and many other things that are not vitally important to most policy decisions. While Vy was attacked by Keynes (1930, vol. 2, p. 24) as a “hybrid conception having no particular significance” because some of the money included in its denominator is used to finance purchases other than those of final output, most contemporary economists would reject the criticism as placing too much emphasis on the “transaction motive” for holding cash. If the volume of spending does not dominate the demand for money, then it does not matter that Vy omits large segments of spending from the analysis.

One can obtain a fourth type of velocity by dis-aggregating whatever concept of spending one wishes to use and dividing each sector’s spending by its money holdings. The sectors can be drawn according to any number of principles (e.g., by regions, industries, or size classes) and at any level of aggregation; hence, the number of conceivable sector velocities is indefinitely large.

The idea of sectoral velocity analysis is not new; Keynes (1930, vol. 2) advocated such an approach decades ago. Except for the Federal Reserve estimates of Vd, however, which have always been available by groups of cities as well as on an aggregate basis, sector velocities have been ignored for the most part until quite recently. One can compute annual velocities for business firms and households in the United States since the early 1930s and quarterly business velocities since the late 1940s (see Selden 1962).

The principal advantage of the sector approach is that it may facilitate analysis of aggregate velocity. Aggregate velocity is a weighted average of sector velocities, the weights being the share of the money stock that each sector holds. Let Vti and Mi be transactions velocity and money holdings in the ith sector. Then,

Thus, changes in aggregate velocity reflect either changes in the weights of sectors or changes in sector velocities. Velocity changes may emanate from different sectors at different times; specific knowledge of the point of origin of a change should contribute to an understanding of its nature.

Another concept, the velocity of active money, Va, was popularized by Keynes (1936). In a sense this may be regarded as a special kind of sector velocity, in which total spending, however defined, is divided by “active” balances only. The relationship of this velocity to aggregate velocity is then

V = VaMa/M,

where Ma is active money. Because of the difficulty in finding an appropriate basis for separating cash into active and idle components, most economists have found this concept, like Vt , useful mainly in abstract discussions of monetary theory. Angell (1936), Tobin (1947), Bronfenbrenner and Mayer (1960), and several others have attempted to solve this problem by (1) adopting the Keynesian hypothesis that Va changes only gradually over time and (2) finding some period, such as 1929, in which all cash supposedly was drawn into active circulation. Such calculations are not without interest, but there has been a growing tendency in the 1950s and 1960s for economists to abandon the active-idle dichotomy and to work with total cash instead.

The behavior of velocity

It is doubtful whether any economist of recognized stature, from Petty’s day to the present, has regarded the velocity of money as being rigidly fixed over time. Not until the twentieth century, however, did dependable time series become available, permitting close study of velocity movements.

U.S. data reveal the existence of fairly regular seasonal and cyclical velocity variations, as well as persistent secular changes. Seasonally, both Vd and Vy reach lows early in the year and highs in the closing months, despite the fact that the money stock has a similar seasonal pattern.

Cyclically, all velocity measures tend to rise during general business expansions and fall during contractions, with peaks and troughs in velocity coinciding with business cycle peaks and troughs. Cyclical amplitudes, interpreted as deviations from secular trends, are substantially greater in V than in M; indeed, the latter usually continues to rise during business contractions, although at a diminished rate. These cyclical changes in velocity can be seen in Figure 1, which reproduces two income velocity series constructed by Friedman and Schwartz, one referring to the velocity of money defined broadly (total adjusted deposits plus currency outside banks) for the period 1869-1960, the other referring to money defined more narrowly (adjusted demand deposits plus currency outside banks) for the period 1915-1960. Cyclical swings in velocity are characteristic of all major sectors of the economy, but they are much more severe for businesses than for households and governmental units.

Figure 1 also shows a pronounced and steady downtrend in velocity between the early 1880s and the late 1940s—a pattern that was first noted by

Warburton (1945; 1949). The latter’s studies, based on admittedly crude data, suggested that Vy has been declining at a rate of about 1 1/3 per cent per year since the beginning of the nineteenth century. It is interesting that the more elaborate study of Friedman and Schwartz (1963), covering nine decades ending in 1960, also found a declining trend of slightly over 1 per cent per year. These findings are particularly interesting because they are contrary to the expectation, held by Fisher (1911) and others, that velocity would rise over time. Comparable statistics over extended time periods are lacking for other countries, but fragmentary evidence compiled by Doblin (1951) strongly suggests that secular velocity declines have been a world-wide phenomenon, at least through the 1940s.

Since the end of World War n, on the other hand, Vd and Vu have been rising steadily, except for minor cyclical interruptions. The postwar rise shows up regardless of how spending and money are defined, although the rise is dampened considerably if one follows Friedman and Schwartz and defines M broadly to include commercial bank time deposits as well as demand deposits and currency. Moreover, sectoral studies reveal that the postwar velocity rise has taken place in every sector for which data are available.

There has been much controversy over the nature of postwar velocity movements—whether the rise represents a fundamental break with the past or is merely a readjustment from abnormally low levels in the 1930s and during World War n. We shall have more to say on this matter in the next section.

In addition to the temporal changes in velocity already mentioned, there are noteworthy cross-sectional differences at any point in time. Perhaps the most familiar of these differences are in Vd for New York City, for six other major centers, and for the remaining centers for which information is compiled. In 1963 these figures were 84.8, 44.6, and 29.0, respectively.

Among the major sectors covered by Federal Reserve flow-of-funds accounts, corporate business has consistently had higher velocity ratios than noncorporate business, which in turn has higher ratios than the consumer and nonprofit sectors. State and local governments, the farm sector, and nonbank financial intermediaries hold large amounts of cash per dollar of spending, while the federal government operates with relatively small cash balances, though not so small as that of corporate business.

Within the business sector there are further interesting differences by industry and by size of firm. Wholesale and retail trade are high velocity sectors, manufacturing is intermediate, and mining and public utilities maintain low velocity ratios. Until recently small firms have tended to have higher velocities than large firms; however, during the general velocity rise of the 1950s the velocities of very large firms rose much more rapidly than those of medium-size and small firms. By the end of the decade most of the earlier size differentials had been eliminated.

Determinants of velocity

Fisher, Marshall, Pigou, and Wicksell

Although a number of early thinkers gained important insights into the problem of what determines monetary velocity, it is fair to say that real progress dates from the first decade or two of this century, with the contributions of Fisher (1911), Marshall (1923), Pigou (1917), and Wicksell (1906). These men worked more or less independently (except Pigou, who was Marshall’s student and colleague), and they developed rather different modes of analysis. In fact, Marshall and Pigou chose to work with the reciprocal of velocity, which they misleadingly designated k, rather than with velocity itself. Yet the substance of their analyses was remarkably similar. In each case emphasis was placed on more or less mechanical relationships between payments and receipts. This is evident from Fisher’s formal listing of influences on velocity:

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 disbursements.
(b) As to regularity of receipts and disbursements.
(c) As to correspondence between times and amounts of receipts and disbursements.

3. General influences.
(a) Density of population.
(b) Rapidity of transportation.

However, implicitly or explicitly all of these economists assigned some role to the rate of interest as a velocity determinant. This comes out most clearly in Pigou’s work (1917).

Perhaps the major stumbling block in these early analyses was the sterile manner in which velocity (or its reciprocal) was related to the demand for money. It was recognized that velocity and the demand for money are intimately related: a rise (fall) in V implies a fall (rise) in the demand for money. However,, the neoclassical depiction of the demand for money necessarily took the form of a rectangular hyperbola. M was placed on the horizontal axis; the value of money, 1/P, on the vertical. For given levels of V and T, M times 1/P is fixed; that is, real cash balances are constant. Variations in T/V would cause a shift in the demand curve, but the new curve would again be a rectangular hyperbola.

This pseudo integration of monetary theory with orthodox price theory was a cul-de-sac which impeded progress in velocity theory for a generation. To a large extent the theoretical advances made by Angell (1936; 1941), Ellis (1938), and others in the 1920s and 1930s were merely refinements of the technical payments factors isolated earlier by Fisher. The interesting contributions made more recently by Garvy (1959a; 1959b) represent a further development in this direction.

The Hicksian-Keynesian revolution

The transition into modern velocity analysis began with Hicks’s famous article (1935) and Keynes’s General Theory (1936). Both of these works proposed that the demand for money be analyzed by setting M against the cost of holding it rather than against its exchange value (1/P), cost being measured by forgone yields on other assets.

Unfortunately, the analysis was not carried much beyond this. Furthermore, Keynes’s discussion, which attracted more attention than Hicks’s, was built around the arbitrary distinction between active and idle cash—velocity received scant explicit attention. In fact, ridiculed “those who make sport with velocity.” Many years passed, therefore, before it became generally recognized that the Keynesian discussion of “liquidity preference” was a disguised analysis of velocity.

Insofar as they have been expressly concerned with velocity theory, most Keynesian economists have emphasized the causal role of interest rates—low (high) rates being associated with low (high) velocities.

Postwar developments

The most significant advances in velocity theory in the postwar period have been, essentially, elaborations of Hicks’s 1935 contribution. It is now widely accepted that velocity must be analyzed in the framework of the demand for money and that orthodox demand theory can be applied in a fairly straightforward manner to the demand for the services of money. However, the “price” variable—the cost of holding money—has been refined considerably, and attention has been directed increasingly to the impact of such nonprice determinants as income, wealth, money substitutes, tastes, and expectations.

The cost of holding money. Despite a number of interesting contributions, economists remain sharply divided over the role of the cost of holding money as a determinant of V. On the level of pure theory, Baumol (1952) and Tobin (1956) demonstrated that there are good reasons for thinking that, contrary to the earlier Keynesian emphasis, the demand for transactions balances is a function of interest rates. More significantly, several empirical studies were made. Cagan (1956) found striking relationships during hyperinflations in a number of countries between real balances (and presumably V) and the rate of change of the price level. On the basis of annual data for the United States for 1907-1958, Latane (1954; 1960) concluded that desired holdings of demand deposits plus currency, per dollar of gross national product, were fairly responsive to changes in corporate yields. Meltzer (1963Z?), using measures similar to those of Latane, also found a strong interest-rate effect on velocity for 1900-1958. In addition to these aggregate time series studies, Selden (1962) and Meltzer (1963a) made cross-section analyses of velocity and the demand for money among American business firms, and found strong indications of interest-rate effects.

On the other hand, Friedman (1959, p. 345), in a study of velocity movements over the period 1870-1954, concluded:

A rise in the bond yield tends to reduce the real stock of money demanded for a given real income—that is, to raise velocity—and conversely. Bond yields, however, play nothing like so important and regularly consistent a role in accounting for changes in velocity as does real income. The short-term interest rate was even less highly correlated with velocity than the yield on corporate bonds.

In part these differences in emphasis reflect differing concepts, measures, and time periods used in the various statistical tests. Friedman, in contrast with Latane and Meltzer, included commercial bank time deposits in the money stock, and his period of analysis is substantially longer. But the differences also reflect the fact that in Friedman’s work the effect of interest rates on V was examined after allowing for the effect of changes in real income per capita.

