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4. Confidence in the Money

An intangible, but highly important determinant of the demand for money, is the basic confidence that

the public or market has in the money itself. Thus, an attempt by the Mongols to introduce paper money in

Persia in the twelfth and thirteenth centuries flopped, because no one would accept it. The public had no

confidence in the paper money, despite the awesomely coercive decrees that always marked Mongol rule.

Hence, the public’s demand for the money was zero. It takes many years—in China it took two to three

centuries—for the public to gain enough confidence in the money, so that its demand for the money will rise

from near zero to a degree great enough to circulate throughout the kingdom.

Public confidence in the country’s money can be lost as well as gained. Thus, suppose that a money is

King Henry’s paper, and King Henry has entered a war with another state which he seems about to lose. King

Henry’s money is going to drop in public esteem and its demand can suddenly collapse.

It should be clear then, that the demand for paper money, in contrast to gold, is potentially highly

volatile. Gold and silver are always in demand, regardless of clime, century, or government in power. But public confidence in, and hence demand for, paper money depends on the ultimate confidence—or lack

thereof—of the public in the viability of the issuing government. Admittedly, however, this influence on the

demand for money will only take effect in moments of severe crisis for the ruling regime. In the usual course of

events, the public’s demand for the government’s money will likely be sustained. [p. 66]

5. Inflationary or Deflationary Expectations

We have dealt so far with influences on the demand for money that have been either one-shot

(frequency of payment and clearing systems), remote (confidence in the money), or gradual (supply of good

and services). We come now to the most important single influence on the demand for money: This is the

publics expectation of what will happen to prices in the near, or foreseeable, future. Public expectation of

future price levels is far and away the most important determinant of the demand for money.

But expectations do not arise out of thin air; generally, they are related to the immediate past record of

the economy. If prices, for example, have been more or less stable for decades, it is very likely that the public

will expect prices to continue on a similar path. There is no absolute necessity for this, of course; if conditions

are changing swiftly, or are expected to change quickly, then people will take the changes into account.

If prices are generally expected to remain the same, then the demand for money, at least from the point

of view of expectations, will remain constant, and the demand for money curve will remain in place. But

suppose that, as was the case during the relatively free-market and hard-money nineteenth century, prices fell

gradually from year to year. In that case, when people knew in their hearts that prices would be, say, 3%

lower next year, the tendency would be to hold on to their money and to postpone purchase of the house or

washing machine, or whatever, until next year, when prices would be lower. Because of these deflationary

expectations, then, the demand for money will rise, since people will hold on to more of their money at any

given price level, as they are expecting prices to fall shortly. This rise in the demand for money (shown in

Figure 3.6) would cause prices to fall immediately. In a sense, the market, by expecting a fall in prices,

discounts that fall, and makes it happen right away instead of later. Expectations speed up future price

reactions. [p. 67]

On the other hand, suppose that people anticipate a large increase in the money supply and hence a

large future increase in prices. Their deflationary expectations have now been replaced by inflationary

expectations. People now know in their hearts that prices will r/se substantially in the near future. As a result,

they decide to buy now—to buy the car, the house or the washing machine—instead of waiting for a year or

two when they know full well that prices will be higher. In response to inflationary expectations, then, people

will draw down their cash balances, and their demand for money curve will shift downward (shown in Figure

3.7). But as people act on their expectations of rising prices, their lowered demand for cash pushes up the

prices now rather than later. The more people anticipate future price increases, the faster will those increases


Deflationary price expectations, then, will lower prices, and inflationary expectations will raise them. It

should also be clear that the greater the spread and the intensity of these expectations, the bigger the shift in the

public’s demand for money, and the greater the effect in changing prices.

While important, however, the expectations component of the demand for money is speculative and  reactive rather than an independent force. Generally, the public does not change its expectations suddenly or

arbitrarily; they are usually based on the record of the immediate past. Generally, too, expectations are sluggish

in revising themselves to adapt to new conditions; expectations, in short, tend to be conservative and

dependent on the record of the recent past. The independent force is changes in the money supply; the

demand for money reacts sluggishly and reactively to the money supply factor, which in turn is largely

determined by government, that is, by forces and institutions outside the market economy.

During the 1920s, Ludwig von Mises outlined a typical inflation process from his analysis of the

catastrophic hyperinflation in Germany in 1923—the first runaway inflation in a modern, industrialized country.

