Tuesday, March 3, 2015

Say's Principle and Macroeconomic Analysis

In his 1936 treatise, Keynes formulated Say’s Law as proposing that “supply creates its own demand.” It is not clear exactly what Keynes meant by this. The statement implies an assumption of equilibrium where all excess demands are zero. That is, if supply creates its own demand, than quantity demand of a good and the quantity supplied must be equal. This is at worst a misrepresentation of Say’s Identity and at best an incoherent statement that appeared in one of the most popular economics treatises in history.

What is Say’s Law and why does it matter? In A Treatise on Political Economy, Say argues
A man who applies his labour to the investing of objects with value by the creation of utility of some sort, can not expect such a value to be appreciated and paid for, unless where other men have the means of purchasing it. Now, of what means do these consist? Of other values of other products, likewise the fruits of industry, capital, and land. Which leads us to a conclusion that may at first sight appear paradoxical, namely, that it is production which opens a demand for products.
Ultimately, goods must pay for goods. If an agent wishes to purchase a product, he or she must either exchange another good directly for the desired good or else acquire by exchange money to purchase the item. Confusion arises when money must be integrated into the framework. Unfortunately, Say does not do a good job of explaining the significance of money within this schema.

Thus, to say that sales are dull owing to the scarcity of money, is to mistake the means for the cause; an error that proceeds from the circumstance, that almost all produce is in the first instance exchanged for money, before it is ultimately converted into other produce: and the commodity, which recurs so repeatedly in use, appears to vulgar apprehensions the most important of commodities, and the end object of all transactions, whereas it is only the medium. Sales cannot be said to be dull because money is scarce, but because other products are so. Should the increase of traffic require more money to facilitate it, the want is easily supplied, and is a strong indication of prosperity – a proof that a great abundance off values has been created, which it is wished to exchange for other values.

Say’s description implies that he understands that there can be an excess demand for money that raises money price. That increase in price will encourage an increase in the available money stock. Having brushed off the problem of insufficient demand by relying on an invisible-hand process, Say give a less than satisfactory supply-side argument for explaining general gluts.

It is because the production of some commodities has declined, that other commodities are superabundant. To use a more hackneyed phrase, people have bought less, because they have made less profit; and they made less profit for one or two causes; either they have found difficulties in the employment of their productive means, or these means have themselves been deficient.

Say describes here a misallocation of resources that only adjustment of price, and subsequently, of the capital structure can fix. It is possible however, that the processes that coordinate market activity might be interrupted by extreme swings in demand for money. It is this problem for which Leijonhufvud and Clower’s extension of Say’s Law as “Say’s Principle” (they refer to it as SP) provides a clear explanation.

Leijonhufvud and Clower describe Say’s Principle first in terms of individual agents. The core of their claim goes that “the net value of an individual’s planned trades is identically zero.” Individual agents make decisions concerning the allocation of their money. An agent may decide to spend all available money on goods and hold no cash on hand or he may decide to withhold some amount of money for safe-keeping. In the latter case, the agent has a positive portfolio demand for money. Algebraically, the authors represent this budget constraint in a system of exchange where such a constraint is implied by secure property rights:

               Pxdx + pydy + dm– sm,0 = 0

They explain further in terms of common interpretations,

‘No one plans to supply anything of value without also planning some use for the proceeds from the sale, which may include simply planning to hold money until a later decision is made to purchase other commodities.’ This statement is correct and sensible.”

‘Confronted with given prices, each transactor must plan to supply commodities of sufficient value to finance all his planned net demands.’ This statement is also correct.

If you have not intuited this by now, understand that Say’s Principle is simply an observation of agent action given a budget constraint.

When money is not included as the “mth commodity”, it is possible that excess supplies of goods can exist. However, when money is included we find that all excess supplies are equally offset by excess demands for goods. This is of special significance if one is to understand macroeconomic fluctuations. Distortionary representations of Say’s Principle connect the identity to an equilibrium assumption. This seems to be what Keynes was implying. Say’s Principle, however, is in no way dependent on an assumption of equilibrium. Rather, it is an observation. Movement toward equilibrium requires some minimum threshold of convergent expectations amongst the population of agents as well as some combination of flexible prices and an endogenous money stock.