Aside from these extensive empirical investigations, there was increasing concern, in general commentaries on monetary problems during the 1950s, with the interest elasticity of velocity. It was frequently contended that during periods of rising demand for goods and services, banks and other lenders can easily sell securities on the open market and use the proceeds to finance additional spending. Thus, while the monetary authorities can keep M from expanding at such times, they may be unable to prevent inflationary increases in V. However, the validity of this line of argument depends on (1) the terms on which the holders of cash are willing to acquire additional securities and (2) the terms on which prospective spenders are willing to incur additional debt. If the first of these relationships is highly interest-inelastic while the second is not, then lenders have little power to circumvent monetary policy. But the facts concerning these interest elasticities, and hence the interest elasticity of V, need much further study before any definite conclusions can be reached.

Other hypotheses. A number of economists, including Warburton (1949), Selden (1956), and Friedman (1959), have studied the role of per capita real, income as a velocity determinant. Friedman’s analysis is particularly interesting, in that he relies on income changes to explain not only broad secular movements in V but cyclical movements as well. This is done by use of a “permanent income” hypothesis.[SeeMONEY, article on QUANTITY THEORY, for additional discussion.] As income rises secularly, corresponding to rises in permanent income, the demand for money rises faster than income; hence, the ratio of income to the money stock (Vy) falls. On the other hand, during cyclical expansions measured income rises faster than permanent income; hence, Vy rises. Friedman was able to explain nearly all velocity movements in the United States between 1870 and 1954 in terms of this permanent income hypothesis. However, the persistent rise in Vy, despite rising real incomes, during the 1950s and early 1960s has created a problem for all of these income approaches.

The postwar rise in V has stimulated economists to propose other explanations as well. Some have stressed the greater sense of economic security in the postwar world because of the altered economic role of government. Others have pointed out the generally inflationary environment that characterized the 1940s and much of the 1950s, making cash an unattractive asset to hold. However, other than changes in interest rates and income, the factor that has received most attention as a velocity determinant has been wealth. The role of financial wealth has been singled out by Gurley and Shaw (1960, pp. 177-179), who point out that in its broad historical contours the ratio of income to all financial assets has followed a pattern similar to that of the ratio of income to the money stock. Certainly the growth of money substitutes in the form of claims against nonbank financial intermediaries has been an outstanding feature of the postwar world. A different kind of wealth hypothesis has been put forth by Meltzer (1963Z?), who found a close multiple correlation between V, corporate bond yields, and nonhuman tangible wealth over the period 1900-1958.

It is clear from these various studies that economists are still some distance from reaching a consensus on the determinants of velocity. Nevertheless, the studies indicate that the velocity concept continues to preoccupy a large number of economists and that important progress has been made.

Richard T. Selden


Angell, James W. 1936 The Behavior of Money: Exploratory Studies. New York: McGraw-Hill.

Angell, James W. 1941 Investment and Business Cycles. New York: McGraw-Hill.

Baumol, William J. 1952 The Transactions Demand for Cash: An Inventory Theoretic Approach. Quarterly Journal of Economics 66:545-556.

Bronfenbrenner, Martin; and Mayer, Thomas 1960 Liquidity Functions in the American Economy. Econometrica 28:810-834.

Cagan, Phillip 1956 The Monetary Dynamics of Hyperinflation. Pages 25-117 in Milton Friedman (editor), Studies in the Quantity Theory of Money. Univ. of Chicago Press.

Doblin, Ernest 1951 The Ratio of Income to Money Supply: An International Survey. Review of Economics and Statistics 33:201-213.

Ellis, Howard S. (1938) 1951 Some Fundamentals in the Theory of Velocity. Pages 89-128 in American Economic Association, Readings in Monetary Theory. Philadelphia: Blakiston.

Fisher, Irving (1911) 1920 The Purchasing Power of Money: Its Determination and Relation to Credit, Interest and Crises. New ed., rev. New York: Macmillan.

Friedman, Milton 1959 The Demand for Money: Some Theoretical and Empirical Results. Journal of Political Economy 67:327-351.

Friedman, Milton; and Schwartz, Anna J. 1963 A Monetary History of the United States: 1867-1960. National Bureau of Economic Research, Studies in Business Cycles, No. 12. Princeton Univ. Press. → Copyright © 1963, by National Bureau of Economic Research.

Garvy, George 1959a Deposit Velocity and Its Significance. New York: Federal Reserve Bank of New York.

Garvy, George 1959b Structural Aspects of Money Velocity. Quarterly Journal of Economics 73:429-447.

Gurley, John G.; and Shaw, Edward S. 1960 Money in a Theory of Finance. With a mathematical appendix by Alain C. Enthoven. Washington: Brookings Institution.

Hicks, John R. (1935) 1951 A Suggestion for Simplifying the Theory of Money. Pages 13-32 in American Economic Association, Readings in Monetary Theory. Philadelphia: Blakiston.

Holtrop, Marius W. 1929 Theories of the Velocity of Circulation of Money in Earlier Economic Literature. Economic History 1:503-524.

Keynes, John Maynard (1930) 1958-1960 A Treatise on Money. 2 vols. London: Macmillan. → Volume 1: The Pure Theory of Money. Volume 2:The Applied Theory of Money.

Keynes, John Maynard 1936 The General Theory of Employment, Interest and Money. London: Macmillan. → A paperback edition was published in 1965 by Harcourt.

LatanÉ, Henry A. 1954 Cash Balances and the Interest Rate: A Pragmatic Approach. Review of Economics and Statistics 36:456-460.

LatanÉ, Henry A. 1960 Income Velocity and Interest Rates: A Pragmatic Approach. Review of Economics and Statistics 42:445-449.

Marget, Arthur W. 1938 The Theory of Prices: A Re-examination of the Central Problems of Monetary Theory. Vol. 1. New York: Prentice-Hall.

Marshall, Alfred (1923)1960 Money, Credit … Commerce. New York: Kelley.

Meltzer, Allan H. 1963a The Demand for Money: A Cross-section Study of Business Firms. Quarterly Journal of Economics 77:405-422.

Meltzer, Allan H. 19632? The Demand for Money: The Evidence From the Time Series. Journal of Political Economy 71:219-246.

Pigou, Arthur C. (1917) 1951 The Value of Money. Pages 162-183 in American Economic Association, Readings in Monetary Theory. Philadelphia: Blakiston.

Pigou, Arthur C. (1927) 1929 Industrial Fluctuations. 2d ed. London: Macmillan.

Selden, Richard T. 1956 Monetary Velocity in the United States. Pages 177-257 in Milton Friedman (editor), Studies in the Quantity Theory of Money. Univ. of Chicago Press.

Selden, Richard T. 1962 The Postwar Rise in the Velocity of Money: A Sectoral Analysis. New York: National Bureau of Economic Research.

Tobin, James 1947 Liquidity Preference and Monetary Policy. Review of Economics and Statistics 29:124-131.

Tobin, James 1956 The Interest-elasticity of Transactions Demand for Cash. Review of Economics and Statistics 38:241-247.

Warburton, Clark 1945 Volume of Money and the Price Level Between Two World Wars. Journal of Political Economy 53:150-163.

Warburton, Clark 1949 The Secular Trend in Monetary Velocity. Quarterly Journal of Economics 63:68-91.

Wicksell, Knut (1906) 1935 Lectures on Political Economy. Volume 2: Money. London: Routledge. → First published in Swedish.


In its broadest sense, the term “monetary reform” refers to any programs or measures intended to change basic features of a nation’s monetary and banking system. Recently the term has been extended to include proposals for reform of the international financial mechanism through fundamental changes in the present system of operations under the gold exchange standard. But in its most commonly accepted sense, the term relates to the comprehensive stabilization programs adopted in many European countries after World War II with a view to ending monetary disorders or disorganization and re-establishing a well-functioning currency system.

Monetary reform programs after World War II typically provided for a reduction in varying degrees of the liquid asset holdings of the public. While differing in many respects from country to country, the reforms always involved a withdrawal of most, and on occasion all, of the outstanding currency and the issue of a new currency. In most countries that adopted such programs, only a small part of the currency holdings was directly converted into a new currency; the remainder had to be deposited in banks. All or a large part of the balances in bank accounts were usually blocked, with withdrawals or transfers permitted only up to specified amounts or for specified purposes. In some cases, a substantial proportion of the blocked deposits was eventually wiped out. Several reform programs were associated with fiscal measures of varying sorts, such as capital levies or war-profits taxes. In a few cases the compulsory exchange of some of the blocked deposits into nonmarketable government securities was required.

Background and objectives

The objectives of the reform programs can be readily understood given the monetary situation prevailing through most of continental Europe during World War II and immediately afterward. In German-occupied Europe, the diversion of goods and services to the occupation armies, and similar exactions, were typically financed by central banks. The same was true of the large export surpluses vis-a-vis Germany. In that country, only a relatively small part of the war effort was financed out of taxes and public subscriptions to government bonds. Following liberation of western Europe and the occupation of Germany and Austria, the Continent was subjected to new financial strains. The allies’ military expenditures for local supplies and services, and particularly the spending of military currency by their armies, added to monetary disorders during a period of severe disruption of the civilian economy.

Yet, despite the vast accumulation of liquid reserves in the hands of the public throughout the Continent and the shrinkage of civilian production, the familiar signs of open inflation—rapidly rising prices and wages and skyrocketing currency circulation—were largely confined to France, Italy, and southeastern Europe. The reason was a rigid enforcement of comprehensive price, wage, and allocation controls. Experience in postwar Europe demonstrates that when shelves are bare of all save the most essential supplies and actual economic transactions are at a bare minimum, considerable scope exists for the effective enforcement of such controls. [See Prices,article on Price control and rationing.]

As conditions for a recovery of production were re-established, the effectiveness of controls rapidly diminished. Even then in some parts of Europe they were fairly effective in preventing price inflation. But it became apparent that repressed inflation was exerting a deactivating, if not disintegrating, effect on economic life. Farmers resisted selling in legal markets for money with which there was little to buy and which was likely to depreciate; they preferred to barter their produce for consumer goods, including jewelry and other valuables that could serve as hoarding media. Manufacturers were reluctant to use up their remaining stocks of raw materials and semiprocessed goods and preferred to produce not for sale but primarily for the purpose of adding to their inventories. Consumers with large hoards of unwelcome funds at their disposal had no incentive to work at legal wage rates, payment of which added little to their purchasing power in real terms and merely left them with so much more unusable cash holdings.

In some countries, notably Germany, money was thus increasingly repudiated as a medium for effecting transactions, and a growing segment of trade moved entirely outside the traditional money economy. Farmers and manufacturers, as well as traders, turned to barter and so-called “compensation trading,” with sales of goods tied to the delivery of usable products. Elsewhere, several heterogeneous market spheres existed side by side, with gray and black markets taking over an ever larger share of the distribution of current output. Currency in circulation tended to be used only as one of several media of exchange in illegal market deals and as a supplement to the ration ticket in transactions at authorized prices. Especially in Italy and to a lesser extent in France, the control mechanism had largely broken down and open inflation taken hold. In some parts of southeastern Europe, particularly in Hungary and Greece, hyperinflation reigned after the end of the war.

Thus in much of postwar Europe a basic task for civilian and military governments was to mop up idle money before it leaked into illegal markets and undermined the control mechanism and to rehabilitate the monetary system so that producers, whether farmers or manufacturers, would again be responsive to incentives to sell for monetary compensation and workers would depend on current income instead of past savings. A longer-term objective was to make the economy more amenable to the traditional controls of monetary policy. In those parts of Europe where inflation was no longer repressed, the task of monetary reform was to re-establish public confidence in money as a store of value.

