Stephen Monrad

If people are only modestly rational, prices are only loosely connected to value. Value gets prices into the right ballpark. The final price is determined by the decisions made by individuals with imperfect information and understanding.

Prices are more or less stable today because factors that tend to increase prices are balanced against those that tend to decrease prices. Sellers, motivated by self interest, would love to increase prices. They are prevented from doing this by competition. Competition balances greed. Buyers want good deals. However, they have limited time and energy to hunt for bargains.

Printing money causes inflation because competition is reduced. Too many people are looking to buy when the new money begins to circulate. Sellers can get away with charging more without worrying about losing sales. Greed dominates competition and prices go up.

While the total amount of money that has been printed is important, it is how the extra money affects people’s decisions in the market place that matters. If people started saving money by stashing cash under their mattresses, the money supply could safely be expanded without triggering inflation.

While this story of balanced forces on prices has the same consequences as the value theory of money based on scarcity, I think it is interesting for a couple of reasons. First, by focusing on how buyers and sellers make decisions, it is easier to understand why prices can change erratically. Second, it is easier to understand why paper money doesn’t need to be backed by gold. It’s how people set prices that matters, not the money itself.

The gold standard is only useful in that it stops governments from creating problems by printing too much money. If a government monitors prices and manages the money system prudently, there is no reason to have money backed by anything of value.