Money is different from all other goods in that it comprises one side of every monetary exchange. For this reason, we may separate economic goods into two categories for the sake of analysis. There is 1) money and then there are 2) all other goods. The value of goods in the second category are enumerated in a given currency unit. An excess supply of any good occurs when agents plan, in aggregate, to purchase less of the commodity than is available at a given price. This leads, by definition, to an excess demand for the “mth” good, money, meaning that at given the current constellation of prices, agents demand more money than is available. This will tend to push the price of money – the amount of goods that money exchanges for – upward and, conversely, the prices of commodities downward. This does not mean that the price of all commodities will necessarily fall, but that there will be deflationary pressure as the real stock of money (M/P) is others unable to facilitate exchange of goods until either prices have fallen or the nominal money stock (just M) rises. Until the problem is corrected, there will be a fall in output and employment of both labor.

We can illustrate Say’s principle with graphs of the money stock and of aggregate supply and demand. Those of you reading last week should recognize these graphs.

This represents an economy where agents have elected to increase the nominal value of their dollar holdings. Before prices adjust to reflect this change, there will be 1) and excess demand for money and 2) an excess supply of goods. Not enough money exists to facilitate exchange until prices drop. Eventually, prices must drop in order to clear available inventories. If the general fall in prices takes an extended period of time to occur, then there will be a depression: an extended fall in real output. This comes with an increase in unemployment and a fall in living standards for those agents not prepared for the depression.
Two solutions to this problem have been discussed. Either prices can fall to alleviate growing inventories or the money stock can increase. This has policy implications. 1) A central bank can attempt to alleviate, either in whole or in part, fluctuations in demand for money. The most popular formulation of this proposal is that the central bank should attempt to stabilize MV by adjusting M to offset changes in V. Leijonhufvud and Clower note some historical skepticism about this approach:

. . . Its use raises other issues. To whom is ‘the engine of inflation’ to be entrusted? What limits to that party’s discretionary use of the throttle would it be advisable to impose? . . . Reliance on the automatic solution, in this [classical] view, is argued to be the lesser of two evils.

Perhaps a better solution to this problem is to enact policies that enable the money stock to automatically fluctuate according to changes in demand for it. This might include the removal, or at least minimization, of barriers to liquidity that discourage asset owners from converting those assets into cash (i.e., the capital gains tax and legal restrictions applied to particular classes of assets). Another significant element in promoting a robust economy is the facilitation of expectation formation in regard to public policy. Government agencies are “Big Players” whose plans and actions are considered by agents in the formation of their own expectations (Koppl 2002). If “Big Players” act unpredictably, agents will be less able to coordinate. If these “Big Players” are unable to accommodate this need due to the nature of the political process, then there may be a case for a shrinking of the scope of influence for these government agencies. Of course, this is not to deny that it is possible that changes in government structure might also accommodate this need, but this is even more difficult of a task to accomplish.

I leave you with Say’s perspective concerning this problem.

. . . Wherever , by reason of the blunders of the nation or its government, production is stationary, or does not keep pace with consumption, the demand gradually declines, the value of the product is less than the charges of its production; no productive exertion is properly rewarded; profits and wages decrease; the employment of capital becomes less advantageous and more hazardous; it is consumed piecemeal, not through extravagance, but through necessity, and because the sources of profit are dried up. The laboring classes experience a want of work; families before in tolerable circumstances, are more cramped and confined; and those before in difficulties are left altogether destitute. Depopulation, misery, and returning barbarism, occupy the place of abundance and happiness.

Wednesday, February 25, 2015

Upward-Sloping Short-run Aggregate Supply

Today we add short-run aggregate supply (SRAS) to the analysis. The short-run aggregate supply curve is tricky to justify theoretically. Given an increase in the money supply, the SRAS convey that total output increases as a result of increase in aggregate demand and a delay in price adjustments. It is convenient to think of this in terms of nominal income and then consider the behavior of the individual variables.

