I was reading the epub version of “A Free Market Monetary System” and came across this passage by Hayek:
“I do believe that if today all the legal obstacles were removed which prevent such an issue of private money under distinct names, in the first instance indeed, as all of you would expect, people would from their own experience be led to rush for the only thing they know and understand, and start using gold. But this very fact would after a while make it very doubtful whether gold was for the purpose of money really a good standard. It would turn out to be a very good investment, for the reason that because of the increased demand for gold the value of gold would go up; but that very fact would make it very unsuitable as money. You do not want to incur debts in terms of a unit which constantly goes up in value as it would in this case, so people would begin to look for another kind of money: if they were free to choose the money, in terms of which they kept their books, made their calculations, incurred debts or lent money, they would prefer a standard which remains stable in purchasing power”.
I know I have read elsewhere that Hayek believed that the supply of money should be increased if the demand of money also increases. What are your views on this issue? Why wouldn’t debtors want to exchange in a currency that increases in value? Couldn’t they just renegotiate their debt terms? What did people do during certain periods of the 19th century when the value of the currency increased? Finally, isn’t a stable currency the same policy that Friedman advocated?
Yes, people could negotiate contracts to avoid the ill-effects of a rising purchasing power of money. And, if they still thought it disadvantageous to use gold, they could choose silver or some other commodity that didn’t appreciate over time in a manner they considered troublesome.
Debtors and creditors dealt with the price deflation of the 19th century without the market evaporating.
Production of commodity money on the unhampered market would be regulated by its profitability, just like the production of every other good. If demand for men’s dress shoes (money) increased, then its price (purchasing power) would rise making it more profitable to produce. Entrepreneurs would step up production to earn the profit. Their increased demand for inputs would bid their prices up and their increased supply of output would moderate its price. They would continue their reallocation until production earned the rate of interest again like every other line of production.