But Hand M' are not independent factors; they bear a more or less constant ratio to each other, because of two facts: (1) that bank reserves are kept in a more or less definite ratio to bank de posits, out of the requirements of law or business expediency; (2) that individuals, firms, and corporations preserve more or less def inite ratios between their cash transactions and their check trans actions, and also between their money on hand and deposit bal ances. In a given community the quantitative relation of deposit currency to money in circulation is determined by considerations of convenience; and while the ratio differs greatly for the individ ual, for the community the average ratio is quite constant and can be approximately determined. If the ratio of bank reserves to M' is 1: 4, this means that as the quantity of bank reserves in creases, M' may expand four times the amount of the reserve increase. For instance, if the quantity of money in bank re serves were $1,000,000 and the superposed M', $4,000,000, an increase of the reserves to $2,000,000 would bring M' to $8,000, 000. The price level P will vary with the combined amounts of M and M'. A lowering of reserve requirements is, therefore, likely to bring a higher price level through the inflation of deposits.
Remoter Influences on Prices The five factors, M, M', V, V', and T, are the only factors that can affect P directly. Any other influences on prices must act through one or more of these five factors and there are hun dreds of such influences. M is affected by such factors as the production of gold and other metals, their consumption in the arts, the habit of hoarding, the international shipment of specie, and so forth. V and V' depend upon the methods of making payment—how frequent, how regular, how synchronized with receipts—the habit of hoarding, the facilities of communication, the development of banking, and the like. M' varies with the banking system, with the extent of the use of deposit currency and with industrial conditions. T is affected by geographical differ ences in natural resources, the division of labor, the knowledge of the technique of production, the accumulation of capital, the extent and variety of human wants, facilities of transportation, freedom of trade, the character of the monetary and banking systems.
To illustrate: Consider the effect of the introduction and development of the telegraph on the price level. This means of communication has increased the velocity of the circulation of money (V) and of deposits (V') and therefore has tended to in crease prices (P) ; it has also facilitated production and increased the volume of trade (T), and therefore has tended to lower prices.
The net resultant of these two opposing forces is difficult to deter mine, but it was probably upward. Or consider the effect of the immigration of foreign workmen to our country. It has increased the total production and trade (T), and therefore tended to lower prices (P) ; it has also occasioned a continuous outgo of funds from our country to friends in the emigrant country, reducing M and Al', and therefore P. The immigrants have tended largely to live in cities and other densely populated areas, and thus to accelerate the velocity of money (V) and of deposits ( V') and to foster banking accounts (M and therefore to increase prices (P). In this instance also the net effect of these influences on the various factors is difficult to determine. These illustrations are sufficient to suggest to the reader that too categorical statements as to the effect of some factor on the price level are dangerous unless careful consideration is given to the various and often con flicting ways in which a particular factor may possibly affect the price level.
Index Numbers The price level is calculated and estimated in terms of an index number, which is some form of average of prices of repre sentative commodities. When the price level rises or falls the prices of all commodities do not rise or fall together or in the same degree or direction. The index number is simply an average of prices, or of the percentages of increase or decrease of prices, of a selected list of commodities.
In the preparation of index numbers there are many considera tions which vitally affect their usefulness, among which are the following: 1. The Prices Used. What prices should be used is governed by the purposes to which the index number is devoted. If the index is to be used over a broad area, the prices should be those prevailing in a central, organized, competitive market. If the price movement in a limited locality is to be studied only prices obtaining in that locality should be used.
Wholesale prices fluctuate more widely and are more quickly responsive to changes in supply and demand than retail prices. An index number based upon wholesale prices is therefore a better barometer of business conditions for manufacturers, jobbers, large credit-grantors, and the like, but an index number based upon retail prices measures better the changes in the cost of living and the proper adjustment of wages thereto. In any case, the average price for the day, week, or month is better for purposes of comparison than the prices on the market at a certain instant.