Imagine that there is an increase in the money stock of 5%. Given the log-derivative of the equation of exchange, this looks like
%∆M + %∆V = %∆P + %∆y
Rewrite as:
%∆M + %∆V = %∆(Py)
For now, let’s assume that portfolio demand for money is constant. Now,
%5 + %0 = %∆(Py)
%∆(Py) = %5
Within a static model, we know that in the long-run, the price level will absorb the entirety of the change, and that y remains unchanged. This is known as the classical dichotomy. Often rendered, “Reals affect reals, and nominal affect nominal.” In the real world, however, we see that nominal changes have real effects. A more realistic rendition states, when the economic activity is in something close to an equilibrium condition, changes in nominal aggregates do not lead to long-lasting changes in a given measure of aggregate output. It is possible that at first a change in y comprises some portion of the change in the nominal income. In the long run, y returns to its original level as prices come to fully reflect the increase in the money stock.

A thought experiment is enough to convey the nature of short-run effects. Imagine that, over night, Hume’s money fairy has increased everyone’s money balances by exactly double. If, at the moment this occurred, not before, all agents became aware of this doubling, there would be no effect on the allocation and employment of resources. Now, let’s imagine that our agents only become aware of this slowly. Some agents are able to spend the money before prices rise. Of course some suppliers have become aware of this change, but certainly all of them have not. At least some of those who recognize their increase in cash balances will make purchasers from those suppliers who have not changed the price. These suppliers may even believe that there has been an increase in demand and will sell more than they would have if that had realized that they suffer from “money illusion.” This leads to a temporary increase in output that will last as long as suppliers do not increase their prices. Eventually, competition and a need for solvency forces them to act in accordance with economic reality. Prices rise and output falls back to its long-run level.

As prices rise, there is no reason to expect that all prices move in the same direction at the same time. It is possible that a substantial portion of the increase in money is used to purchase only one or a few types of goods. These markets receiving the new money will increase prices more quickly than those that do not. For example, the doubling of the money stock might increase the price of luxury goods by 3 or 4 times since those who discover the new money early on feel richer. Relative prices shift as money enters the economy through the purchase of specific goods.

As prices rise, not only are relative prices distorted, but so also is the function of profit. Profits appear to be augmented by the price increases, but again, this is only due to "money illusion." Irving Fisher’s observation is of help to us:

“I remember particularly a long talk with one very intelligent German woman who kept a shop in the outskirts of Berlin. She gave all kinds of trivial reasons for the high prices. . . When I talked with her the inflation had gone on until the mark had depreciated by more than ninety-eight per cent, so that it was only a fiftieth of its original value (that is, the price level had risen about fifty fold), and yet she had not been aware of what had really happened. Fearing to be though a profiteer, she said: ‘That shirt I sold you will cost me just as much to replace as I am charging you.” Before I could ask her why, then, she sold it at so low a price, she continued: “But I have made a profit on that shirt because I bought it for less.

 She had made no profit; she had made a [economic] loss. She thought she had made a profit only because she was deceived by the ‘Money Illusion’. . She had kept her accounts in what was in reality a fluctuating unit, the market. In terms of this changing unit her accounts did indeed show a profit; but if she had translated her accounts into dollars, they would have shown a large loss. . . ” (392)

I am an economist by training. I don’t think in terms of price levels in my day to day life. I notice that the prices of goods change from time to time. Some of the change may be due to an increase in the money stock. Some may be from changes in demand due to preferences or to supply shocks. A change in price tells us nothing about why a price has changed. Uneven adjustment of prices changes the nature of monetary exchange. Humans think in terms of observed nominal prices. Losses are easier to stomach when they are written on a balance sheet as a nominal gain, as Fisher’s story shows. Even if all agents came to know of the increase in the money stock beforehand, their preparations cannot prevent the realization of errors in prediction of prices of specific goods that are inevitable for the vast majority of agents. Agents with expectations of an increase in the money stock cannot necessarily prevent a temporary increase in AD. Distortion of the profit and loss mechanism promotes this outcome.

