Our guest commentator cites Austrian thinkers Menger and Mises. He traces the purchasing power of paper money back its historical root: real money, i.e. physical gold.

Why does the dollar bill in our pocket have value? The value of money is established, according to some experts, because the government in power says so. For other commentators, the value of money is on account of social convention.

The Difference between Money and Other Goods

Demand for a good arises from its perceived benefit. For instance, individuals demand food because of the nourishment it offers them. With regard to money, individuals demand it not for direct use in consumption but in order to exchange it for other goods and services. Money is not useful in itself, but because it has an exchange value, it is exchangeable in terms of other goods and services. Money is demanded because the benefit it offers is its purchasing power.

Consequently, for something to be accepted as money it must have a preexisting purchasing power. So how does a thing that the government proclaims will become the medium of exchange acquire such purchasing power?

Again, demand for a good arises because of its perceived benefit. This is, however, not so with regard to the pieces of paper we call money. So why do we accept them? According to Plato and Aristotle, the acceptance of money is a historical fact endorsed by a government decree. It is government decree, so it is argued, that makes a particular thing accepted as the general medium of the exchange (i.e., money). In his writings, Carl Menger raised doubts about the soundness of the view that money is the origin of a government proclamation.

We know that the law of supply and demand explains the price of a good. Likewise, it would appear that the same law should explain the price of money. However, there is a problem with this way of thinking since the demand for money arises because money has purchasing power (i.e., money has a price). Yet if the demand for money depends on its preexisting price (i.e., purchasing power), how can this price be explained by demand?

We are seemingly caught here in a circular trap, for the purchasing power of money is explained by the demand for money while the demand for money is explained by its purchasing power. This circularity seems to provide credence to the view that the acceptance of money is the result of a government decree and social convention.