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Gold and paper money substitutes

8 - Price Setting Under A Gold Standard

We have seen that the money supply has no bearing on our wealth and that one money supply will do as well as any other money supply. We have also seen that if the supply of money does change for some reason, perhaps if some good fairy places an additional gold coin into our pocket, that the free market will simply adjust prices by changing the purchasing power, or effectiveness of the gold-unit. If the fairy doubles the amount of gold in circulation, then prices will also approximately double, but with a small delay in the adjustment.

So the next question to ask is “what stops us raising prices to whatever level we wish”? If the purchasing power can be altered, what is to stop a shop owner raising the price of his goods at his discretion?

Intuitively we might expect that prices of things are set by the people who sell them, or perhaps that prices are set jointly by the people who sell and the people who buy. Since all sales involve only two parties, buyers and sellers, who by mutual agreement fix the price which is acceptable to both of them, it would appear that between them they have absolute power to set prices as high or as low as they please.

However, this notion is largely false. The genuine feeling of each buyer and seller that he is free to do as he wishes when he agrees on a price, and therefore could do something else if he wishes, is largely an illusion. “Buyers and sellers of any one kind of thing, such as food or medical care, do have some freedom to increase the prices of that one kind of thing; but every dollar more that a buyer spends for food or medical care is a dollar less that he can spend for something else, and every increased price of one thing must come out of a decreased price of something else.”2 As a result, buyers and sellers have some freedom to set prices, but this freedom is limited by external forces.

Therefore, in a system where money substitutes are backed by a limited store of value, such as gold, prices generally remain stable.

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