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<font size="2"><font face="Verdana" color="#002864" size="5"><strong>Money
Matters No More?</strong></font>
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<font face="Verdana" size="4">by Joseph T. Salerno</font>
<font face="Verdana">[Posted June <span class="267461113-29062004">2</span>9,
2004]</font>
<font face="Verdana"><img alt src="http://www.mises.org/images/dirtymoney.gif" align="right" border="0" width="205" height="220"></font>
<font face="Verdana">Although there are deep and abiding differences
between Chicago school monetarists and Austrian monetary theorists, there has
always been strong agreement among them on one thing: the central importance
of the money supply in explaining the purchasing power of money or"price
level" in the economy.</font>
<font face="Verdana">This does not appear to be the case any longer.
The June 2004 cover article of </font><font face="Verdana">Monetary
Trends</font><font face="Verdana"> a publication of the St. Louis Federal
Reserve Bank, long a staunch bastion of monetarism, is entitled"How
Money Matters." A more accurate description of its contents is
"Why Money Doesn’t Matter Anymore." The author, William T.
Gavin, emphasizes that"money still matters"—just not its
quantity. </font>
<font face="Verdana">When economists such as Irving Fisher and other
pre-Friedmanite quantity theorists used to conceive the medium of exchange as
the central function of money, they focused on M1—basically currency and
demand deposits—as the relevant empirical measure of the money supply.
Later, under the influence of the Keynesian Revolution, Friedman"restated"
the quantity theory, shifting its main focus to money’s function as a"store
of value" whose corresponding statistical aggregate M2 included
interest-bearing financial assets in addition to the transaction balances
included in M1.</font><a id="_ftnref1" title href="http://www.mises.org/fullstory.asp?control=1550#_ftn1" name="_ftnref1"><font face="Verdana">[1]</font></a><font face="Verdana"> </font>
<font face="Verdana">Austrians, beginning with Carl Menger in 1871,</font><a id="_ftnref2" title href="http://www.mises.org/fullstory.asp?control=1550#_ftn2" name="_ftnref2"><font face="Verdana">[2]</font></a><font face="Verdana">considered
the store of value function of money as secondary and derived from its primary
function as the general medium of exchange. They therefore
objected that some of the items included in the Friedman/Schwartz M2 aggregate
did not fulfill this primary function while other assets excluded from M2 were
in fact instantaneously interchangeable at par with currency or demand
deposits and hence economically indistinguishable from the latter.</font><a id="_ftnref3" title href="http://www.mises.org/fullstory.asp?control=1550#_ftn3" name="_ftnref3"><font face="Verdana">[3]</font></a><font face="Verdana"> </font>
<font face="Verdana">This led to differences in the monetary aggregates
emphasized by the two groups, but they remained united in a shared view of the
tight link between the quantity of money and the height of prices despite
Friedman’s formalization of the"inflation transmission mechanism"
in terms of a Keynesian portfolio balance approach. </font>
<font face="Verdana">Now it appears that this last area of agreement
between Austrians and monetarism, or at least its policy branch, has gone by
the boards. </font>
<font face="Verdana">For Gavin now tells us that money’s role as"the
unit of account"—another derivative function of the general medium of
exchange, as Menger pointed out—"is at the center stage in monetary
policy today." The reason, according to Gavin, is"Our models
and our discussions focus not on the quantity of money but on the purchasing
power of the dollar." In other words the essential nature of money
has changed merely because economists’ models and Fed policy have been
altered to"keep [the] federal funds rate fixed for months at a
time," in which case"the short-term money supply is perfectly
elastic with respect to the interest rate and all changes in money demand are
perfectly accommodated."</font>
<font face="Verdana">Gavin goes on to conclude: "[A]n important
channel by which the Federal Reserve stabilizes the value of a dollar is
through expectations of future inflation, the main channel through which
