Hayek notes that by the 1930s it was widely accepted that monetary influences can play a great role in the “volume and direction of production” (Hayek 1935: 1).
Hayek devotes much of Lecture I to a review of the history of monetary theory. The first major stage of monetary theory was the development of the quantity theory.
However, Hayek criticised the quantity theory for neglecting the way in which money supply changes can cause changes in relative prices (Hayek 1935: 3–6). Hayek concludes that money is not neutral in its effects (Hayek 1935: 7).
The “second stage” in the history of monetary theory was the realisation that the quantity theory is wrong to assume that money supply changes merely affect the general price level in a uniform and proportional manner (Hayek 1935: 8). Locke, Montanari and, above all, Richard Cantillon realised this (Hayek 1935: 8). Hayek sketches the mechanism we now call Cantillon effects (Hayek 1935: 9–10):
“… [sc. Cantillon] attempts to show ‘by what path and in what proportion the increase of money raises the price of things’. Starting from the assumption of the discovery of new gold or silver mines, he proceeds to show how this additional supply of the precious metals first increases the incomes of all persons connected with their production, how the increase of the expenditure of these persons next increases the prices of things which they buy in increased quantities, how the rise in the prices of these goods increases the incomes of the sellers of these goods, how they, in their turn, increase their expenditure, and so on. He concludes that only those persons are benefited by the increase of money whose incomes rise early, while to persons whose incomes rise later the increase of the quantity of money is harmful.” (Hayek 1935: 8–9).The “third stage” in the development of monetary theory was when economists examined how money supply increases affect the rate of interest, and through this the demand for capital goods and consumer goods (Hayek 1935: 11–12).
Hayek traces these ideas through the 19th century British economists and writers, and lists the following:
(1) Henry Thornton’s An Enquiry into the Nature and Effects of the Paper Credit of Great Britain (1802), p. 287.These authors presented monetary theories that were precursors to Knut Wicksell’s monetary equilibrium theory, with a natural rate of interest set by the profits on real capital and a money rate of interest that can diverge from the natural rate.
(2) Lord King’s Thoughts on the Effects of the Bank Restriction (London, 1803), p. 20.
(3) John Leslie Foster’s An Essay on the Principles of Commercial Exchanges (London, 1804), p. 113.
(4) David Ricardo’s The High Price of Bullion: A Proof of the Depreciation of Bank Notes (2nd edn.; London, 1810), p. 47, and On the Principles of Political Economy and Taxation (3rd edn.; London, 1821), p. 349–350.
(5) the “Report of the Committee on Gold Bullion” (London, 1810), p. 56.
(6) Thomas Joplin’s Outlines of a System of Political Economy (London, 1823), pp. 37–38, and An Analysis and History of the Currency Question (London, 1832).
(7) Thomas Tooke’s An Inquiry into the Currency Principle (London, 1844), p. 77, and Considerations of the State of the Currency (London, 1826), p. 22.
(8) Nassau William Senior’s Biographical Sketches (London, 1863).
(9) John Stuart Mill’s Principles of Political Economy: With Some of their Applications to Social Philosophy (6th edn.; London, 1865).
The “fourth stage” of monetary theory seen by Hayek as the antecedent to the ABCT was that linking money supply and interest rate changes to the production of capital goods (Hayek 1935: 18). The authors cited by Hayek who developed the idea of “forced saving” in relation to capital goods investment are as follows:
(1) Jeremy Bentham’s Manual of Political Economy (written in 1804 but only published in 1843).Leon Walras probably rediscovered the “forced saving” doctrine in 1879, and from him it passed to Wicksell (Hayek 1935: 22).
(2) Thomas Robert Malthus’ “Depreciation of Paper Currency,” Edinburgh Review 17.34 (1811): 339–372, at p. 363.
(3) John Stuart Mill’s “On Profits and Interest” and Principles of Political Economy (6th edn.; London, 1865).
But it was Wicksell who combined the different strands of monetary theory into one synthesis (Hayek 1935: 23).
Hayek then summarised Wicksell’s monetary equilibrium theory as follows:
“Put concisely, Wicksell’s theory is as follows: If it were not for monetary disturbances, the rate of interest would be determined so as to equalize the demand for and the supply of savings. This equilibrium rate, as I prefer to call it, he christens the natural rate of interest. In a money economy, the actual or money rate of interest (“Geldzins”) may differ from the equilibrium or natural rate, because the demand for and the supply of capital do not meet in their natural form but in the form of money, the quantity of which available for capital purposes may be arbitrarily changed by the banks.Mises had already adopted Wicksell’s monetary theory and developed the first form of the ABCT (Hayek 1935: 25), and Hayek’s own version in Prices and Production was a development of Mises’.
