Value & Capital, CHAPTER XIII, Section 4

This section looks at the various sorts of securities discussed in this chapter, including money, as being substitutes for one another "in very much the same sort of way as a chain of substitute commodities, say different qualities of wheat or sugar.  Money is naturally the highest grade, and that is why other grades ordinarily stand at a discount relatively to money."  As noted earlier in the chapter, it is the lack of general acceptability of investment bills as a method of payment that causes them to stand at a discount.

The discussion notes that in early societies, "some sort of durable material commodity" tended to be used as money.  Although the discussion here does not bring out this point, such durable commodities would have alternate uses, which motivates the following passage.

[I]t was not easy to distinguish the demand for the commodity as money from the demand for it as durable consumption good -- or even to see what the demand for it as money could mean.  But when some sorts of promises to pay money began to be so generally acceptable as to become perfect substitutes for the original money -- and thus to stand with the original money in the highest grade -- it became clear that the pure monetary demand had acquired an independent existence.  Money had left its chrysalis stage of durable consumption good, and had developed into pure money -- which is nothing else but the most perfect type of security.

The discussion goes on to address the next highest grade of security, "bills of short maturity."  These are "not quite perfect money, but still very close substitutes for it."  The argument for this claim is that the fluctuating prices for three-month bills tend to remain much closer to the face value of such bills than the differences between pairs of material commodities regarded as being very good substitutes.

The text notes that longer term securities are a lower grade of security.  Their greater fluctuations in value make them "much less of a perfect substitute" for money, and they sell at a greater discount.  Despite this greater imperfection, the discussion observes that "substitution between money and long-term securities does take place," and it proceeds to describe several forms of such substitution.

The text argues that small investors, who buy securities "in order to live on the interest from them" typically choose when to convert their money into securities based more on when they can afford the cost of making the investment, rather than on a change in interest rates.  More speculative investors that do not have ready access to short-term issues, the text argues, "will use the long-term security market as a repository for funds only temporarily idle."  For these types of investors, "the margin between money and securities is a very sensitive margin; the more conscious they are of the importance of capital losses, the more easily they will switch about when the rate of interest varies."  These investors still have access to "at least one form of short term security" -- namely, they can deposit funds in a bank.  This observation leads into the discussion of a third class of investor -- banks themselves, along with "financial houses, public institutions, large industrial and commercial firms."   These have access to "a whole gamut of securities of different maturity."

It is these professional investors, operating upon the whole gamut, and paying close attention to small differences in rates, who provide most of the logic of the interest system (just as it is the professional arbitrageurs who provide most of the logic of the system of foreign exchange rates).... The whole working of the system of interest rates is an example of the working of the general rule of substitution:  if two commodities are close substitutes for an important section of a market, they will behave as close substitutes for the market as a whole.