Several other major objectives of monetary reform programs had little to do with the removal of excess liquidity. Among such purposes were a census of wealth, the detection of war profiteering and tax evasion, the cancellation of currency held by the enemy, and the unification of the currency in countries where several currencies had been introduced during the war. In some countries, political objectives also played a major role; reforms were directed at depriving certain socioeconomic groupings of most or all of their savings. This was true particularly in the countries of Soviet-occupied Europe, where monetary reforms had the incidental aim of strengthening the planning and allocation system. In sharp contrast, one of the major objectives of the West German currency reform was to revitalize free market forces and to permit the price mechanism to reassert itself as the decisive determinant of economic behavior.


Despite the variety of their purposes, monetary reform programs can be classified by a few basic types, although of course few programs fall wholly in any one category. A useful classification, based on the method of reform employed, distinguishes (1) those that reduce the money supply by canceling part of the currency in circulation and part of existing bank deposits; (2) those that reduce the money supply by directing part of it into bank deposits, which are then to some extent demonetized or deactivated; (3) those that provide for conversion of the outstanding currency into another currency, without any significant blocking of bank deposits; and (4) those that virtually replace the entire money circulation with a new unit of account, after the pre-existing unit has depreciated to an infinitesimal fraction of its original value. Further useful lines of distinction may be based on whether or not the programs include fiscal devices, such as capital levies directed at absorbing significant amounts of funds held by owners of real, rather than monetary, assets. (For a somewhat different typology of monetary reforms, see Gurley 1953.)

(1) Cancellation—Germany. Monetary reform programs of the first type—featuring a severe reduction of the money supply by simply wiping out large portions of outstanding notes and deposits—were enacted in West Germany and several eastern European countries. West Germany’s program, enacted in June 1948, is of special interest because it was a resounding success and a turning point in the postwar history of that country. Under a series of decrees by the occupation powers, individuals were issued Deutsche mark (DM) 60 in exchange for an equal amount of old reichsmark (RM) holdings, and DM60 per employee were paid out to businesses for payroll purposes. Business holdings and individual holdings in excess of the converted amount were credited to bank accounts. Only a small fraction of all bank deposits was eventually converted into Deutsche marks, the great bulk being simply wiped out. For individuals the ultimate conversion ratio was in effect one-to-one for original holdings of no more than RM60, between one-to-one and ten-to-one for those holdings between RM60 and RM600, and between ten-to-one and slightly over fifteen-to-one for those holdings over RM600. The effective conversion ratios were more favorable, however, for heads of families and for businesses with more than one employee, becoming less onerous with increasing size of family or firm.

All bonds, mortgages, annuities, and other forms of private indebtedness were written down by 90 per cent; but prices, wages, rentals, and similar payments had to be converted at the one-to-one ratio. Cash holdings of public bodies were canceled and replaced by Deutsche mark allotments based on average monthly receipts over a given period. The government security holdings of financial institutions were simply canceled. Banks received cash reserves and state equalization claims in amounts equal to their new liabilities plus an allotment of 5 per cent of deposit liabilities, the counterpart of which constituted the capital account of their balance sheets. Similar provisions applied to insurance companies and other financial institutions.

West Germany’s monetary reform was not accompanied by a capital levy on real asset holdings. However, one of the military government laws providing for the reform called on appropriate German legislative bodies to frame the necessary legislation for the equalization of the war burden. Such legislation was subsequently adopted, along with laws that provided for special conversion rates applicable to deposit holdings of pensioners, refugees, savers, and selected groups of other liquid-asset holders.

(2) Blocking—Belgium. Belgium provides an example of the second type of monetary reforms—those that do not cancel any part of the money supply but reduce it by requiring the conversion of liquid holdings into illiquid assets and by imposing severe restraints on the spending of these illiquid assets. The Belgian program, executed in October 1944, was the forerunner of all other monetary reform measures in liberated Europe and probably the inspiration for several of the reform laws adopted elsewhere. For immediate needs, the head of each family could exchange old banknotes for new ones, on a one-to-one basis, up to the amount of 2,000 francs per family member; all remaining holdings of bank notes in denominations of 100 francs and higher had to be declared and deposited in blocked bank accounts. Simultaneously, all existing bank deposits were blocked. (A certain portion, representing either the amount held on the day preceding the German invasion or 10 per cent of the amount held immediately before the reform, was excepted; for business firms the exempted portion was 1,000 francs per employee.) A short time later, each deposit owner was permitted to withdraw an additional amount of up to 3,000 francs. Each blocked amount, whether arising from note deposits or from pre-existing deposits, was divided into two parts, with 40 per cent temporarily blocked and 60 per cent definitively blocked until a means for its disposition was determined. A series of general releases gradually deblocked the temporarily blocked deposits. At the end of 1945, the 60 per cent portion of previously deposited notes and frozen bank balances was converted into long-term nonnegotiable government bonds carrying an interest rate of 3.5 per cent; subsequently, a large part of these bonds was absorbed by a special tax program.

(3) Simple conversion—Denmark, France. Turning now to the third type of monetary reforms—those that convert the old currency into a new one, without significant contraction of the money supply—Denmark’s currency exchange of July 1945 affords a good illustration. Its major objectives were to reduce currency holdings relative to bank deposits, to prevent the reimport into Denmark of German-held Danish currency, and to facilitate the taxation of war profits. The reform program called for a declaration of wealth, a limited exchange of banknote holdings, the depositing of excess holdings in blocked bank accounts, the blocking of existing bank deposits if in excess of 10,000 kroner or in excess of 150 per cent of deposit holdings on the day of Denmark’s invasion by Germany. Within five months, however, the blocked deposits were released, except those of tax evaders.

The French currency reform of June 1945 had the same purposes as that of Denmark but did not call for even a temporary blocking of deposits. The reform was accompanied by a progressive capital levy and a capital gains tax, with payment of these taxes spread over several years. In February 1948 the French government withdrew all 5,000 franc notes in circulation, and amounts in excess of 10,000 francs were returned to their owners only after they had discharged certain tax liabilities. But this measure did little more than sterilize part of the money supply for a short period.

(4) Drastic conversion—Greece, Hungary. The monetary reform programs in Greece and Hungary, which exemplify the fourth type, were put into operation only after protracted periods of currency disturbances and not until inflation had brought about a depreciation of the currencies to an infinitesimal fraction of their prewar value. Special interest attaches to the Hungarian stabilization scheme of 1946, inasmuch as it brought to an end possibly the greatest inflation of history. Its special feature was that it provided for an internally consistent wage and salary structure designed to permit the distribution of scarce supplies at rigidly fixed prices. The program, executed in August 1946, called for the introduction of a new currency unit, the forint, to replace the pengö at the rate of 1 forint to 400 octillion pengö. (This conversion was preceded by the issue earlier in 1946 of a special currency, the so-called tax pengö, a monetary unit of account whose value was related to a price index expressed in terms of the regular pengö.)

The reform program was based on computations of the gross national product in relation to its prewar level. Proportionate ceilings were set on wages, somewhat less favorable ceilings were established for salaries, and the income to be allocated to farmers and to manufacturers was related to the new money supply. The architects of the reform were insistent on limiting total income to the money value of available goods and services. The program was reinforced by a balanced budget, by the central bank’s acquisition of dollars circulating in the country, and by the return of the gold removed by the Nazi regime. (For details, see Nogaro 1948.)

Capital and increment levies. Many of the monetary reforms, notably those in western Europe, were accompanied by a census of both monetary and real assets. This served the purpose of laying the basis for capital levies and for taxes on capital increments and war profits—fiscal devices that in several countries, including Denmark and Norway, played a central role in the reform program. The motive, apart from the obvious desire to confiscate profits resulting from trading with the enemy and illegal transactions, was to distribute the financial burden of monetary sanitation programs more equitably between holders of monetary and real wealth. By and large, monetary reforms that involve a cancellation of currency and bank deposit holdings affect solely households and businesses that have been unable or unwilling to dispose of their liquid funds. Capital and increment levies, on the other hand, can be laid on property owners in approximate proportion to their share in, or gains of, real wealth as well as monetary assets.

With few exceptions, capital levies and similar devices have failed to make a major contribution to achieving the objectives of monetary reforms, although some of them have produced handsome yields over time. Most of the nonmonetary property subject to such levies consists of real estate, buildings, plants, equipment, valuables, and securities. Quite apart from the valuation problems involved, such assets cannot be converted into cash with which to discharge the levy because of the absence of capital markets that could absorb large offerings. In actual practice, the collection of these levies had to be spread over many years, which meant that payment was usually made out of current income. The proceeds were rarely employed for the redemption of government debt and contraction of the money supply. In some countries, notably Belgium and the Netherlands, such levies were in part paid out of blocked accounts or non-negotiable government securities into which blocked accounts had been converted. But even in these two countries, individual tax liabilities often substantially exceeded blocked or nonnegotiable asset holdings. Postwar experience has demonstrated that capital and increment levies, whatever their merit from the viewpoint of social justice and equity, give rise to highly complex assessment and collection problems. For this reason they do not commend themselves as an effective tool for the removal of a monetary overhang.


Not many additional generalizations about the efficacy of monetary reforms can be made with any assurance; there has been too much diversity in both the design and the execution of reform programs. On the whole, the preventive, ameliorative, and bracing effects of the more farreaching measures, at least during the six months or year after their adoption, may be judged as quite impressive. In two or three countries, particularly in Germany, the effects of the reforms in stimulating the economy were truly remarkable; in several other countries they succeeded in eliminating black markets, at least temporarily, and in restoring the public’s waning faith in the worth of money as a store of value. The resurgence of both open and repressed inflation and the re-emergence of black markets in many countries relatively soon after the completion of reforms should not be laid at their door, except in the few cases where the scope of the measures was so narrow as to cast doubt on the propriety of their designation as “reforms.” In most cases, the reappearance of monetary maladies—which in several countries necessitated another sanitation program—should be attributed not to faulty or weak reforms but to subsequent inflationary monetary and fiscal policies and to the fact that in economies suffering from supply scarcities there was a low propensity to save and yet strong official pressures for investment.

This is not to deny that several of the reforms were marred by economic disturbances. A number of technical mistakes were made in the preparation and execution of reform programs, including premature announcements of details, too scanty or too liberal releases of deposits, and misjudgments of the public’s transaction requirements. But this need not evoke surprise, since the architects of at least the initial programs had few if any precedents to draw on in their decision making.

From the viewpoint of equity, most monetary reform programs of the postwar period left much to be desired. The elimination or blocking of large proportions of the money supply without, or with scant, regard to the total wealth of its holders is a very crude device of the sledge-hammer variety, even if cushioned by exemptions for holders of small amounts of currency and bank deposits. But social justice would probably not have been served any better if the money surfeits of postwar Europe had been permitted to be absorbed by rising prices or if the authorities had continued their largely unsuccessful attempts to suppress the manifestations of excessive monetary expansion. On balance, the evidence justifies the conclusion that postwar monetary reforms made a major contribution to economic recovery in Europe.

Fred H. Klopstock


Currency Reform in Eastern Europe. 1946 Federal Reserve Bank of New York, Monthly Review 28:39–43.

Currency Reform in the Netherlands. 1946 Federal Reserve Bank of New York, Monthly Review 28:8–9.

De Ridder, Victor A. 1948 The Belgian Monetary Reform: An Appraisal of the Results. Review of Economic Studies 16, no. 1:25–40.

