Velocity however is affected by certain known causes, particu larly by people's expectations in regard to markets. When demand is active and prices are rising, traders become more unwilling than usual to keep money idle, for the consequent loss of profit is greater ; they pay away money for goods as fast as they can. When demand is sluggish and prices are falling, traders become unwilling to add to their stocks of goods. The loss on idle money is dimin ished, and in extreme cases vanishes altogether ; for investment in goods may, owing to a fall of prices, bring an actual loss instead of a profit. With a given unspent margin the consumers' outlay is greater when credit is expanding and prices rising, smaller when credit is contracting and prices falling. Therefore when expanding credit increases the unspent margin, the price level rises more than in proportion, and when contracting credit decreases the unspent margin, the price level falls more than in proportion. On the other hand these exaggerated movements in the price level may be temporarily masked by changes in stocks of commodities. The quantity theory is often misinterpreted to mean merely that when the unspent margin increases prices rise, and whenever it decreases prices fall. But it is more precise than that, for it says that, other things being the same, whenever the unspent margin increases or decreases prices rise or fall exactly in proportion. In the nature of things such a principle can never be proved by practical examples, because the condition that other things remain the same can never be fulfilled. The quantity theory can never be anything but theory; along with the requisite analysis of the "other things," it supplies a clue to the interpretation of the facts.
Relation of the Monetary Unit to the Standard.—We have now shown how the price level or its reciprocal, the wealth value of the monetary unit, is determined. In the earlier sections we have shown how the value of the unit can be fixed in terms of gold or silver. Here are two processes for determining the value of the monetary unit ; how are they to be reconciled? Payment by weight automatically equates the monetary unit to a specified amount of the standard metal. The quantity of metal in use as money is bound so to adjust itself that the market value in mone tary units of the metal as an industrial material is equal to its value as money. For if its price as a material is too low, some will be diverted from money to industry; if too high, some will be diverted from industry to money. Where coin is used and payment by tale prevails, the adjustment is not so certain. To divert metal from industrial to monetary use, the market price must fall to the coinage price. To divert it from monetary to industrial use, the market price must rise to the melting point of the coin, that is to say, to the point at which the metal in a coin is worth more than the value for which the coin passes current. There may be a gap between coinage price and melting point, not only on ac count of seigniorage, but possibly on account of imperfection in the coin.
Suppose that for any reason the value of the monetary unit falls, or in other words the price level rises. The rise in prices would be general. Under the conditions of practical life it would not be in identically the same proportion for all products, but any product would, in the absence of any disturbing cause, be affected to approximately the same extent as the average of the others. The market price of the standard metal would rise. If the coins in circulation are imperfect, there is no one melting point applicable to all. The value as bullion of the least imperfect coins would be highest, and would overtake their nominal value first. Thus the best coins would be melted or sold as metal first, and only the more imperfect would be left. Before the modern im provements in the technique of coining, the deterioration of the coinage through the disappearance of all the best coins was a frequently recurrent experience in all countries. An issue of debased or light coin (containing less than the prescribed amount of the standard metal) if added to the existing stock of money, has the effect of depreciating the unit. The good coins of full weight then reach melting point, and their disappearance keeps down the stock of money, and, so long as any of them remain, the depreciation is kept within limits. The debased coin simply displaces the good coin.
This is the principle known as "Gresham's Law." Bad money drives out good. H. D. Macleod rather hastily attributed it to Sir Thomas Gresham on the strength of a letter written to Queen Elizabeth, but he afterwards found that the law had been known long before (e.g., to Oresme and Copernicus). Gresham's law only operates where coins are paid by tale at their nominal value. If the better coins pass in payment at the value of the metal they actually contain, there is no profit in melting them. But it is so inconvenient to have to allow a variable premium on coins that this does not usually occur.
If the coinage is perfect, all the coins reach melting point at the same time. It must not be inferred that the entire stock of money will be disposed of as metal in a day. As soon as coins begin to be melted, the stock of money is thereby diminished, and the tendency to depreciation is counteracted. Only so much coin is melted as will bring this result about. Paper money convertible into good coin behaves in the same way as good coin itself. If the issue is increased, and the unit tends to depreciate, notes are converted into metal, and so withdrawn from circulation. With out invoking the quantity theory, it is easy to see that an increase in the supply of money must, if it goes far enough, depress the value of the unit, and a decrease raise it. So long as money is composed of a marketable material or is convertible into such a material, the adjustment which raises or lowers the value of the unit so as to be constant in terms of the material is automatic.