Now that we've worked through this thought experiment, we are ready to consider what happens by considering a graph of aggregate demand, short-run aggregate supply, and long-run aggregate supply. We consider an increase in aggregate demand.

Two effects are working here. The short run effect, which temporarily elevates y, and the long-run effect, which dominates the short-run effect having P absorb the total change in the money stock. It is important that we do not interpret long-run and short-run as representing specific time span. These are categories that describe types of change. The long-run is the state to which the model eventually converges. Long-run changes always swamp short-run changes. It is possible that long-run effects set in very quickly so that short-run changes are hardly observed. Or short-run changes may last for an exceptionally long period of time. There is no measurement of time that can consistently define the long-run and short-run. 

Tuesday, February 24, 2015

Dynamics of Aggregate Demand

Money may be thought of as the life blood of any economy. Possession of money by an agent empowers that agent to coordinate resources and even other agents. It is a mistake to look at money only as one good among money. This perspective may aid analysis of changes in the value of money and its allocation, but they only partly capture money’s influence. Money is the universal numeraire. It is the measuring rod that aids economic calculation. In every exchange that occurs in a monetary economy, money is one side of transaction – the other side being the good or service offered in exchange for money. Given this feature, a dichotomy arises between the demand side and the supply side of the economy. The demand side is represented by the money that is available to be used for the purchase of goods and services. The supply side is comprised of the flow of existing goods over some time period and the stocks already on hand. To avoid shortages or surpluses, sellers of goods must adjust prices to accommodate changes in demand for goods. Markets also experience fluctuations in aggregate demand as 1) the money stock fluctuates and 2) general demand to hold money changes. That is, the tendency of agents to collectively decrease or increase consumption over a period is reflected by fluctuations in total expenditures of all agents.

Those of you who are familiar with macroeconomics or have been engaging the previous posts in thorough dialectic will, I hope, see what this implies for macroeconomic analysis. The equation of exchange helps us to identify the aggregate demand and aggregate supply. Recall that MV = Py. Total expenditures on final goods and services is equal to the nominal value total income. For the exercise, let us assume that the economy is static so as to avoid analytical problems that arise from innovation. For now, we will assume that prices adjust to accommodate changes in the supply of and demand for money. Of course, the store owner would likely never imagine that he is accommodating these changes. She instead adjusts price of the good based on changes in available stocks of the good itself as well as changes in the price inputs. She also accounts for expected changes in demand for the good at the given price. Remember, as Hayek (1945) argues, that suppliers need not know the source of a price change. They only need to correctly interpret an appropriate cue or cues that helps them adjust prices to prevailing conditions. In this early analysis, we shall make the grandiose assumption that prices adjust instantaneously. In the future, we shall consider situations where the given array of prices produce excess supplies of goods. For now, we will consider the nature of changes in the aggregate demand curve both at the instance of the change and the equilibrium outcome results.
Now we have appropriately identified our objects of analysis and the objects that comprise them, we may move forward in employing the aggregate variable M, V, P, and y. Aggregate demand and aggregate supply are both described in P-y space. As mentioned above, the aggregate demand curve is defined by total outlays, MV. The curve intersects the long-run aggregate supply (LRAS) curve at some price level comprising the equilibrium state. The value y* at this point is the value of real income in the long-run. At this level, the economy is said to be at full employment.

Figure 1
The aggregate demand curve falls as a result of an decrease in either the money stock, M, or an increase in demand for money (equivalently a fall in velocity). In Figure 1, the AD curve falls, but the reason is not indicated. For the sake of analysis, let us assume that this change was either entirely the result of a fall in the money stock or an increase in demand, but not a combination of both. Possible changes in the composition of total expenditures, MV, that yield this result are shown below in Figures 2 and 3.
Figure 2

Figure 3
The effect of changes in total expenditures is dependent upon the nature of subsequent price changes. If adjustment of prices is instantaneous, than there will be no change in y. Iif agents perfectly predict changes in prices given a change in the money stock or a change in demand for money, there will be no temporary change in output. This is the long run effect of changes in these variables, given that complications do not arise within the capital structure. (Say a wave of bankruptcies results from an increased rate of insolvency. Contracts are typically set in nominal, not real terms. In that case, nominal changes can, therefore have real effects.)