Dupriez, LÉon H. 1947 Monetary Reconstruction in Belgium. New York: King’s Crown Press.

Grotius, Fritz 1949 Die europäischen Geldreformen nach dem zweiten Weltkrieg. Parts 1–2. Weltwirtschaftliches Archiv 43:106–152, 276–325.

Gurley, John G. 1953 Excess Liquidity and European Monetary Reforms: 1944–1952. American Economic Review 43:76–100.

Klopstock, Fred H. 1946 Monetary Reform in Liberated Europe. American Economic Review 36, no. 4: 578–595.

Klopstock, Fred H. 1948 a Monetary and Fiscal Policy in Post-liberation Austria. Political Science Quarterly 63, no. 1:99–124.

Klopstock, Fred H. 1948 b Western Europe’s Attack on Inflation. Harvard Business Review 26, no. 5:597–612.

Klopstock, Fred H. 1949 Monetary Reform in Western Germany. Journal of Political Economy 57, no. 4:277–292.

Nogaro, Bertrand 1948 Hungary’s Recent Monetary Crisis and Its Theoretical Meaning. American Economic Review 38, no. 4:526–542.

Pesek, Boris P. 1958 Monetary Reform and Monetary Equilibrium. Journal of Political Economy 66, no. 5: 375–388.

Schouten, D. B. J. 1948 Theory and Practice of the Capital Levies in the Netherlands. Oxford University, Institute of Statistics, Bulletin 10, no. 4:117–122.

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MONEY is any item of value that can be exchanged and accepted as payment for goods, services, or debts. Historically, money had taken many forms, but today the most common types include paper and coin issued by a government and personal or bank checks that constitute a promise to pay and that can readily be converted into currency. Money makes it possible to bypass the practice known as bartering, in which a person trades either goods or services in order to receive other needed goods or services. Although its value may fluctuate on currency markets, money, unlike perishable or exhaustible commodities, also constitutes "stored value"; it can be acquired in the present expressly to be used in the future.

The Properties of Money

Good money is made of a material that is durable, easily stored, lacking in bulk, and light in weight. Small coins and paper are ideal for these purposes. Money is created by a government and also by private institutions under the direct supervision and control of a government. The Constitution of the United States, for instance, grants Congress the "power to coin money and regulate the value thereof." Congress has delegated this authority to the United States Treasury Department, the Federal Reserve System, and through it to privately owned commercial banks.

Some money also serves as legal tender. This money by law must be accepted as payment for debts. Currency and coin are considered legal tender because they are created by a government or by government authority and must be accepted in payment for all debts, public and private. Checks, however, are products of commercial banks and, although considered a form of money, they are not legal tender. A merchant or debtor has the legal right to refuse to accept a personal check and, instead, to demand payment in cash.

Money also has the ability to affect prices. Because money finances almost all economic activity, the total money supply in circulation at any given time exercises an impact not only on the price of goods and services but also on the price of money itself in the form of interest rates charged for borrowing. If for some reason the quantity of money doubles, it usually follows that prices will increase as well.

The Functions of Money

Money performs four basic functions. It is a medium of exchange, a measure or standard of value, a store of value, and a standard of deferred payment. As an instrument of exchange, money serves as an asset that enables consumers, whether they are individuals, corporations, or governments, to acquire goods and services. In this way, money facilitates both conversion and growth. If, for example, a farmer grows and then sells soybeans for money, that money can, in turn, be converted into other goods and services. A series of related transactions fuels the growth of the economy.

As a standard of value, money acts as what economists call the "unit of account." In this capacity, money serves as the common denominator of value because the price of all goods and services is stated in monetary terms, regardless of how the value of money changes or affects the price charged for goods and services.

Economists define money that is earned from services provided or labor completed as a store of value because it can be kept for future use as purchasing power rather than immediately expended. Money in a savings or checking account, however, is not the only store of value. Value can also be stored in stocks, bonds, real estate, and even such commodities as wheat or corn. In some cases, money, held in the form of cash, is actually inferior to interest- or dividend-bearing assets as a store of value, since cash by itself yields no return and is subject to its value being eroded by inflation. Money is easily stored, however, because it is not bulky and will not physically deteriorate.

As a standard of deferred payment, money in the form of credit permits consumers to acquire goods and services now and to pay for them over a specified period of time. The ability to access credit and defer full payment enhances purchasing power.

Coins, currency, and checking accounts are the only items that perform all four of these monetary functions. However, in recent years, some economists have extended their definition of money to include what they called "near money" or money substitutes. These items have become known simply as M1, M2, and M3 and refer to the different levels of the money supply.

The Money Supply

The debate over how to define the "money supply" of the United States centers primarily on the question of whether savings deposits should be included in it. To that end, economists have identified the following levels for the money supply. M1 is the traditional money supply consisting only of coin, currency, and checking accounts. M2 includes M1 plus deposits in commercial savings banks, both passbook accounts and certificates of deposit. However, negotiable certificates worth $100,000 or more are not part of M2. M3 consists of M2 plus savings deposits in savings and loan associations, banks, and credit unions. It also excludes certificates valued at $100,000 or more.

Once the money supply has been determined, the next question is who will manage it and to what end. In the United States the Federal Reserve oversees the money supply. It does so by controlling the dollar amount of commercial bank reserves and, through these reserves, the total supply of money available for circulation or borrowing. Among the objectives of the Federal Reserve is the maintenance of price stability and control of the rate of economic growth.

The Circulation of Money

The speed with which money circulates, or changes hands, is one of the most important factors determining economic health. Economists call this characteristic the "velocity of money." If a dollar changes hands five times per year, the velocity of money is five. Overall price levels are determined by the quantity of money multiplied by the velocity of its circulation. Increases in either the quantity or velocity of money will cause prices to rise. Decreases will bring a decline in prices. If the quantity of money in circulation or the velocity at which it circulates is such that one rises while the other falls, there is little or no impact on prices.

The Money Market

Institutions that bring the borrowers and lenders of short-term funds together on an impersonal basis are known collectively as the money market, a highly competitive arena in which borrowers pay whatever the going interest rate may be to access available funds. Commercial banks are the most important source of short-term funds in the money market. The Federal Reserve, working through member banks, also supplies funds. At times, life insurance companies, pension funds, savings and loan associations, credit unions, and mutual funds also supply funds in the money market.

Common borrowers in the money market include businesses looking to finance short-term expansion often in response to economic conditions, as well as the U.S. Treasury Department, which seeks funds to finance the federal deficit. Treasury bills are the major money market instrument used by the Treasury to finance the deficit. These T-bills, as they are known, represent short-term obligations sold at a discount and redeemed at face value upon maturity. The two major instruments that corporations use to satisfy short-term needs are commercial paper and bankers' acceptances. They, too, are sold at a discount and then appreciate to face value at maturity.

The Monetary System of the United States

The monetary system of the United States is made up of two government agencies, the United States Treasury and the Federal Reserve system (the Fed), along with 14,700 privately owned commercial banks. These institutions create the money supply. The U.S. Treasury and the Federal Reserve can strike coins, print paper money, or write checks as outlined in their duties by the United States Congress. Commercial banks can create bank money or checking accounts, but only under the close supervision of the Federal Reserve. Commercial banks must first have adequate reserves before they can make loans and set up new accounts for borrowers. The Federal Reserve controls the dollar amount of these reserves and, in that way, also controls the volume of money in circulation and the costs of borrowing.

The Fed implements monetary policy through this control and manipulation of the money supply. By increasing or decreasing the amount of money flowing through the economy, monetary policy can accelerate or slow the rate of economic growth. The object of monetary policy is, thus, to influence the performance of the economy as reflected in such factors as inflation, productivity, and employment. It works by affecting demand across the economy, that is, consumers' willingness or ability to pay for goods, services, and credit.

There are several methods by which the Fed implements monetary policy. The Fed adjusts bank reserve requirements by buying and selling U.S. government securities. By raising or lowering the reserve requirements, the Board of Governors at the Fed can either encourage or discourage the expansion of credit.

The most powerful and efficient entity within the Fed for shaping monetary policy, however, is the Federal Open Market Committee (FOMC). This group, headed by the Chairman of the Federal Reserve Board, who in 2002 was Alan Greenspan, sets interest rates either directly (by changing the discount rate) or through the use of "open market operations," the buying and selling of government securities to affect the federal funds rate. The discount rate is the rate the Federal Reserve Bank charges member banks for overnight loans. The Fed actually controls this rate directly, but adjustment tends to have little impact on the activities of banks because funds are available elsewhere. This rate is agreed upon during the FOMC meetings by the directors of the regional banks and the Federal Reserve Board.

The federal funds rate is the interest rate at which banks lend excess reserves to each other. Although the Fed cannot directly influence this rate, it effectively controls the rate through buying and selling Treasury bonds to banks. During the course of eight regularly scheduled meetings, the FOMC sets the federal funds rate by determining a plan of open market operations. The group also sets the discount rate, which technically is established by the regional banks and approved by the Board.

In the early twenty-first century, the FOMC began announcing its decisions at the end of every meeting. The committee can increase or decrease the discount rate, or leave it unchanged. Increasing the interest rates is called "tightening" the money supply because this action reduces the amount of money flowing through the economy. Lowering interest rates is called "easing" because this action increases the money supply. Generally, analysts believe that changes in the discount rate will have little direct effect on the economy because banks can get credit from outside sources with ease.

The Fed has the same three options with the federal funds rate. By carefully buying and selling government securities, the Fed can actually change what other banks charge each other for short-term loans. Over time, changes in the money supply will affect the economy as a whole. Most analysts believe that monetary policy takes at least six months to have an impact, and by that time the economic circumstances that the policy was designed to address may have changed. Consequently, the members of the FOMC must predict what the conditions will be when the rate changes begin to exercise an influence over the rate of economic growth. Needless to say, such foresight can be difficult.

As a consequence, the Fed also routinely announces it current "bias," indicating its present thinking about the future direction the economy will take. Such an announcement usually explains whether the Fed will continue to be concerned about inflation (a tightening bias), about slow growth (a loosening bias), or about neither (a neutral bias). In this way, the Federal Reserve tries to maintain a sustainable level of economic growth, without allowing growth to proceed too rapidly or, on the contrary, without allowing the economy to become sluggish and stagnant.

If growth is too fast, inflation will rise, prices will fluctuate upward, and, as wages also rise, unemployment will eventually ensue. These three factors, inflation, rising prices, and unemployment, will short-circuit economic growth. If, by contrast, economic growth is too slow, unemployment will also rise as workers are laid off, leaving growing numbers of consumers without adequate reserve capital to spend their way out of the recession. The Fed, therefore, tries to use monetary policy to maintain a sustainable level of growth for the economy that will keep inflation, prices, and unemployment at manageable levels.

The monetary policy of the United States affects the kinds of economic decisions people make, from obtaining a loan to buying a new home to starting a business. Because the U.S. economy is the largest and most prosperous in the world, American monetary policy also has a significant impact on economies around the world. As economic circumstances change at home and around the world, the Fed adjusts its policies to stimulate, sustain, or slow growth. When the Japanese economy began to fall apart in the mid-1990s, for example, it greatly diminished the volume of American exports to Japanese markets and threatened to short-circuit the unprecedented economic boom that the United States was then experiencing. To counteract this development, the Fed cut interest rates to stimulate economic growth or at least to slow decline and to execute what economists call "soft landing."