monetary policy affects the real economy. We do not have to pay
attention to the quantity of money today because policymakers are paying
attention to its price, by focusing on inflation and inflation expectations." </font>
<font face="Verdana">Gavin thus depicts the essential role of money in the
economy today as a disembodied accounting unit whose value can be stabilized
by a central bank that ignores the law of supply and demand while carefully
molding the public’s expectations of inflation through the hocus pocus of
manipulating, or even just making"credible" threats to manipulate,
a short-term interest rate. This is nonsense on stilts and merely a
sophisticated version of George Knapp’s mystical State theory of money—</font><font face="Verdana">demolished</font><font face="Verdana"> by
Ludwig von Mises in 1912—according to which the value of money was not
determined by market forces but directly imposed by State fiat regardless of
its quantity.</font><a id="_ftnref4" title href="http://www.mises.org/fullstory.asp?control=1550#_ftn4" name="_ftnref4"><font face="Verdana">[4]</font></a>
<font face="Verdana">Hayek once commented to the effect,<font color=#FF0000>"God help us,
if people ever forget the lessons taught by the naive quantity theory of money." </font>
Who would have thought that the St. Louis Fed would one day require such
divine guidance?</font>
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<font face="Verdana">Joseph T. Salerno teaches economics at Pace
University. </font><font face="Verdana">Jsale@earthlink.net</font><font face="Verdana">.
See the </font><font face="Verdana">Study
Guide on Money and Banking</font><font face="Verdana">, particularly
Salerno on the </font><font face="Verdana">Austrian
Definition of Money</font><font face="Verdana"> and Rothbard on"</font><font face="Verdana">Austrian
Definitions of the Supply of Money</font><font face="Verdana">." Comment
on the </font><font face="Verdana">blog</font><font face="Verdana">.<br clear="all">
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<p class="MsoFootnoteText"><a id="_ftn1" title href="http://www.mises.org/fullstory.asp?control=1550#_ftnref1" name="_ftn1"><font face="Verdana">[1]</font></a><font face="Verdana">
Milton Friedman,"The Quantity theory of Money—A Restatement" in
idem, ed., Studies in the Quantity Theory of Money (Chicago:
University of Chicago Press, 1973), pp. 3-21. For a description of the
monetary aggregate preferred by monetarists, see Milton Friedman and Anna
Jacobson Schwartz, A Monetary History of the United States, 1867-1960
(Princeton: University Press, 1963), pp. 4-5.</font>
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<p class="MsoFootnoteText"><a id="_ftn2" title href="http://www.mises.org/fullstory.asp?control=1550#_ftnref2" name="_ftn2"><font face="Verdana">[2]</font></a><font face="Verdana">
Carl Menger, Principles of Economics, trans. James Dingwall and Bert
F. Hoselitz (New York: New York University Press, 1981), pp. 258-80</font>
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<p class="MsoFootnoteText"><a id="_ftn3" title href="http://www.mises.org/fullstory.asp?control=1550#_ftnref3" name="_ftn3"><font face="Verdana">[3]</font></a><font face="Verdana">
For an explanation of the empirical definition of the money supply based on
the Austrian theoretical emphasis on money the general medium of exchange,
see Murray N. Rothbard,"Austrian Definitions of the Supply of
Money," in idem, The Logic of Action One: Method, Money, and
the Austrian School (Lyme, NH: Edward Elgar Publishing, Inc., 1997) pp.
337-49; and Joseph T. Salerno, The ‘True’ Money Supply: A Measure of the
Supply of the Medium of Exchange in the U.S. Economy," Austrian
Economics Newsletter 6 (Spring 1987): 1-6.</font>
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<div id="ftn4">
<p class="MsoFootnoteText"><a id="_ftn4" title href="http://www.mises.org/fullstory.asp?control=1550#_ftnref4" name="_ftn4"><font face="Verdana">[4]</font></a><font face="Verdana">
For Mises’s critique of the several variants of the State theory of money,
see Ludwig von Mises, The Theory of Money and Credit, trans. H. E.
Batson, 3<sup>rd</sup> ed. (Indianapolis, IN: Liberty Classics, 1981), pp.
506-512.</font>
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