If prices do not instantly adjust, then we are left with an excess demand for money and an excess supply of goods. The excesses perfectly offset one another. The value of the excess demand for money [Figure 4] is equivalent to the value of the excess supply of goods [Figure 5]. This can only be alleviated by an adjustment in the price level – i.e., adjustment of all prices to cohere with the new allocation of money. The process of the opposite adjustment works in reverse. An increase in AD brought about by a fall in demand for money or an increase in the money stock will create excess demand for goods and an excess supply of money. As with the previous example, this will eventually be offset by changes in prices. (You  may want to refer back to this paragraph in the coming discussion of Say’s Principle.)
 Figure 4
Figure 5

A final warning. The process of adjustment in a real economy is not as smooth as aggregate analysis might suggest. Remember that this is a tool for conceptualizing aggregate changes in a monetary economy. A change in the price level tells us little about changes in relative prices (price ratios). These will be considered in the section on monetary policy under the heading of the non-neutrality of money.

Thursday, February 19, 2015

Intuitive Sums: Making the Equation of Exchange Easy to Interpret

Today I’m going to work some fast math magic. Yesterday I reviewed the equation of exchange. Working with the products can be somewhat confusing. So, briefly, I will show the reader how to transform the equation of exchange into (approximate) sums of percent changes. The process is straight forward.

1. Begin with the equation in its basic form
MV = Py
2. Log both sides
ln(MV) = ln(Py)
3. Convert into sums of logs
ln(M) + ln(V) = ln(P) + ln(y)
4. Take the first derivative of both sides
(dM/M) + (dV/V) = (dP/P) + (dy/y)
5. The result is approximately the sum of percent changes
%∆M + %∆V = %∆P + %∆y
6. Rearrange so that desired variable is on the left hand side of the equation. I’ll leave this last step to you.
Notice that this is useful for setting up a regression. If you have data for the 3 variables, you can estimate the fourth. It should be kept it mind that measures of velocity tend to be measures of this sort. If I were to attempt to measure changes in velocity, the form of the equation would be,
%∆V = %∆P + %∆y - %∆M.
Notice that this is similar to the log version
ln(V) = ln(P) + ln(y) – ln(M).
A regression with the log measures will estimate the log of velocity while the equation using the derivative of the logs will estimate percent changes.

One last trick: P and y can be merged, and rightly so. P is a variable that is estimated. Better sometimes to use the aggregate, Y instead.
MV = Py 
MV = Y 
V = Y/M 
ln(V) = ln(Y) – ln(M) 
(dV/V) = (dY/Y) - (dm/M) 
%∆V = %∆Y - %∆M

Wednesday, February 18, 2015

The Equation of Exchange, Its Versions, and Its Elements

Where does the value of money derive from? There is a common misconception that money must have some intrinsic value. A common question I hear from students is: “The dollar is backed by gold, right?” While the earliest moneys came into existence by virtue of the use value of the commodity traded, this is not the case in the world of modern finance.

As you know if you have been reading this series, money essentially arose by accident. When some agent comes in possession of a commodity that she plans only to exchange, rather than consume, the agent increases her demand for that good. The value gained from this type of increase in demand represents the value of the object as a medium of exchange. Thus, money has two sources of value: value derived from use and from exchange. As a commodity used as a medium of exchange gains value, producers are encouraged to increase production and new producers of the good are drawn by the opportunity of profit. Notice that endogeneity of the money stock (for example see this) – the tendency for the quantity of money to adjust to changes in demand for it – falls out of this example as a property that derives from the price system. More on this later. (This will also be important in coming posts when I review the automatic operation of a prototypical gold standard.) 