Monetary Theory: The Prevailing Models

There are two predominant theories about how best to manage the money supply. One of these is associated with supply-side economics. According to the basic principles of supply-side economics, the growth and operation of the economy depends almost entirely on factors affecting supply rather than demand. In terms of monetary theory and policy, supply-side economists embrace such measures as cuts in the interest and tax rates to encourage investment and, at the same time, favor restricting the growth of the money supply to dampen inflation.

Supply-side economists generally hold that if people had more cash in hand, they would spend more on goods and services, thereby increasing the aggregate demand for those goods and services and stimulating economic growth. Since there are natural limits to the amount of goods and services people require, they would invest their surplus assets in interest- or dividend-bearing securities, thus making additional capital available for investment and further driving down interest rates. Lower interest rates, coupled with higher aggregate demand, would prompt businesses to borrow to fund expansion, a development that also quickens economic growth. According to monetarist theory, even a small reduction in taxes and interest rates would increase consumer spending, aggregate demand, and capital investment and, as a consequence, ensure economic growth.

An alternative to the monetary theory of supply-side economies emerged when economist James Tobin criticized the narrow emphasis on money. Tobin argued that there was a range of financial assets that investors might be willing to hold in their portfolios besides money, including bonds and equities. Their preferences were rationally determined by calculating potential gains against potential risks. Tobin, following John Maynard Keynes, showed how government economic and fiscal policy could impinge on productivity and employment.

Keynes had argued that a drop in prices would increase the value of money in real terms. Simply put, without raising wages, falling prices would mean that consumers enjoyed greater purchasing power. An increase in the real value of money would also make available a greater surplus of capital for investment and bring about a consequent decline in interest rates, thus prompting additional investment and stimulating economic growth. In the Keynesian system, the quantity of money determined prices. Interest rates brought savings and investment into balance, while the interest rate itself was set by the quality of money people desired to hold (liquidity preference) in relation to the money supply. Government monetary policy, therefore, ought to aim at keeping money in the hands of consumers and investors, either through increasing wages to counter the effects of inflation or by lowering prices if wages remained stable. Lowering wages to cut business costs, increase profit margins, and stimulate employment, Keynes suggested, was counterproductive. Lower wages only served to decrease income, depress aggregate demand, and retard consumption, all of which would more than offset any benefits that accrued to business from a reduction in wages. During economic hard times, when the private sector could not absorb the costs of labor, the government could take over the role of business by spending money on public works projects to reduce unemployment.

The Future of Money

By the 1990s, Americans were already becoming immersed in the technology of the digital economy. The idea of digital money, e-cash, is simple. Instead of storing value in paper, e-cash saves it in a series of digits and codes that are as portable and exchangeable as paper, but more secure and even "smarter." If e-cash is lost or stolen, its proponents maintain, the card can easily be canceled via computer and its value transferred to another card. E-cash is also more mutable and controllable than paper money. It enables individuals to send funds over the Internet, encoded in an e-mail message rather than sending cash, checks, or wire transfers. Digital currency can also be programmed so that it can be spent only in specific ways; money budgeted for food cannot be used to go to the movies or visit the local pub. Finally, e-cash, unlike paper money when withdrawn from an account, continues to earn interest until it is used.

This characteristic of e-cash gave rise to another extraordinary aspect of the digital financial revolution: the dissolution of the government monopoly on money. Digital cash has no boundaries. Cardholders are free to acquire e-cash from worldwide lenders willing to pay higher interest rates than banks in the United States. As long as e-cash is easily convertible and widely accepted, customers will find that there is no reason to limit themselves to the currency of a single government. Government-issued money will not cease to exist, but it will have to compete with dozens of other currencies, each tailored to meet specific needs of customers. "In the electronic city, the final step in the evolution of money is being taken," explained Howard M. Greenspan, president of Heraclitus Corporation, a management consulting firm. "Money is being demonetized. Money is being eliminated."


Ando, Albert, and R. Farmer Eguchi and Y. Suzuki, eds. Monetary Policy in Our Times. Cambridge, Mass.: MIT Press, 1985.

Auerbach, Robert D. Money, Banking, and Financial Markets. New York: Macmillan 1985.

Block, Valerie. "Atlanta Conference Previews the Future of Money." American Banker 161 (May 14, 1996): 14.

Davidson, William. "Does Money Exist?" Forbes 157 (June 3, 1996): 26.

"E-Cash." The Economist 354 (February 2000): 67.

Friedman, Milton, and Anna Schwartz. A Monetary History of the United States, 1867–1960. Princeton, N.J.: Princeton University Press, 1963.

Hahn, Frank. Money and Inflation. Cambridge, Mass.: MIT Press, 1983.

Hutchinson, Harry D. Money, Banking, and the United States Economy. 5th ed. Englewood Cliffs, N.J.: Prentice Hall, 1984.

Lacker, Jeffrey M. "Stored Value Cards: Costly Private Substitutes for Government Currency." Economic Quarterly 82 (Summer 1996): 25.

Niehans, Jurg. The Theory of Money. Baltimore: Johns Hopkins University. Press, 1978.

Nixon, Brian. "E-Cash." America's Community Banker 5 (June 1996): 34–38.

Ritter, Lawrence S., and William L. Silber. Money. 5th rev. ed. New York: Basic Books, 1984.

Meg GreeneMalvasi

See alsoCurrency and Coinage ; Keynesianism ; Treasury, Department of the .

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Money can only be defined adequately in the context of a dynamic economy with markets and other financial institutions existing in a society complete with its laws and customs. It is a network or system of public good of considerable complexity. Even if money is privately produced, in the sense that it always depends on network acceptance it is a public good.

A quick perusal of any standard textbook immediately specifies the key economic properties of money as: (1) a means of payment; (2) a store of value; and (3) a numeraire. There are also a host of physical properties that are desirable for an item that serves as money. A partial list includes: (1) transportability; (2) durability; and (3) cognizability.

Left off these two lists is the strategic and informational properties of money. In particular the rules of operation with money distinguish among economic agents. The powers of an individual with respect to the creation and destruction of money are different from those of commercial banks, the central bank, and the treasury.

Part of the basic financial control mechanism of any society is the ability of some institutions to control the money supply and influence the money rate of interest. Although it can be shown at a high level of abstraction that with a perfect clearing system all individuals could issue their own currencies, the degree of reputation, trust, and memory required for such a system to work is unreasonable. The financial institutions that have been invented have been designed to provide a viable system for imperfect individuals.

The informational aspects of the use of money are critical to a modern complex economy. Money is an information aggregating, disaggregating device. Given prices, any collection of diverse assets can be valued by a single number. Bets of almost any variety on the future deal not only with the changes in uncertain bundles of assets, but with how they will be evaluated in monetary terms.

Because people are almost always concerned with a dynamic economy in disequilibrium, money does not provide a constant standard of measure like a carefully measured standard meter. It is a somewhat flexible, crude, and changing store of value. The conditions required to guarantee that a unit of money is of the same value in each period are rarely if ever encountered. A strict specification of all of the conditions that must be specified to guarantee no inflation or deflation is such that it is rarely met in reality. However in a dynamic economy the fact is that money does not maintain a precise value throughout time but permits prices to change in a flexible manner. And, up to a point, this is a desirable property.

Given that there are many desirable properties for ideal money, the institutional manifestation of the ideal money is hard to come by as most actual financial instruments called money miss some of the properties.


Precisely when in history individuals switched over from direct trade, where commodity A was exchanged for commodity B with no intervening means of payment, is not known. The open market with prices is by no means the only way that society distributes its resources. Among the ways extant today are direct bargaining, bidding, the free market with a price system, the dictates of higher authority, force, fraud and deceit, custom including inheritance and other gifts, and last, but not least, chance. Most of these, like society itself, preceded the development of an organized law-enforcing economy utilizing money.

A dynamic economy is a living organism with many ways of achieving some of its goals. Even the most advanced economy will not transfer many of its resources only through markets. Government, alone, at its many levels will account for 20 to 40 percent of the reported monetary income of any society. Gifts will still be made; housewives, husbands, handymen, and gardeners will still produce a considerable nonmarket produce; bribes and theft are all present to contribute to the nonmarket or only obliquely market parts of the economy.


It is not clear whether the development of money preceded, succeeded, or happened simultaneously with the evolution of markets. Their functions are deeply intertwined. The knowledge of the existence of markets makes it easier for individuals to find what they want to buy and where they should go to sell. The existence of money and other financial instruments makes it easier for them to trade. Among the earliest known monies were barley and silver, both of which were used in Mesopotamia over four thousand years ago. A considerable variety of substances have been used as money. They can be usefully divided into storable consumables, such as barley, and durables such as silver. Consumable monies have included barley, rice, cocoa beans, salt, bricks of tea, and cigarettes. Durables have included cowrie shells, wampum, furs, and many metals, including gold, silver, copper, tin and platinum, as well as alloys.

Among the earliest portrayals of the use of a metal as money is a painting from the tomb of Mereruka at Saqqara, Egypt, dating around 2300 BCE, showing gold being weighed in a transaction. Before the invention of coinage, payments utilizing metals were made in dust or ingot form. The invention of coinage is attributed to King Andrys of Lydia around 630 BCE. When one views money and financial institutions it is helpful to adopt the viewpoint of an engineer. This dispels much of the mystery often associated with finance. In particular, the transactions technology is seen to be a part of the economic production process. The switch to coinage contrasts with using metal by weight as a means of exchange. Coinage provided standardization of both the weight and quality of the metal and came with the stamp of authority, providing for law and its enforcement.

In return for the services rendered by coinage the king took a payment termed a seignorage fee estimated at 3 percent. As is evinced by the association of Croesus with wealth, coinage by the king was a source of revenue. In the subsequent history of coinage permission for the operation of mints has often been granted to private entities, although the government has always played a role. The technology of the production of coins has progressed from slow crude hand striking to vast automation where machines can produce coins at the rate of 45,000 per hour. Coining is still a profitable occupation as is evinced by the profits that the U.S. Mint turns over to the U.S. Treasury. It is also an art form as is illustrated by the design by the renowned sculptor Saint-Gaudens of the double eagle gold coin.

Within a few hundred years the use of coinage stretched from England to China. Although historians are not certain, it appears that the Chinese might have invented coinage independently a little later than the West. The mere fact that coinage was quickly and broadly accepted, providing many services that payment in bullion did not provide, does not imply that all coins are accepted even if the issuer is trusted. Mixtures of law, custom, and even aesthetic appeal all come into play. An example is provided by the livre tournois in the thirteenth century, which dominated the use of the livre parisis of Paris, the official coin of the central government.


Gold is malleable, ornamental, inert, and easily alloyed. It is estimated that at the end of 2005, the stock of mined gold was approximately 171,000 tons, of which 64 percent had been mined since 1950. World production in 2005 was 2,770 tons. There is a considerable amount of gold in the ocean, but retrieval costs are prohibitive.

Various countries have employed gold, silver, and copper as currency simultaneously. A reason for doing so is to provide a fit for different levels of consumption: coppers for a glass of beer or newspaper; silver for a pair of shoes; and gold to buy a house. The size of a gold coin to buy a beer is too small and as Swedens experiment with a copper currency demonstrated, buying a house with copper currency required cartloads of copper.

