Tuesday, February 28, 2006


Austrian Monetary Theory

Austrian economists differ from neo-classical economists on money in at least two key ways. First, they don't think money is neutral with respect to relative prices; and second, they don't buy the concept of a price level.

When I say money is not "neutral" with respect to relative prices, I mean changes in the money supply cannot leave relative prices unchanged. This is mainly because an increase (or decrease) in the supply of money is never perfectly uniform. It is usually injected at one place (as in creating new money to be spent on government services) and takes time to run its course through the whole of the economy. Those who are first in this chain (and enjoy low prices before they rise fully) benefit at the expense of those who receive the new money last or not at all (people on a fixed income are hit hardest). Naturally, this wealth effect has a lasting impact on the structure of demand and, in turn, relative prices. So money is not neutral with respect to relative prices.

Austrians also grimace at the mention of the "price level." It should be clear from the last paragraph that the concept of the price level is meaningless if relative prices are affected by changes in the supply of money. But to get more fundamental, what is the price level supposed to capture? Changes in the purchasing power of money? As Murray Rothbard points out in "The Austrian Theory of Money":

What, then, is the purchasing power, or the price, of a dollar? It will be a vast array of all the goods and services that can be purchased for a dollar, that is, of all the goods and services in the economy. In our example, we would say that the purchasing power of a dollar equals one dozen eggs, or two pounds of butter, or one-tenth of a hat, and so on, for the entire economy. In short, the price, or purchasing power, of the money unit will be an array of the quantities of alternative goods and services that can be purchased for a dollar. Since the array is heterogeneous and specific, it cannot be summed up in some unitary price-level figure.

How can that fit into a "price level"? Why would that even be desirable, considering that money is not neutral w.r.t. relative prices? The followers of everyone from Keynes to Friedman have a lot of explaining to do.

P.S. Mises figured most of this out by 1912 when he published "The Theory of Money and Credit." My hat is off to the man.

Something recent on the Austrian Theory of Money:
I should mention that even if new money is injected uniformly, relative prices are still affected. See the "Angel Gabriel" model in the Rothbard article.
Today's Mises Daily Article is on Money and its misconceptions.

Very timely Travis!!
Travis, you should continue this to issues of 'inflation' and 'deflation'
The next one will likely be a full-blown business cycle post. I'm already looking forward to it.
I am going to be contrary again. :)

1) I am not exactly sure what you mean by "neoclassical", but it's my impression that most economists would agree that an unexpected monetary expansion can be non-neutal in the short term. I'm not sure how Austrians would argue that a fully expected monetary expansion could influence real variables.

2) I'm not sure I understand Murray's problem with the "price level" concept. The price isn't suppose to measure relative prices, so how can the fact that it doesn't be considered a fault?
1. I think you're thinking of "non-neutral" with respect to real output, which monetarists don't agree with but Keynesians do. Austrians mean "non-neutral" with respect to relative prices, nevermind real output for the moment.

2. If relative prices change with the introduction of new money, it makes no sense to "deflate" new, higher prices using a price level or index, since all prices did not rise by the same amount.

I highly recommend reading the entire article by Rothbard if the reason why relative prices must change is unclear. I had to read that article twice before it started making sense to me, but I bet you could get most of it in one pass.
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