The essence of this theory is that the. quantity of money in circulation furnishes the key to the explanation of prices and especially to that of the value of the monetary unit or standard. The explanation of prices given by its advocates may be illustrated as follows: -
Suppose that one thousand exchanges are to be made to-day, and that there are in existence precisely one thousand pieces of money. Under these circumstances there will be one piece of money for each commodity, and if we name this a dollar, the price of each commodity will be one dollar, and the price of the thousand commodities precisely one thousand dollars. If from one thousand the number of pieces of money be increased to two thousand, there will be two pieces of money for each commodity, and accordingly the price of each will be two dollars, and of the entire thousand, two thousand dollars. If the number of pieces of money were five hundred instead of one thousand, directly the opposite result would follow. One piece of money would then have to be exchanged for two commodities, or one-half a piece for each one, and prices would fall for each commodity to one-half a dollar, and for the entire number to five hundred dollars. The general prin-ciple, therefore, is that, other things remaining the same, increasing the quantity of money raises prices, and decreasing the quantity causes them to fall; also that the value or purchasing power of the monetary unit is a function of the quantity of money in circulation, and is affected by the market value of the material of which it is made only to the extent that such value may exert an indirect influence upon the quantity of money in circulation. Indeed, it is claimed by the advocates of this theory that an object entirely without value may become a community's primary standard, and they refer to the circulation of inconvertible government notes as an instance in point.
Of equal importance with the quantity of money in the explanation of prices these theorists place the quantity of commodities to be exchanged and the rapidity of the circulation of money on the one hand and of commodities on the other. In the above illustration, for example, if the number of pieces of money be assumed to remain fixed at one thousand, and the number of commodities to be increased from one to two thousand, the price of each commodity would fall to half a dollar. On the other hand, if the number of commodities were halved, the price of each would be doubled. Likewise, if we assume that each piece of money changes hands twice as often as formerly, the effect upon prices would be the same as doubling the quantity; and, if each commodity were exchanged twice as often as formerly, the amount of money and the rapidity of its circulation remaining unchanged, the result would be the same as doubling the quantity.
This theory is usually stated in such a way as to conform to the requirements of the doctrine of demand and supply, of which it is supposed to be a special case. It is said, accordingly, that the demand for money is a function of the number of commodities to be exchanged in a given time and the rapidity of their circulation, and the supply of money a function of the number of pieces and the rapidity of their circulation, and that, in the case of the money unit as in all others, increasing the demand or diminishing the supply raises the price, and diminishing the demand or increasing the supply causes the price to fall. By the price of the money unit is meant, of course, its purchasing power.
The great age* of this theory, its general acceptance by political economists, and its simplicity and great utility in the solution of certain problems have given it in the popular belief the character of an axiom, and to question its validity stamps one as a heretic and in some quarters throws suspicion upon his mental processes. It is nevertheless true that it will not bear analysis and the tests of logic and facts, and, since it has been a fruitful source of misleading monetary theories, and has been again and again employed in support of questionable financial practices, a presentation of the fallacies it contains is justified in a book of this kind.