The German inflation had begun [p. 68] during World War I, when the Germans, like most of the warring

nations, inflated their money supply to pay for the war effort, and found themselves forced to go off the gold

standard and to make their paper currency irredeemable. The money supply in the warring countries would

double or triple. But in what Mises saw to be Phase I of a typical inflation, prices did not rise nearly

proportionately to the money supply. If M in a country triples, why would prices go up by much less? Because

of the psychology of the average German, who thought to himself as follows: “I know that prices are much

higher now than they were in the good old days before 1914. But that’s because of wartime, and because all

goods are scarce due to diversion of resources to the war effort. When the war is over, things will get back to

normal, and prices will fall back to 1914 levels.” In other words, the German public originally had strong

deflationary expectations. Much of the new money was therefore added to cash balances and the Germans’

demand for money rose. In short, while M increased a great deal, the demand for money also rose and

thereby offset some of the inflationary impact on prices. This process can be seen in Figure 5.3.

Figure 5.3 Phase I of Inflation [p. 69]

In Phase I of inflation, the government pumps a great deal of new money into the system, so that M

increases sharply to M’. Ordinarily, prices would have risen greatly (or PPM fallen sharply) from 0A to 0C.

But deflationary expectations by the public have intervened and have increased the demand for money from D

to D’, so that prices will rise and PPM falls much less substantially, from 0A to 0B.

Unfortunately, the relatively small price rise often acts as heady wine to government. Suddenly, the government officials see a new Santa Claus, a cornucopia, a magic elixir. They can increase the money supply

to a fare-thee-well, finance their deficits and subsidize favored political groups with cheap credit, and prices

will rise only by a little bit!

It is human nature that when you see something work well, you do more of it. If, in its ceaseless quest

for revenue, government sees a seemingly harmless method of raising funds without causing much inflation, it

will grab on to it. It will continue to pump new money into the system, and, given a high or in creasing demand

for money, prices, at first, might rise by only a little.

But let the process continue for a length of time, and the public’s response will gradually, but inevitably,

change. In Germany, after the war was over, prices still kept rising; and then the postwar years went by, and

inflation continued in force. Slowly, but surely, the public began to realize: “We have been waiting for a return

to the good old days and a fall of prices back to 1914. But prices have been steadily increasing. So it looks

as if there will be no return to the good old days. Prices will not fall; in fact, they will probably keep going up.”

As this psychology takes hold, the public’s thinking in Phase I changes into that of Phase II: “Prices will keep

going up, instead of going down. Therefore, I know in my heart that prices will be higher next year.” The

public’s deflationary expectations have been superseded by inflationary ones. Rather than hold on to its money

[p. 70] to wait for price declines, the public will spend its money faster, will draw down cash balances to make

purchases ahead of price increases. In Phase II of inflation, instead of a rising demand for money moderating

price increases, a falling demand for money will intensify the inflation (Figure 5.4).

Figure 5.4 Phase II of Inflation

Here, in Phase II of the inflation, the money supply increases again, from M’ to M”. But now the

psychology of the public changes, from deflationary to inflationary expectations. And so, instead of prices

rising (PPM falling) from 0B to 0D, the failing demand for money, from D’ to D”, raises prices from 0D to 0E.

Expectations, having caught up with the inflationary reality, now accelerate the inflation instead of moderating it.

Both these phases of a typical inflation can be combined as shown in Figure 5.5.

Figure 5.5 Combined Inflation: Phases I and II

There is no scientific way to predict at what point in any inflation expectations will reverse from

deflationary to inflationary. The answer will differ from one country to another, [p. 71] and from one epoch to

another, and will depend on many subtle cultural factors, such as trust in government, speed of communication,

and many others. In Germany, this transition took four wartime years and one or two postwar years. In the

United States, after World War II, it took about two decades for the message to slowly seep in that inflation

was going to be a permanent fact of the American way of life.

When expectations tip decisively over from deflationary, or steady, to inflationary, the economy enters

a danger zone. The crucial question is how the government and its monetary authorities are going to react to

the new situation. When prices are going up faster than the money supply, the people begin to experience a

severe shortage of money, for they now face a shortage of cash balances relative to the much higher price

levels. Total cash balances are no longer sufficient to carry transactions at the higher price. The people will then

clamor for the government to issue more money to catch up to the higher [p. 72] price. If the government

tightens its own belt and stops printing (or otherwise creating) new money, then inflationary expectations will

eventually be reversed, and prices will fall once more—thus relieving the money shortage by lowering prices.