When one country bases its currency on gold and another on silver, any attempt by a country to fix an internal price between gold and silver will cause an influx or outflow of one of the metals. When the English physicist and mathematician Sir Isaac Newton (16421727) was master of the mint, in 1717 he overvalued gold in terms of silver sufficiently that silver went out of circulation as it could be sold for gold and the proceeds repatriated and converted at a profit.


From the late seventeenth century onward starting with the formation of the Bank of England in 1694, the world switched more and more to the use of paper currencies. Each currency represents a claim by a national government that it can use its monetary strategic powers to help to control its economy. Monetary consolidations such as the introduction of the euro must be viewed in terms of politics as well as economics. Viewed purely from economics the currency union offers a considerable saving in transactions costs, but from the viewpoint of international politics it marks a considerable change in the strategic powers of individual nation-states.

The mixture of law, custom, and logic that produces a viable monetary system is sufficiently subtle that it is extremely difficult to produce formal models that adequately reflect the many functions of money and near monies. The phrase near money refers to an instrument that has many but not all of the properties of a money. For example, confining the observations to the transactions use of money, it should be acceptable in all markets. Nevertheless there may be financial instruments in existence, such as bank checks, which are accepted in almost all markets. For many purposes of analysis it makes sense to lump bank money with the issue of the government.

Because other financial instruments and real assets may have some, but not all, of the properties of money there is a considerable problem in defining a single simple measure of the amount of money there exists in any country. For example the property of being a store of value is present for assets such as land or houses as well as gold.

If a single number is required to measure the amount of money, the United States produces three different measures with many components. The three measures are aggregations called M1, M2, and M3. M1 is the sum of paper currency and coin that is held outside banks, travelers checks, and checking accounts (but not demand deposits), minus the amount of money in the Federal Reserve float. M2 is the sum of M1, plus savings deposits, including money market accounts from which no checks can be written, time deposits less than $100,000, and retirement accounts. M3 is the sum of M2 plus the large time deposits, Eurodollar deposits, dollars held at foreign offices of U.S. banks, and institutional money market funds.

In the twenty-first century with the proliferation of computers and cheap communication together with data banks on credit evaluation, many new forms of payment, credit cards, debit cards, and e-money are coming into being. Groups of individuals who trade frequently and are well known to each other can set up their own clearing and credit systems without using banks.


One of the mysteries of fiat money and national income accounting is what backs fiat or paper money. Is it custom, the power of government, trust in the government, gold reserves and other government assets, the presence of taxation, expectations, the negative incentives of default punishment, or factors associated with insurance and inheritance? A tentative answer is all of the above, in part. The mix may vary through time and place. The ideal money is a symbol that serves as a substitute for trust. It is an abstract trust pill. This ideal currency does not exist, but the currency of a stable noninflationary economy is hopefully an approximation to this trust pill. Fiat money is an asset like gold but it is an artificial or societally created virtual gold. Treating it as an asset has some paradoxical features. What does one receive on surrendering a one dollar bill to the Federal Reserve? One gets another new bill. Currently the average life of a dollar bill is estimated at twenty-two months; hence this activity is not merely symbolic but relevant. In their work Money in a Theory of Finance (1960), Jack Gurley and Edward Shaw made a distinction between outside money and inside money that stresses the role of government. Outside money is government fiat money against which a government debt exists. Inside money is fiat money held as an unencumbered asset by a private individual. A way in which the government can adjust the overall supply of fiat money held by private individuals is by selling to or buying from them, public debt. The basic difference between fiat money and credit is that money is a virtual commodity. It is a fictitious gold. It is the only financial instrument for which there is no operationally meaningful offsetting instrument on the other side of the balance sheet. The government maintains a fiction that it owes something to the individual who owns a dollar bill, but apart from obtaining a newer piece of paper from the bank it has no operational meaning. From the mid-eighteenth century until today there has been considerable interest in what has become known as the quantity theory of money. In his essay Of Interest (1752) the Scottish philosopher and historian David Hume (17111776) noted, All augmentation has no other effect than to heighten the price of labor and commodities; and even this variation is little more than that of a name.... Money having chiefly a fictitious value, the greater or less plenty of it is of no consequence if we consider a nation within itself ([1752] 1985, pp. 296297).

In the modern terminology of Don Patinkin, Humes concept of money shows a classical dichotomy illustrating that the amount of money does not matter. More money merely raises the level of prices. The classical dichotomy means that the structure of real economy in equilibrium is independent of the amount of money in the system. The latter only fixes the price level.

The conditions for the classical dichotomy between money and other goods are that there are absolutely no frictions in the speed of adjustment of the economy to the introduction of more money. This is counterfactual as can be seen by trying to build a playable game of the system.


In the 2000s there are at least two major schools of thought, one deriving from Hume, the monetarists, exemplified by Milton Friedman and the other modern followers, and modifiers of the work of the English economist John Maynard Keynes. Both schools have skilled analysts. The key distinctions lie in basic assumptions and different interpretations of unclear evidence. Those following variants of the quantity theory appear to stress long-run equilibrium conditions playing down the influence of short-term adjustments and coordination problems as well as ignoring nonsymmetries in wealth, expertise, and decision-making abilities. The neo-Keynesians are more concerned with the influence of monetary policy on short-run adjustments and on problems in economic coordination. They tend to be more concerned with non-symmetries among industry, the workforce, consumers, and government. More than the monetarists they appreciate the constant disequilibrium in the economic system.

A strategic and more biological view of money and financial institutions is that they represent the neural network and control system over the economic body of society. The government and the private financial establishment form a considerable segment of the economy. They are large enough to have considerable influence on the overall supply of money and credit. This alone places an upper bound on prices. The presence of default penalties and bankruptcy laws places a lower bound on prices. If there is enough deflation it pays a debtor to default unless the bankruptcy laws are changed at the same speed as the money supply. The laws of contract and the bankruptcy laws reflect a societys attitude toward risk. In a highly innovative society in constant disequilibrium, the laws of default and bankruptcy control the innovation rate or the speed of mutation of that society. Furthermore the ability of the government and banks to create money and the other parts of the financial system to direct where credit goes gives government and the financial system considerable control in directing the disequilibrium dynamics of a modern economy. In this structure money matters considerably. In a static equilibrium of a society without innovation the classic dichotomy appears and the importance of money and financial institutions is diminished.

The financial system and money provide the interfacing mechanisms between the economy and the polity. Human society, like an individuals body, is not an undifferentiated mass of independent individuals or cells. There is a complex organization, which in both instances requires a flow of information, control instructions, and nourishment to differentiated organisms that require coordination. The financial system provides for the flow of information and control and the economy provides the various physical forms of nourishment needed by the society.

SEE ALSO Balance of Payments; Currency; Divisia Monetary Index; Exchange Rates; Monetary Theory; Money, Endogenous; Money, Exogenous; Policy, Monetary; Quantity Theory of Money; Trade


Bagehot, Walter. [1873] 1962. Lombard Street. Homewood, IL: Irwin.

Fisher, Irving. [1930] 1977. The Theory of Interest. Philadelphia: Porcupine Press.

Fisher, Irving. 1931. The Purchasing Power of Money. 2nd ed. New York: Macmillan.

Gurley, John G., and Edward Shaw. 1960. Money in a Theory of Finance. Washington, DC: Brookings Institution.

Friedman, Milton. 1969. The Optimum Quantity of Money and Other Essays. Chicago: Aldine.

Hume, David. [1752] 1985. Of Interest. In Essays: Moral, Political and Literary, ed. E. F. Miller, 296297. Indianapolis, IN: Liberty Classics.

Jevons, William S. 1875. Money and the Mechanism of Exchange. London: MacMillan.

Keynes, John M. [1936] 1957. The General Theory of Employment, Interest and Money. London: Macmillan.

Lejonhufvud, Axel. 1968. On Keynesian Economics and the Economics of Keynes. New York: Oxford University Press.

Simmel, Georg. [1907] 1978. The Philosophy of Money. London: Routledge and Kegan Paul.

Schumpeter, Joseph A. 1934. The Theory of Economic Development. Cambridge: MA: Harvard University Press.

Schumpeter, Joseph A., ed. 1954. History of Economic Analysis. London: Allen and Unwin.

Shubik, Martin. 1999. The Theory of Money and Financial Institutions. 2 vols. Cambridge, MA: MIT Press.

Tobin, J. 1961. Money Capital and Other Stores of Value. American Economic Review 51: 2637.

Von Mises, Ludwig. 1935. The Theory of Money and Credit. New York: Harcourt Brace.

Wicksell, Knut. [1935] 1962. Lectures on Political Economy. Vol. 2. London: Routledge and Kegan Paul.

Martin Shubik

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money, term that actually refers to two concepts: the abstract unit of account in terms of which the value of goods, services, and obligations can be compared; and anything that is widely established as a means of payment. Frequently the standard of value also serves as a medium of exchange, but that is not always the case.


Many ancient communities, for instance, took cattle as their standard of value but used more manageable objects as means of payment. Exchange involving the use of money is a great improvement over barter, since it permits elaborate specialization and provides generalized purchasing power that the participants in the exchange may use in the future. The growth of monetary institutions has largely paralleled that of trade and industry; today almost all economic activity is concerned with the making and spending of money incomes.

From the earliest times precious metals have had wide monetary use, owing to convenience of handling, durability, divisibility, and the high intrinsic value commonly attached to them. Whether an article is to be regarded as money does not, however, depend on its value as a commodity, except where intrinsic worth is necessary to make it generally acceptable in exchange; the relation between the face value of an object used as money and its commodity value has actually become increasingly remote (see coin). Paper currency first appeared about 300 years ago; it was usually backed by some "standard" commodity of intrinsic value into which it could be freely converted on demand, but even during the early development of currency, issuance of inconvertible paper money, also called fiat money, was not infrequent (see, for example, Law, John). The world's first durable plastic currency was introduced by Australia in a special issue in 1988 and in a regular issue in 1992. Plastic bills are more resistant to counterfeiting than paper, and a number of countries now issue plastic currency.

The importance of money has been variously interpreted. While the advocates of mercantilism tended to identify money with wealth, the classical economists, e.g., John Stuart Mill, usually considered money as a veil obscuring real economic phenomena. Since the mid-20th cent., a group known as the monetarists has given increasing attention to the role of money in determining national income and economic fluctuations.

The Monetary System of the United States

The monetary system of the United States was based on bimetallism during most of the 19th cent. A full gold standard was in effect from 1900 to 1933, providing for free coinage of gold and full convertibility of currency into gold coin; the volume of money in circulation was closely related to the gold supply. The passage of the Gold Reserve Act of 1934, which put the country on a modified gold standard, presaged the end of the gold-based monetary system in domestic exchange. Under this system, the dollar was legally defined as having a certain, fixed value in gold. While gold was still thought to be important for maintenance of confidence in the dollar, its connection with the actual use of money was at best vague. The 1934 act stipulated that gold could not be used as a medium of domestic exchange. More recently, a number of measures have de-emphasized the dollar's dependence on gold; since the early 1970s, practically all U.S. currency, paper or coin, is essentially fiat money.

