Why does the dollar bill in one’s pocket have value? The value of money is established, according to some experts, because the government in power says so. For some commentators the value of money is on account of social convention. What this implies is that money has value because it is accepted.
And why is it accepted? …because it is accepted! Obviously this is not a good explanation of why money has value.
The Difference between Money and Other Goods
Let us try another approach. Demand for a good arises from its perceived benefit. For instance, people demand food because of the nourishment it offers them. Likewise, people demand money 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 it offers the benefit of its purchasing power, i.e., its price.
Consequently, for something to be accepted as money it must have a preexisting purchasing power, a price. So how does a thing that the government proclaims will become the medium of exchange acquire such purchasing power, a price?
We know that the law of supply and demand explains the price of a good. 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., because money has a price. Yet if the demand for money depends on its preexistenting price, i.e., its 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 government decree and social convention.
Mises Explains How the Value of Money Is Established
In his writings, Mises had shown how money becomes accepted.