Like any good, money, at a given moment and over extended time horizons, is potentially offered for sale by agents at some array of prices. Ex post we observe the prices associated with particular transactions. Likewise, at a given moment, agents collectively demand some quantity of goods at a given array of prices. Ex post, these observed prices are equivalently the prices for supplied quantities (for simplicity let’s assume that the supplier of the good incurs all costs that might otherwise be spread over a network of producers).

Given the above construction, we can consider what might happen given changes in the preferences and agent knowledge concerning the available stock of money, its quantity demanded, and factors of supply. One additional tool for analysis is required: the equation of exchange (often identified as the quantity equation which is a derivative of the equation of exchange). The equation of exchange is an accounting identity that equates the quantity of money demanded with that supplied. The stock of money and its average velocity of circulation (an unfortunate term meaning the number of times the average currency unit is spent in a given time period) is identical to the quantity of goods purchased times their transaction prices. The rendition has thus far built upon microfoundations. In the modern formulation, we reduce the series of prices and goods to aggregate variables. Thus:

MV = Py


M = money stock
V = velocity
P = price level
y = real income

These variables tell us nothing of the composition of the economic system. Rather, it conveys an important truth about the supply of money (MV) and the demand for money (Py). As John Stuart Mill expressed in his Principles of Political Economy,

The supply of money, then, is the quantity of it which people are wanting to lay out; that is, all the money they have in their possession, except what they are hoarding, or at least keeping by them as reserve for future contingencies. The supply of money, in short, is all the money in circulation at the time.

The demand for money, again, consists of all the goods offered for sale. Every seller of goods is a buyer of money, and the goods he brings with him constitute his demand. The demand for money differs from the demand for other things in this, that it is limited only by the means of the purchaser.

As those demanding dollars and those supplying dollars successfully exchange and satisfy their preferences for dollars and goods, each market for money tends toward an equilibrium. This in no way suggests that the economy moves smoothly from equilibrium to equilibrium as agent actions and preferences are not independent of one another. The actions of every agent changes the distribution and prices of scarce goods. All markets, including markets for money, experience endogenous turbulence.

Types of Demand for Money 

It is necessary to more closely examine elements contained within the equation of exchange in terms of the demand for and supply of money. There are two types of demand for money contained within the identity. These are transactions demand and portfolio demand. MV represents the money stock that is available for exchange and that Py represents the demand for money by sellers of goods and services. Demand, however, can be broken down further. On the right hand side there is nominal income which is equivalently transactions demand. All goods sold must be exchanged for money. The money exchanged comprises transactions demand.

Portfolio demand for money is a different type of demand for money that consists of the demand to hold money. This demand is represented indirectly by the velocity, or rapidity, of circulation of money. Remember that the available supply of money is MV. The total money stock multiplied by the average number of times a given currency unit is spent represents the available money stock for a given time period. Money that is spent multiple times in a given period influences prices across that period. Money that is withheld from circulation by agents fails to positively impact the prices of any good, assuming that there is no expectation of expenditure later. The equation of exchange can be rewritten to include this demand for money on the right hand side of the identity.

MV = Py

M = (Py)/V

Let k = 1/V

M = Pyk

This formulation, known as the Cambridge cash-balance version, shows that the total money stock is equal to the product of transactions demand (Py) and demand to hold money on reserve (k).

The Quantity Theory

The quantity theory is a particular rendition of the equation of exchange where velocity – the inverse of portfolio demand – is assumed constant and where real income is thought not to be affected in the long run by changes in the money stock.  It is stated as

This is a long run definition that shows that an increase in the money stock, all else equal, will lead to an increase in prices generally.

Endogenous Money

With the quantity theory, causation is thought to work from the left to the right side of the equation, but this is not always the case. Imagine that there occurs a general increase in demand to hold money. The immediate effect may be for prices to fall, but this does not occur instantaneously. Remember that an increase in demand for money tends to increase its price, also known as purchasing power. Under a commodity money standard, a rise in the price of money will encourage production of that money. This is easily conceptualized with the Cambridge cash-balance interpretation. Recall

               M = Pyk

If k – portfolio demand for money – increases, then M may also increase, owing to an increase in money’s price, in order to offset this effect.