Under the Legal Tender Act of 1933, all American coin and paper money in circulation is now legal tender, i.e., under the law it must be accepted at face value by creditors in payment of any debt, public or private. Most of the currency circulating in the United States consists of Federal Reserve notes, which are issued in denominations ranging from $1 to $100 by the Federal Reserve System, are guaranteed by the U.S. government, and are secured by government securities and eligible commercial paper. A small fraction of the currency supply is made up of the various types of coin, none of which has a commodity value equal to its face value. Finally, an even smaller part of the circulating currency is composed of bills that are no longer issued, such as silver certificates, which were redeemable in silver until 1967, and bills in denominations between $500 and $100,000, which have not been issued since 1969. Today, currency and coin are less widely used as a means of payment than checks, debit cards, and credit cards; demand deposits (checking accounts) are, therefore, generally considered part of the money supply. Starting in 1996, the Federal Reserve undertook the redesign of all paper bills, chiefly to deter a new wave of counterfeiting that uses computer technology; further changes, including colors in addition to green, were introduced in 2003. (See banking; on the regulation of the supply, availability, and cost of money, see Federal Reserve System and interest.) Certain assets, sometimes called near-monies, are similar to money in that they can usually be readily converted into cash without loss; they include, for example, time deposits and very short-term obligations of the federal government. Funds that are frequently transferred from country to country for maximum advantage are called hot monies. The technical definition of the nation's aggregate money supply includes three measures of money: M-1, the sum of all currency and demand deposits held by consumers and businesses; M-2 is M-1 plus all savings accounts, time deposits (e.g., certificates of deposit), and smaller money-market accounts; M-3 is M-2 plus large-denomination time deposits held by corporations and financial institutions and money-market funds held by financial institutions.

Electronic Money

Electronic payment systems, already in place for use by credit-card processors, were adapted in the 1990s for use in electronic commerce (e-commerce) on the Internet. Such "digital cash" payments allow customers to pay for on-line orders using secure accounts established with specialized financial institutions; related technology is used for on-line payment of bills.


See J. M. Keynes, General Theory of Employment, Interest, and Money (1936); J. Niehans, The Theory of Money (1980); J. Wheatley, An Essay on the Theory of Money and Principles of Commerce (1983); A. Schwartz, Money in Historical Perspective (1987); J. Hicks, A Market Theory of Money (1989); C. Rogers, Money, Interest and Capital (1989); J. Goodwin, Greenback (2002); N. Ferguson, The Ascent of Money (2008).

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In the modern world we take money for granted. However, pause for a moment and imagine what life would be like without money. Suppose that you want to consume a particular good or service, such as a pair of shoes. If money did not exist, you would need to barter with the cobbler for the pair of shoes that you want. Barter is the process of directly exchanging one good or service for another. In order to purchase the pair of shoes, you would need to have something to trade for the shoes. If you specialized in growing peaches, you would need to bring enough bushels of peaches to the cobbler's shop to purchase the pair of shoes. If the cobbler wanted your peaches and you wanted his shoes, then a double coincidence of wants would exist and trade could take place.

But what if the cobbler did not want your peaches? In that case you would have to find out what he did want, for example, beef. Then you would have to trade your peaches for beef and the beef for shoes. But what if the person selling beef had no desire for peaches, but instead wants a computer? Then you would have to trade your peaches for a computerand it would take a lot of peaches to buy a computer. Then you would have to trade your computer for beef and the beef for shoes. But what if ? At some point it would become easier to make the shoes yourself or to just do without.


Money evolved as a way of avoiding the complexities and difficulties of barter. Money is any asset that is recognized by an economic community as having value. Historically, such assets have included, among other things, shells, stone disks (which can be somewhat difficult to carry around), gold, and bank notes.

The modern monetary system has its roots in the gold of medieval Europe. In the Middle Ages, gold and gold coins were the common currency. However, the wealthy found that carrying large quantities of gold around was difficult and made them the target of thieves. To avoid carrying gold coins, people began depositing them for safekeeping with goldsmiths, who often had heavily guarded vaults in which to store their valuable inventories of gold. The goldsmiths charged a fee for their services and issued receipts, or gold notes, in the amount of the deposits. Exchanging these receipts was much simpler and safer than carrying around gold coins. In addition, the depositors could retrieve their gold on demand.

Goldsmiths during this time became aware that few people actually wanted their gold coins back when the gold notes were so easy to use for exchange. They therefore began lending some of the gold on deposit to borrowers who paid a fee, called interest. These goldsmiths were the precursors to our modern fractional reserve banking system.


Regardless of what asset is recognized by an economic community as money, in general it serves three functions:

  • Money is a medium of exchange
  • Money is a measure of value
  • Money is a store of value

Money is a medium of exchange

Used as a medium of exchange, money means that parties to a transaction no longer need to barter one good for another. Because money is accepted as a medium of exchange, you can sell

your peaches for money and purchase the desired shoes with the proceeds of the sale. You no longer need to trade peachesa lot of themfor a computer and then the computer for beef and then the beef for the shoes. As a medium of exchange, money tends to encourage specialization and division of labor, promoting economic efficiency.

Money is a measure of value

As a measure of value, money makes transactions significantly simpler. Instead of markets determining the price of peaches relative to computers and to beef and to shoes, as well as the price of computers relative to beef and to shoes, as well as the price of beef relative to shoes (i.e., a total of six prices for only four goods), the markets only need to determine the price of each of the four goods in terms of money. If we were to add a fifth good to our simple economy, then we would add four more prices to the number of good-for-good prices that the markets must determine. As the number of goods in our economy grew, the number of good-for-good prices would grow rapidly. In an economy with ten goods, there would be forty-five good-for-good prices but only ten money prices. In an economy with twenty goods there would be one hundred and ninety good-for-good prices but only twenty money prices. Imagine all of the good-for-good prices in a more realistic economy with thousands of goods and services available.

Using money as a measure of value reduces the number of prices determined in markets and vastly reduces the cost of collecting price information for market participants. Instead of focusing on such information, market participants can focus their effort on producing the good or service in which they specialize.

Money as a store of value

Money can also serve as a store of value, since it can quickly be exchanged for desired goods and services. Many assets can be used as a store of value, including stocks, bonds, and real estate. However, there are transaction costs associated with converting these assets into money in order to purchase a desired good or service. These transaction costs could include monetary fees as well as time delays involved in the liquidation process.

In contrast, money is a poor store of value during periods of inflation, while the value of real estate tends to appreciate during such periods. Thus, the benefits of holding money must by balanced against the risks of holding money.


Money simplifies the exchange of goods and services and facilitates specialization and division of labor. It does this by serving as a medium of exchange, as a measure of value, and as a store of value.

see also Currency Exchange ; Money Supply

Denise Woodbury

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In economics and finance, currency refers to paper money and coins that represent the monetary base of a country. Currency is a form of money, which is used primarily as a medium of exchange. In international economics, the word currency is used mostly as a reference to foreign currency, the monetary unit of a foreign country.

Currency developed because of the need for a unit of exchange that would be portable, nonperishable, and easily divisible. It appeared with a shift from commodity money to coins made out of precious metals. Currency further developed into fiat money, money that carries no intrinsic value, such as coins made out of nonprecious metals and banknotes, the paper money that is used in most countries today. In the form of fiat money, currencys value is based on the universal acceptance of the currency for payments. For a given level of a countrys output, the more currency that is in circulation, the higher would be the level of prices in the country.

Many countries have their own national currency, such as the dollar in the United States. There are some countries, however, that do not have their own currency. Economists separate the latter into two groups: those that belong to a common currency area, and those that simply use foreign currency for transactions in their countries. An example of a common currency area is the European Monetary Union. The members of the European Monetary Union all use the same currency, the euro. Countries and regions that use foreign currency are Panama, Ecuador, and El Salvador, which use the U.S. dollar; Kosovo and Montenegro, which use the euro; and small countries and island nations that use the currencies of their closest neighbors or the country that had formerly governed them as a protectorate. Such economies are referred to as dollarized, even if the currency they use is not called the dollar.

The amount of currency in circulation is determined by the monetary authority of the country and represents one of the instruments of the countrys monetary policy. In the United States, the monetary authority is the Federal Reserve System. In the European Monetary Union, the European Central Bank, which includes representatives from all the member countries, determines the amount of currency in circulation. Dollarized countries cannot influence the amount of currency in circulation and therefore do not have an independent monetary policy.

Should each country have its own currency? This question, first analyzed in modern economics literature by Robert Mundell (1961), has been the subject of heated debate ever since. Mundells theory suggests that two countries should have a common currency if monetary efficiency gain outweighs economic stability loss from having a common currency. This will more likely be the case if the two countries are closely integrated through trade, capital, and labor mobility. Many economists believe that the European Monetary Union is not an optimum currency area because the economies that represent it are too diverse and are not sufficiently integrated. On the other hand, most economists agree that the United States is an optimum currency area, and that it would be costly for each state to use its own currency. Some believe that the world can benefit from the introduction of the single global currency, but most economists think it is not a good idea because independent monetary policy is important to stabilize both real goods and asset markets in conjunction with fiscal policy.

SEE ALSO Euro, The; Money; Quantity Theory of Money


Mundell, Robert. 1961. A Theory of Optimum Currency Area. The American Economic Review 51 (4): 657665.

Single Global Currency Association.

Galina Hale

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money money comes from Latin moneta ‘mint’, originally a title of a goddess (in classical times regarded as identical with Juno), in whose temple in Rome money was minted.

A money box (or moneybag) is the emblem of St Matthew and St Nicholas of Myra.
money can't buy happiness a recurrent theme in invectives against materialism down the ages, but this formulation of it appears to be comparatively recent. (The saying, in the form gold cannot buy happiness, is first recorded in the mid 19th century.)
money changer an archaic term for a person whose business was the exchanging of one currency for another; often with biblical allusion, as to Matthew 21:12.
money for jam money or reward earned for little or no effort; the allusion is said to be to the prevalence of jam in Army rations in the early 20th century. Money for old rope is an alternative, giving another type of a virtually worthless item.
money has no smell proverbial saying, which in this form is recorded from the early 20th century. A translation of Latin Pecunia non olet, it derives from a comment made by the Emperor Vespasian (ad 9–79), when his son Titus objected to a tax levied on public lavatories. Vespasian is said to have held a coin to Titus's nose, and on being told that it did not smell, to have replied, ‘Atque e lotio est [Yes, that's made from urine]’.
money is power proverbial saying, mid 18th century. (Compare knowledge is power.)
money is the root of all evil proverbial saying, mid 15th century; with biblical allusion to 1 Timothy 6:10, ‘The love of money is the root of all evil.’
money isn't everything proverbial saying, early 20th century, often said in consolation or resignation.
money makes a man possession of wealth confers status; proverbial saying, early 16th century, translating the Latin tag, ‘divitiae virum faciunt [wealth makes the man]’.
money makes money proverbial saying, late 16th century, implying that those who are already wealthy are likely to become more so.
money makes the mare to go proverbial saying, late 15th century, referring to money as a source of power.
money talks money has influence; proverbial saying, mid 17th century.
put one's money where one's mouth is take action to support one's statements or opinions.
see the colour of someone's money receive some proof that someone has enough money to pay for something.

See also bad money drives out good, a fool and his money are soon parted, lend your money and lose your friend, never marry for money, but marry where money is, you pays your money and you takes your choice, time is money.