Now, so long as the money rate of interest coincides with the equilibrium rate, the rate of interest remains “neutral” in its effects on the prices of goods, tending neither to raise nor to lower them. When the banks, however, lower the money rate of interest below the equilibrium rate, which they can do by lending more than has been entrusted to them, i.e., by adding to the circulation, this must tend to raise prices; if they raise the money rate above the equilibrium rate—a case of less practical importance—they exert a depressing influence on prices. From this correct statement, however, which does not imply that the price level would remain unchanged if the money rate corresponds to the equilibrium rate, but only that, in such conditions, there are no monetary causes tending to produce a change in the price level, Wicksell jumps to the conclusion that, so long as the two rates agree, the price level must always remain steady. There will be more to say about this later. For the moment, it is worth observing a further development of the theory. The rise of the price level which is supposed to be the necessary effect of the money rate remaining below the equilibrium rate, is in the first instance brought about by the entrepreneurs spending on production the increased amount of money loaned by the banks. This process, as Malthus had already shown, involves what Wicksell now called enforced or compulsory saving. That is all I need to say here in explanation of the Wicksellian theory.” (Hayek 1935: 23–25).
Hayek departs from Wicksell’s monetary theory on a number of points:
(1) Hayek thinks that the banks need to keep the amount of money in circulation unchanged to secure a stable price level, andBut Hayek thinks that the banks cannot keep the demand for real capital in line with the supply of savings and the price level stable at the same time, except in a stationary equilibrium state (Hayek 1935: 27). In times of expansion of production, even when the money rate of interest is equal to the natural rate, there would be a falling price level (Hayek 1935: 27):
(2) the amount of money in circulation has to be changed as the volume of production increases or decreases (Hayek 1935: 27).
“The banks could either keep the demand for real capital within the limits set by the supply of savings, or keep the price level steady; but they cannot perform both functions at once. Save in a society in which there were no additions to the supply of savings, i.e., a stationary society, to keep the money rate of interest at the level of the equilibrium rate would mean that in times of expansion of production the price level would fall. To keep the general price level steady would mean, in similar circumstances, that the loan rate of interest would have to be lowered below the equilibrium rate. The consequences would be what they always are when the rate of investment exceeds the rate of saving.” (Hayek 1935: 27–28).Hayek also repudiates the idea of a general price level as a useful economic concept (Hayek 1935: 29–30).
In place of the general value of money, Hayek substitutes the crucial concept of how money influences the relative values of goods (Hayek 1935: 31). If money leaves relative values of goods’ prices unchanged, then money is “neutral” (Hayek 1935: 31).
Foster, John Leslie. 1804. An Essay on the Principles of Commercial Exchanges, and more particularly of the Exchange between Great Britain and Ireland: With an Inquiry into the Practical Effects of the Bank Restrictions. J. Hatchard, London.
Hayek, F. A. von. 1931. Prices and Production. G. Routledge & Sons, Ltd, London.
Hayek, F. A. von. 1935. Prices and Production (2nd edn). Routledge and Kegan Paul.
Joplin, Thomas. 1823. Outlines of a System of Political Economy: written with a View to Prove to Government and the Country, that the Cause of the Present Agricultural Distress is Entirely Artificial: and to suggest a Plan for the Management of the Currency. Baldwin, Cradock, and Joy, London.
Joplin, Thomas. 1832. An Analysis and History of the Currency Question: Together with an Account of the Origin and Growth of Joint Stock Banking in England: Comprised in a Brief Memoir of the Writer’s Connexion with these Subjects. James Ridgway, London.
Malthus, Thomas Robert. 1811. “Depreciation of Paper Currency,” Edinburgh Review 17.34: 339–372.
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Ricardo, David. 1810. The High Price of Bullion: A Proof of the Depreciation of Bank Notes (2nd edn.). John Murray, London.
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Tooke, Thomas. 1826. Considerations of the State of the Currency. John Murray, London.
Tooke, Thomas. 1844. An Inquiry into the Currency Principle: The Connection of the Currency with Prices, and the Expediency of a Separation of Issue from Banking. Longman, Brown, Green, and Longmans, London.