But if government follows its own inherent inclination to counterfeit and appeases the clamor by printing more

money so as to allow the public’s cash balances to “catch up” to prices, then the country is off to the races.

Money and prices will follow each other upward in an ever-accelerating spiral, until finally prices “run away,”

doing something like tripling every hour. Chaos ensues, for now the psychology of the public is not merely inflationary, but hyperinflationary, and Phase III’s runaway psychology is as follows: “The value of money is

disappearing even as I sit here and contemplate it. I must get rid of money right away, and buy anything, it

matters not what, so long as it isn’t money.” A frantic rush ensues to get rid of money at all costs and to buy

anything else. In Germany, this was called a “flight into real values.” The demand for money falls precipitously

almost to zero, and prices skyrocket upward virtually to infinity. The money collapses in a wild “crack-up

boom.” In the German hyperinflation of 1923, workers were paid twice a day, and the housewife would stand

at the factory gate and rush with wheelbarrows full of million mark notes to buy anything at all for money.

Production fell, as people became more interested in speculating than in real production or in working for

wages. Germans began to use foreign currencies or to barter in commodities. The once-proud mark collapsed.

The absurd and disastrous way in which the Reichsbank—the German Central Bank—met the crucial

clamor for more money to spend immediately in the hyperinflation of the early 1920s is revealed in a notorious

speech delivered by Rudolf Havenstein, the head of the Reichsbank, in August 1923. The Reichsbank was the

sole source of paper money, and Havenstein made clear that the bank would meet its responsibilities by

fulfilling the increased demand for paper money. Denominations [p. 73] of the notes would be multiplied, and

the Reichsbank would stand ready to keep its printing presses open all night to fill the demand. As Havenstein

put it:

The wholly extraordinary depreciation of the mark has naturally created a rapidly

increasing demand for additional currency, which the Reichsbank has not always been

able fully to satisfy. A simplified production of notes of large denominations enabled us

to bring ever greater amounts into circulation. But these enormous sums are barely

adequate to cover the vastly increased demand for the means of payment, which has

just recently attained an absolutely fantastic level, especially as a result of the

extraordinary increases in wages and salaries.

The running of the Reichsbank’s note-printing organization, which has become

absolutely enormous, is making the most extreme demands on our personnel.2

During the latter months of 1923, the German mark suffered from an accelerating spiral of

hyperinflation: the German government (Reichsbank) poured out ever-greater quantifies of paper money which

the public got rid of as fast as possible. In July 1914, the German mark had been worth approximately 25

cents. By November 1923, the mark had depreciated so terrifyingly that it took 4.2 trillion marks to purchase

one dollar (in contrast to 25.3 billion marks to the dollar only the month before).

And yet, despite the chaos and devastation, which wiped out the middle clam, pensioners and

fixed-income groups, and the emergence of a form of barter (often employing foreign currency as money), the

mark continued to be used. How did Germany get out of its runaway inflation? Only when the gov ernment

resolved to stop monetary inflation, and to take steps dramatic enough to convince the inflation-wracked

German public that it was serious about it. The German government brought an end to the crack-up boom by

the “miracle of the Rentenmark.” The mark was scrapped, or rather, a new currency, the Rentenmark, was

issued, valued at 1 trillion old marks, [p. 74] which were convertible into the new currency. The government

pledged that the quantity of Rentenmarks issued would be strictly limited to a fixed amount (a pledge that was

kept for some time), and the Reichsbank was prohibited from printing any further notes to finance the formerly

enormous government deficit. Once these stem measures had been put into effect, the hyperinflation was

brought to an end. The German economy rapidly recovered. Yet, it must be pointed out that the German

economy did not escape a posthyperinflation recession, called a “stabilization crisis,” in which the swollen and

unsound investments of the inflationary period were rapidly liquidated. No one complained bitterly; the lessons

of the monstrous inflation were burned into everyone’s heart)

Only a clear and dramatic cessation of the spiraling expansion of the money supply can turn off the

money tap and thereby reverse the accelerating inflationary expectations of the public. Only such a dramatic

end to monetary inflation can induce the public to start holding cash balances once again.

Thus we see that price levels are determined by the supply and the demand for money, and that

expansion of the money supply—a function solely of government—is the prime active force in inflation. [p. 75]

[p. 76] [p. 77]