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276. Money

See also 131. DUES and PAYMENT ; 137. ECONOMICS ; 160. FINANCE ; 325. POVERTY ; 398. TRADE .

the business of buying and selling the curreneies of various countries by taking advantage of differences in rates of exchange. agio , n.
the act of lending with interest.
Rare. the science of wealth.
the business of buying and selling securities, curreneies, and commodities on an international scale so as to take advantage of differences in rates of exchange and prices. arbitrager, arbitrageur , n.
the use of two metals jointly as a monetary Standard with fixed values in relation to one another. bimetallist , n. bimetallistic , adj.
the doctrine that paper money should at all times be convertible into bullion. bullionist , n.
cambism, cambistry
the theory and practice of money exchange as an item of commerce, especially in its international features. cambist , n.
a person whose chief goal in life is the gaining of wealth. chrematistic , adj.
1. the study of wealth.
2. any theory of wealth as measured in money. chrematistic , adj.
a mania for money.
an abnormal fear or dislike of money.
a mania for great wealth.
Irish. the lending of money at usurious interest. gombeen, gombeenman , n.
the greedy pursuit of riches.
a doctrine advocating the use of metal money instead of paper. metallist, metalist , n.
an economie theory maintaining that stability and growth in the economy are dependent on a steady growth rate in the supply of money. monetarist , n., adj.
government or domination of society by the rich.
1. the use of only one metal, usually gold or silver, as a monetary Standard.
2. the use of only one metal for coinage. monometallist , n.
the lifestyle of a nabob, i.e., of one possessing considerable wealth.
an excessive devotion to wealth.
Economics. the scientific study or theory of wealth.
1. an abnormal craving for wealth.
2. a mania characterized by delusions of wealth.
the use of a number of different metals in coinage.
a mania for spending money.
a system of coinage based on a unit of two or more metals in combination, each of a specified weight. symmetallic , adj.

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Money (in Occult Tradition)

Money (in Occult Tradition)

Money that comes from a pact with the devil is of poor quality, and such wealth, like the fairy-money, generally turns to earth, or to lead, toads, or anything else worthless or repulsive. St. Gregory of Tours (d. 594 C.E.) told a illustrative story: "A youth received a piece of folded paper from a stranger, who told him that he could get from it as much money as he wished, so long as he did not unfold it. The youth drew many gold pieces from the papers, but at length curiosity overcame him, he unfolded it and discovered within the claws of a cat and a bear, the feet of a toad and other repulsive fragments, while at the same moment his wealth disappeared."

It is said that an Irishman outsmarted the devil. In his book Irish Witchcraft and Demonology (1913; 1973), St. John D. Seymour told the amusing story of Joseph Damer of Tipperary County, who made a bargain with the devil to sell his soul for a top-boot full of gold. On the appointed day, the devil was ushered into the living room, where a top-boot stood in the center of the floor. The devil poured gold into it, but to his surprise, it remained empty. He hastened away for more gold, but the top-boot would not fill, even after repeated efforts. At length, in sheer disgust, the devil departed. Afterward it was claimed that the shrewd Irishman had taken the sole off the boot and fastened it over a hole in the floor. Underneath was a series of large cellars, where men waited with shovels to remove each shower of gold as it came down.

In popular superstition it is supposed that if a person hears the cuckoo for the first time with money in his pocket, he will have some all the year, while if he greets the new moon for the first time in the same fortunate condition, he will not lack money throughout the month.

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mon·ey / ˈmənē/ • n. a current medium of exchange in the form of coins and banknotes; coins and banknotes collectively: I counted the money before putting it in my wallet he borrowed money to modernize the store. ∎  (moneys or monies) formal sums of money: a statement of all moneys paid into and out of the account. ∎  the assets, property, and resources owned by someone or something; wealth: the college is very short of money. ∎  financial gain: the main aim of a commercial organization is to make money. ∎  payment for work; wages: she accepted the job at the public school since the money was better. ∎  a wealthy person or group: her aunt had married money. PHRASES: be in the money inf. have or win a lot of money. for my money in my opinion or judgment: for my money, they're one of the best bands around. one's money's worth good value for one's money. on the money accurate; correct: every criticism she made was right on the money. put money (or put one's money) on 1. place a bet on. 2. used to express one's confidence in the truth or success of something: she won't have him back—I'd put money on it. put one's money where one's mouth is inf. take action to support one's statements or opinions. see the color of someone's money receive some proof that someone has enough money to pay for something. throw one's money around spend one's money extravagantly or carelessly. throw money at something try to solve a problem by recklessly spending money on it, without due consideration of what is required.DERIVATIVES: mon·ey·less adj.

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Currency refers to money in any form, either paper or coin, as long as it is in "current" use to pay for goods and services. Although it may have collector's value, money that is no longer accepted for payment, such as coins from ancient Rome, is no longer considered currency. Economists sometimes use the term currency in various specialized ways. A reserve currency, for example, is any medium of exchange, such as gold, that is used for settlement of international debts. The U.S. dollar, which serves as currency within the United States, also serves as a reserve currency to settle accounts which arise from trade among many nations.

See also: Money

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452. Money (See also Finance.)

  1. Brinks Boston armored car service; robbed of over one million dollars (1950). [Am. Hist.: Facts (1950), 24]
  2. Mammon personification; one cannot serve him and God simultaneously. [N.T.: Matthew 6:24: Luke 16:9, 11, 13]
  3. Moneta monitress; epithet of Juno; origin of mint. [Rom. Myth.: Espy, 20]
  4. Newland, Abraham governor of Bank of England; eponymously, banknote. [Br. Hist.: Wheeler, 258]

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money coin, cash, esp. in ref. to its purchasing power XIII; particular coin or coinage XV. ME. monei(e), mone — OF. moneie (mod. monnaie change):- L. monēta mint (in Rome), money, orig. epithet of Juno, in whose temple the mint was housed.
So moneyer † money-changer XIII; coiner, minter XV; † banker, capitalist XVIII. — OF. mon(n)ier, -oier (mod. monnayeur):- late L. monētārius minter.

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cur·ren·cy / ˈkərənsē; ˈkə-rənsē/ • n. (pl. -cies) 1. a system of money in general use in a particular country. 2. the fact or quality of being generally accepted or in use: since the Gulf War, the term has gained new currency. ∎  the time during which something is in use or operation: during the currency of the policy.

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money Any type of payment that is generally accepted within an economy as a medium of exchange for goods and services. It may take many forms besides currency or cash (coins and banknotes). A large portion of the money supply may be in the form of deposits within a banking system, accessed by the use of cheques.

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"money." World Encyclopedia. . 20 Nov. 2017 <>.

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As trade and economies increased, barterthe exchange of goods or services in return for other goods or serviceswas replaced by money. Money is a convenient social invention used to facilitate the exchange of goods and services. Contemporary money takes the form of paper or coins made from durable metals such as nickel, copper, silver, or gold. The first uses of money, however, took a slightly different form. Early items used as money include shells, stones, cattle, and cigarettes.

What is accepted as money from one time to another may vary according to what the society accepts as its medium of exchange. Ancient agricultural societies may have placed more value in cattle than copper, and thus cattle could become accepted as payment for goods or services. Most modern societies use paper and metal coins as their medium of exchange. At the birth of the United States, when the new nation was governed under the Articles of Confederation, the issuing and printing of money was not centrally controlled. Each state printed its own money and there was no guarantee that money from early Virginia would be accepted in Massachusetts. This created problems in the early republic as the states engaged in interstate commerce. The production of money in the United States was eventually centralized under the federal government.

Internationally, nations use different monetary currencies. As in the early days of the United States, the different currencies affect trade. Rather than convert the world to one monetary system exchange rates are established, for example, to convert U.S. dollars to British pounds. This allows nations engaged in international trade to easily purchase goods and services worldwide.

At the end of the twentieth century money was not just paper and coin. Money was plastic and consumers could charge items to a credit account, which they then paid for through another form of money, a check. In addition, the advent of computers and electronic communication allowed banks to begin electronic transfers of money, making it possible to move money from a bank account in Los Angeles, California, to a bank account in Zurich, Switzerland, within a matter of hoursall without the hand-to-hand exchange of paper or coin.

See also: Currency, Exchange Rates, Specie, Wampum

what is accepted as money from one time to another may vary according to what the society accepts as its medium of exchange.

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"Money." Gale Encyclopedia of U.S. Economic History. . 20 Nov. 2017 <>.

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currency: see money.

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"currency." The Columbia Encyclopedia, 6th ed.. . 20 Nov. 2017 <>.

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currency •radiancy •immediacy, intermediacy •expediency • idiocy • saliency •resiliency • leniency •incipiency, recipiency •recreancy • pruriency • deviancy •subserviency • transiency • pliancy •buoyancy, flamboyancy •fluency, truancy •constituency • abbacy • embassy •celibacy • absorbency •incumbency, recumbency •ascendancy, intendancy, interdependency, pendency, resplendency, superintendency, tendency, transcendency •candidacy •presidency, residency •despondency • redundancy • infancy •sycophancy • argosy • legacy •profligacy • surrogacy •extravagancy • plangency • agency •regency •astringency, contingency, stringency •intransigency • exigency • cogency •pungency •convergency, emergency, insurgency, urgency •vacancy • piquancy • fricassee •mendicancy • efficacy • prolificacy •insignificancy • delicacy • intricacy •advocacy • fallacy • galaxy •jealousy, prelacy •repellency • valency • Wallasey •articulacy • corpulency • inviolacy •excellency • equivalency • pharmacy •supremacy • clemency • Christmassy •illegitimacy, legitimacy •intimacy • ultimacy • primacy •dormancy • diplomacy • contumacy •stagnancy •lieutenancy, subtenancy, tenancy •pregnancy •benignancy, malignancy •effeminacy • prominency •obstinacy • pertinency • lunacy •immanency •impermanency, permanency •rampancy • papacy • flippancy •occupancy •archiepiscopacy, episcopacy •transparency • leprosy • inerrancy •flagrancy, fragrancy, vagrancy •conspiracy • idiosyncrasy •minstrelsy • magistracy • piracy •vibrancy •adhocracy, aristocracy, autocracy, bureaucracy, democracy, gerontocracy, gynaecocracy (US gynecocracy), hierocracy, hypocrisy, meritocracy, mobocracy, monocracy, plutocracy, technocracy, theocracy •accuracy • obduracy • currency •curacy, pleurisy •confederacy • numeracy •degeneracy • itinerancy • inveteracy •illiteracy, literacy •innocency • trenchancy • deficiency •fantasy, phantasy •intestacy • ecstasy • expectancy •latency • chieftaincy • intermittency •consistency, insistency, persistency •instancy • militancy • impenitency •precipitancy • competency •hesitancy • apostasy • constancy •accountancy • adjutancy •consultancy, exultancy •impotency • discourtesy •inadvertency • privacy •irrelevancy, relevancy •solvency • frequency • delinquency •adequacy • poignancy

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"currency." Oxford Dictionary of Rhymes. . 20 Nov. 2017 <>.

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moneyabalone, Albinoni, Annigoni, Antonioni, baloney, Bodoni, boloney, bony, calzone, cannelloni, canzone, cicerone, coney, conversazione, coronae, crony, Gaborone, Giorgione, macaroni, Manzoni, Marconi, mascarpone, minestrone, Moroni, Mulroney, padrone, panettoni, pepperoni, phoney, polony, pony, rigatoni, Shoshone, Sloaney, stony, Toni, tony, zabaglione •cartoony, lacunae, loony, Moonie, moony, Nguni, puny, Rooney, spoony, uni •Sunni •bunny, dunny, funny, gunny, honey, money, runny, sonny, sunny, tunny •twopenny • chutney • beermoney

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