All these different qualities were eventually found, after long and varied experience, to be best combined in the two precious metals, gold and silver.
Paper money consists of notes, each made legal tender for a specified amount (denomination) of the money of account, and printed on water-marked paper in such a manner as to make forgery as difficult and unlikely as possible. These notes are mere tokens or tickets, entitling the bearer to pay debts to the amount of their several denominations. They can be issued in high denominations for which coins would be inconveniently big, or in low denominations for which coins would be inconveniently small. (See MINT.) Measurement of Value.—The monetary unit is the common denominator of all market values (prices). So long as it is equated to a prescribed weight of a commodity, such as gold or silver, the measurement of values is a clear enough process. Gold and silver themselves are dealt in on the market, and prices of other commodities simply represent the terms on which they exchange in the market for gold or silver. Paper money itself may be so regulated that the monetary unit is the equivalent of a fixed quantity of gold or silver. For example it may be made con vertible, on demand, into coin. In general, countries using paper money have endeavoured to maintain convertibility into metal, and when they have lapsed from it have aimed at re-establishing it. A metallic standard is the universally accepted monetary policy. Departures from it occur only at times of emergency and transition. Nevertheless such departures do occur, and some times years, and even generations pass before the theoretically normal standard is restored. In such conditions, when the mone tary unit is represented by nothing more solid than paper money, what is the significance of a price? In terms of what does the price measure value? This question is fundamental in the theory of money. If all the exchanges in the markets could be settled from day to day, and no debts of any kind remained outstanding till the next morning, the absolute value of the unit would be a matter of no practical consequence. Prices would do all that is required of them by representing the proportions holding among exchangeable values. But in real life not only are debts left out standing and balances of money kept in hand for indefinitely vary ing intervals, but pecuniary rights and interests extending over long periods are constantly being created and dealt in. Mort gages, the bonds, debentures and preference shares of companies, the debts of public authorities, national and local, are examples.
Every creditor and every holder of money is concerned in the value of the unit in which money and debts are 'reckoned. Essen
tially the unit represents purchasing power. What the creditor possesses is a power of access to markets, where everything is offered at a price. His power over any one product is measured by the inverse of its price. If he wants to buy bread, the greater the price of bread, the less is the purchasing power of a given sum of money in terms of bread. But a creditor does not limit his wants to any one product. He will need to buy a selection from among all the products on sale, and his purchasing power ought to be measured in relation to the prices of this selection. We need to estimate what may be called the "wealth-value" of the monetary unit, its purchasing power in terms of wealth in general. This is a problem admitting of no exact or theoretically perfect solution. The prices of different products are constantly varying in relation to one another, and no possible selection of products can be perfectly typical at all times and places.
What we can do, however, is to construct what is called an index number of prices. In order to compare the value of the monetary units at two different times, we compile a list of products dealt in in the markets at both times, and we express for each product the price at one time as a ratio of the price at the other time. We then take an average of these ratios. For example, if there were five products, and their prices had increased respectively by 2, 4, 6, 8 and i o per cent, the average increase would be 6 per cent. That means that the purchasing power of the unit in terms of these five products has fallen in the proportion of 106 to i oo. The process of averaging can be elaborated by allowing for the relative importance of the products. If one is five times as im portant as another, it can be reckoned as five products and the other as one. There are many refinements in the theory of index numbers (see INDEX NUMBER). What we are concerned with here is that there is a sufficiently definite conception of a price level, measured by an index number, and that the wealth value or purchasing power of the monetary unit varies inversely as the price level. The problem we have to solve is this : how is the price level related to the supply of money? Prices are determined in markets. Dealers who find sales of any product to consumers increasing, and their stocks diminishing, raise prices; if they find their sales falling off and their stocks accumulating, they lower prices. In the one case they give more orders to producers, and at higher prices ; in the other they give fewer orders to producers, and at lower prices. They are always seeking an equilibrium price at which their stocks are just kept at a convenient level.