Money Mischief_ Episodes in Monetary History - Milton Friedman [7]
We can come closer to giving a reasonably general answer to a different, and basically more important, question: What determines the value in terms of goods and services of whatever item has come to be accepted as money?
When most money consisted of silver or gold or some other item that had a nonmonetary use, or of an enforceable promise to pay a specified amount of such an item, the "metallist" fallacy arose that "it is logically essential for money to consist of, or be 'covered' by, some commodity so that the logical source of the exchange value or purchasing power of money is the exchange value or purchasing power of that commodity, considered independently of its monetary role" (Schumpeter 1954, p. 288). The examples of the stone money of Yap, of cigarettes in Germany after World War II, and of paper money currently make clear that this "metallist" view is a fallacy. The usefulness of items for consumption or other nonmonetary purposes may have played a role in their acquiring the status of money (though the example of the stone money of Yap indicates that this has not always been the case). But once they acquired the status of money, other factors clearly affected their exchange value. The nonmonetary value of an item is never a fixed magnitude. The number of bushels of wheat or pairs of shoes or hours of labor that an ounce of gold can be exchanged for is not a constant fact. It depends on tastes and preferences and on relative quantities. The use of, say, gold as money tends to alter the quantity of gold available for other purposes and in that way to alter the amount of goods that an ounce of gold can be exchanged for. As we shall see in chapter 3, in which we analyze the effect of the demonetization of silver in the United States in 1873, the nonmonetary demand for an item used as money has an important effect on its monetary value, but, similarly, the monetary demand affects its nonmonetary value.
For present purposes, we can simplify our attempt to demystify money by concentrating on the monetary arrangement that, while historically a very special case, is currently the general rule: a pure paper money that has practically no value as a commodity in itself. Such an arrangement has been the general rule only since President Richard M. Nixon "closed the gold window" on August 15, 1971—that is, terminated the obligation that the United States had assumed at Bretton Woods to convert dollars held by foreign monetary authorities into gold at the fixed price of $35 an ounce.
Before 1971, every major currency from time immemorial had been linked directly or indirectly to a commodity. Occasional departures from a fixed link did occur but, generally, only at times of crisis. As Irving Fisher wrote in 1911, in evaluating past experience with such episodes: "Irredeemable paper money has almost invariably proved a curse to the country employing it" (1929, p. 131). As a result, such episodes were both expected to be and were temporary. The link was successively weakened, however, until it was finally eliminated by President Nixon's action. Since then, no major currency has had any link to a commodity. Central banks, including the U.S. Federal Reserve System, still carry an entry on their balance sheets for gold, valued at a fixed nominal price, but that is simply the smile of a vanished Cheshire cat.
What, then, determines how much one can buy with the greenbacked five-dollar paper bill we started with? As with every price, the determinant is supply and demand. But that only begs the question. For a full answer, we must ask: What determines thé supply of money? And what determines the demand for money? And what, concretely, is "money"?
The abstract concept of money is clear: money is whatever is generally accepted in exchange for goods and services—accepted not as an object to be consumed but as an object that represents a temporary abode of purchasing power