Prices and Production, Lecture I: Part I

Published Sun, Feb 15 2009 5:57 AM | laminustacitus



            The first lecture of Prices and Production is primarily concerned with the critique of aggregates and contemporary economics, premodern theories of money and interest, the doctrine of forced savings, and the role of the interest rate in respect to keeping the demand for real capital within the limits set by the supply of savings. For the purposes of keeping each live-blog entry as precise as possible, I will divide this lecture into three parts: the first part covering his criticisms of aggregates and contemporary economics, the second covering the history of monetary theory, and the third about the equilibrium rate of interest. The first part is included below:



            F.A. v. Hayek begins Prices and Production by articulating how the inflations during and after the First World War as well as the monetary contraction that the UK went through when it returned to the gold standard displayed production’s relation to monetary conditions. In fact, he stated these have influenced the contemporary psyche enough with the statement: “That monetary influences play a dominant role in determining both the volume and direction of production is a truth which is probably more familiar to the present generation than to any which have gone before.” Despite this, monetary theory at the time had not progressed any further from that of the literature on this subject of the first half of the 19th century. The contemporary economists as well were content with the thought that such theory was perfected to such an extent that any development would naturally be very slow. Not comforted by the status-quo, Hayek knew that not only was much of monetary theory built upon doctrines of dubious validity, but that economists had failed to develop the suggestions that earlier authors had published.


            “(I)t is surely somewhat astonishing,” writes Hayek “that the experiences of the last fifteen years (keep in mind that the first edition of Prices of Production was initially published in September, 1931) have not proved more fruitful. In the past, periods of monetary disturbances have always been great periods of great progress in this branch.” (Hayek 1935, 1). The reason behind this was a dramatic shift in the opinions of economists’ in regard to the suitable methodology to be utilized in the study of economics, more specifically the attempt to replace qualitative analysis with a quantitative one. The most relevant example is the resuscitation of the more mechanistic form of the quantitative theory in his “equation of exchange” whose mathematical formulation enables statistical verification is typical of quantitative economics. Though there was no need for Hayek quarrel with the positive content of the theory in his book, but there was definitely a need to debate that has unrightfully usurped the central position in monetary theory, and that it has isolated the theory of money from the general body of economics.


            Economics truly cannot utilize different methods to explain values existing irrespective of any monetary influence, and to explain the influence of money on prices while remaining on a strong methodological foundation. In addition, it is to the individualistic method of economics that whatever understanding we have about such phenomena, and, by trying to rely on aggregates quantitative economics, the discipline shuns the tool that has enabled it to advanced beyond the Classical economists. Yet, despite this fact that monetary theorists are attempting “to establish direct causal connections between the total quantity of money, the general level of all prices and, perhaps, also the total amount of production.” (Hayek 1935, 4). Further, none of these aggregates, as a magnitude, ever exerts an influence upon the decisions of the individual, monetary theory still bases its theories on them despite the fact that it is on the assumption of knowledge about individuals’ decisions that the primary theories of non-monetary economics are based on; thus leading to an irreconcilable divide between the two.  Nevertheless, to proceed further into this point would be a digression that matters of time would not allow for Hayek’s lectures; instead, he was more concerned about showing their characteristics so that he could show how much more a different theory would be able to accomplish.


            Overall, the central preoccupation of the quantitative monetary theories is fluctuations in the general price level, in the words of R.G. Hawtrey, in his article “Money and Index Numbers”: “tendencies which affect all prices equally, or at the same rate impartially, at the same time and in the same direction.” Also, effects on relative prices are put into the analysis only after the supposed causal relation between alterations in the quantity of money and average prices have been fully considered. Yet, there is generally an assumption that posits that changes in the supply of money affect only the general price level, and that changes in the relative ones are only due to “disturbing factors,” or “frictions” thus leading to relative prices levels being ignored completely. Additionally, there are “lags” that exist between the shifts in different prices, and there is accepted to be a general sequence all different goods are affected by with an implication that it would never occur if the general price level did not change.                                                             


            An inquiry upon how this doctrine would influences the prices on production leads to the same general attributes that assert only the average movement of prices matter. Although the price level ought to affect production, the quantitative monetary theories do not consider the effect upon individual stages of production, but instead the consequences for the total volume of production in general. However, there is most often no conjectures given for why it occurs; instead the quantitative economists refer to statistics that display a high correlation of general prices and the total volume of production in the past. Usually any analysis given follows as so: the anticipation of selling at higher prices than current costs will prompt entrepreneurs to expand production, while, vice versa, the fear of being forced by market conditions to sell below costs will prove a strong impediment.


            To Hayek, the belief that fluxes of relative prices and fluxes in the volume of production are direct results of changes in the price level as well as the belief that money affects individual prices only by means of the general price level is caused by three fallacious sentiments: 1. money affects prices and production only if the general price level changes, thus the two are at their “natural” level as long as the price level is constant, 2. there is a positive correlation between the price level and production in that as price levels increase they have a tendency to cause an increase in production, and vice versa, and 3. that, again quoting R.G. Hawtrey: “monetary theory might even be described as nothing more than the theory of how the value of money is determined.” These three opinions enable economics to fallaciously neglect the influence of money as long as its value is stable, and to have an economic theory that analyzes only the “Real causes” without the need of a monetary theory and then to have that attached to receive a complete understanding of the economy. This was, for Hayek, enough so that any reader would be able to obviously see the superiority of the analysis he would propose in Prices and Production against the quantitative economics of his contemporaries.


            The beginning of Lecture I of Prices and Production was not designed to by an exhaustive critique of quantitative economics, and the contemporary monetary theories obsession with the general price level. Instead, Hayek desired to elucidate the details of such fallacious doctrines so that any reader could clearly recognize the superiority of his own analysis.

For those who have no experience with the equation of exchange it is: MV=PQ

               where: M is the total amount of money in circulation in the economy

                            V is the velocity of money, that is the average frequency an average unit is spent    

                            P is the price level               

                           Q is an index of expenditures