How markets and currencies work

Gary Rabbior is the president of the Canadian Foundation for Economic Education. This is the fifth of a six-part series on understanding how the economy works and why it matters to investors.

The following account of a World War II prisoner-of-war camp economy, helps to illustrate the impact on an economy of changes in the supply of money.

For the prisoners of the Second World War, comforts of material goods came largely through the issue of Red Cross parcels. These contained primarily food items such as biscuits, chocolate, sugar, jam, butter, etc. They also included cigarettes.

Each prisoner received the same parcel. Only through exchange could a prisoner alter, and possibly improve, his level of material comfort. There was some provision of services in the camp such as laundry and tailoring. In addition, some parcels did arrive from home, providing items such as clothing. However, overall, there was very little production activity within the camp so this left the process of exchange as the primary route to improved welfare.

The early economic activity in the camp began as direct barter-one good or service directly traded for one or more of another. Over time, the level and rate of trading increased significantly. Some prisoners became particularly adept at it. There was the story of one prisoner who set out with a tin of cheese and 5 cigarettes. He returned later with another complete parcel, as well as his original cheese and cigarettes.

Rough scales of trade evolved. A tin of jam was worth a half a pound of margarine plus something else. A cigarette was worth several chocolate issues. A tin of diced carrots was worth almost nothing. With the camp being split into different areas, prices in one part of the prison area could be different than in another. This meant that some prisoners could earn a profit from arbitrage-acquiring a good in a market where its price is relatively low and selling it in another market where its price is relatively high.

However, over time, as the camp economy became more developed and complex, bartering became very complicated. A simplifying system was needed, and a simplifying system arose. Eventually, a unit of account and medium of exchange evolved. The value of everything in the camp came to be expressed in terms of cigarettes. The cigarette became the unit of account and the medium of exchange, in effect, a form of commodity money for the camp.

At first this system had some rough edges. In the hours after an issue from the Red Cross was received, the camp would be bedlam as prisoners walked through the camp calling out their offers such as "cheese for seven"-cheese in exchange for seven cigarettes.

This chaotic form of trading, however, eventually changed and the verbal exchange market was replaced by an "Exchange and Mart" notice board. On the board, in each area of the camp, a prisoner's name would be listed along with his room number, what was wanted, and what he was offering in return. Through this type of public trading, prices became generally well-known. Prices, then, were largely influenced by the forces of supply and demand.

In the camp, certain entrepreneurial efforts were established. One prisoner set up a coffee stall selling coffee, tea, and cocoa at two cigarettes a cup. A restaurant was eventually set up in the camp as well.

Credit (being able to use something today and pay for it at a later date) also evolved in the camp as did spot and futures markets. Spot and future prices meant that a good could have a certain price if bought today and another price if you wanted to establish an agreement today to buy it in the future. For example, a treacle ration sold for 4 cigarettes today or 5 cigarettes if you agreed today to buy it next week. To be prepared to make an agreement for a higher future price, the buyer obviously had to believe that the price would rise. The higher price offered today would be worth it in the future, for example, if the buyer thought the price for treacle might be 6 or 7 cigarettes next week when the available supply was less.

Another example of this was the market for bread. Bread was issued twice a week. A four-day ration was issued on Thursday and a three-day ration was issued on Monday. There was a "bread now" price, which would differ from a "bread Thursday" price. For example, by Wednesday night and Sunday night, with bread in short supply, the price would be higher.

But pricing became somewhat difficult due to debasement of the currency. Debasement refers to altering the nature of what is used as commodity money or specie, thus making it worth less. Some prisoners started rolling the cigarettes between their fingers to force out some of the tobacco. They would then use the accumulated tobacco to make new cigarettes. Some cigarettes, therefore, came to have less tobacco in them than others. Traders started inspecting cigarettes and would refuse poor ones or value them less. In addition, the Red Cross would issue pipe tobacco in lieu of cigarettes. You could receive 1 ounce of pipe tobacco or 25 cigarettes. But 1 ounce of pipe tobacco could make 30 cigarettes. Hence, some of the prisoners started receiving pipe tobacco and rolling it into cigarettes. This, too, led to debasement of the "cigarette currency."

Changes in the quantity of cigarettes (camp money) altered prices in the camp. With the output of goods in the camp largely fixed, just like the items in the game, changes in the "money supply" altered prices.

If the quantity of cigarettes in the camp went up, prices rose. If the quantity of cigarettes declined, prices in the camp fell.

There were a variety of factors that would affect the quantity of cigarettes. When Red Cross issues were interrupted for some reason, that meant fewer cigarettes in the camp. As some of the cigarettes were used for smoking, and less were available as currency, prices of various goods and services declined, that is, deflation occurred. (Deflation is a decline in the average price level in the economy).

On the other hand, when new issues arrived and the supply of cigarettes shot up, so did prices. Higher prices would prevail until the supply of cigarettes was again reduced through smoking.

When there was tension in the camp such as bad war news, more cigarettes would be smoked, the quantity of currency would decline, and prices would fall. If there was a rumour that a new issue was due in shortly, raising expectations that the supply of cigarettes was due to increase, prisoners would begin to offer higher prices. These were factors that influenced the "money supply" in the camp and, as such, caused changes in the average price level. When prices, in general, change due to changes in the money supply, we refer to these as absolute changes in the price level.

Alternatively, the price for a particular good or service can change due to the forces of supply and demand. Changes to particular prices due to supply and demand forces are referred to as relative price changes. For example, the weather could affect relative prices. In the warm periods, the demand for cocoa declined, along with its price, and the demand and price for soap increased. New discoveries altered prices. When it was discovered that raisins and sugar could be combined to make a strong liquor drink, their prices shot up. And so on.

The prison camp economy helps to show, once again, that the quantity of money (cigarettes) primarily affects the prices at which transactions for goods and services take place. The production and availability of goods and services are largely determined by other factors.

This article is based on "The Economic Organisation of a P.O.W. Camp" by R.A. Radford. Economica, vol. 12, no. 48, November 1945.