Endogenous Credit

An increase in demand for money does not have to be offset by an increase in the base. Thus far, I have not differentiated between different types of money. Money consists not only of base money, but of higher level moneys known is fiduciary moneys. (Fiduciary meaning the value depends upon faith in the promise to repay). These moneys are linked to base moneys typically by a promise of repayment. Into the first half of the 20th century, this type of currency was best embodied by deposit slips which served as a claim to base money and which were exchanged as money. Then, as now, the money deposited at the bank was lent to agents who demand money in the present and promise repayment in the future. Their demand for money now is constrained by the price of money in the future known as the interest rate. If agents generally increase their demand to hold money, other agents who need money for transactions in the immediate future can borrow and thereby increase the quantity of money presently available. Of course, they must be willing to repay this debt and the interest accrued during the life the loan. As we have not yet covered banking, it will suffice for you to remember that credit adjusts according to changes in demand for money. This will be discussed in greater detail in later posts.

Wednesday, February 11, 2015

The Emergence of the State Monopoly over Money

Just as it is possible to construct a theory of the emergence of money based on principles of agent preference and action, so too is it possible to build a theory of the state monopoly of money with such principles.

Both history and theory converge on the conclusion that money was by no means a creation of the state. Money arose as agents confronted difficulties associated with barter. Instead of bartering directly, agents began to accumulate some goods for the purpose of indirect exchange. Depending on time and place these goods have come to include shells, oats, cows, and the more commonly recognized silver and gold. As agents converged upon common goods for exchange, the commodities began to act as moneys: goods that act as 1) a medium of exchange, 2) a store of value, 3) a unit of account, and 4) a standard of deferred payment. The emergence of money allows for the beginning of specialization that is characteristic of a human economy. A more robust civilization can then be supported. It is at this point in our story where we left off last post.

As society converged to gold and silver for facilitating commerce, this presented an opportunity for the ruling class and those aspiring to comprise it. It is an obvious observation that an increase in money, all else equal, is equivalent to an increase in wealth, and therefore, power. The role of money minting, then, commands an appreciable amount of power. As in any market, this power increases with the establishment and enforcement of monopoly privilege.

There is no a priori reason that we should expect a monopoly on money to occur. In his essay, “An Evolutionary Theory of the State Monopoly over Money", David Glasner argues.

For the production of a good to be a natural monopoly, the technology must exhibit economies of scale that ensure that the average cost of production is always lower if one for produces the entire output of an industry than if two or more firms with access to the identical technology divide the output. But even if the state were the lowest-cost producer of money, it would not necessarily enjoy the economies of scale required for the existence of a natural monopoly.

Printing of the seal of the sovereign on money is in no way evidence that the state was required for monetary stability. The seal of the sovereign may have given “traders more confidence in the weight and fineness of coins.” The sovereign, however, was “seeking not to improve the monetary system but only to exploit profit opportunity implicit in this premium”. A theory of the state monopoly is mistaken if it seeks to justify the monopoly by an argument based on the public good (not to be confused with the category known as public goods). While such an argument is not excluded from comprising part of the explanation, the core of the explanation must also consider the motives of agents close to power and involved in coining.

Glasner offers one clear explanation for the emergence of state monopoly: defense. He is not so naïve as to try to describe the process of this emergence as involving high-minded principles that guided the sovereign to attempt to stabilize and improve the monetary system. Competition for power is fierce. Any leader, elected or unelected, faces competition from numerous agents who would prefer to have the power for themselves and their own allies. One regime is always at risk of being displaced by another. A weapon that an agent or team of agents might potentially use is their influence over the money stock.

Minting a large quantity of debased coins might enable a private mint owner to finance an attempt to overthrow an incumbent sovereign. To be sure, such a debasement would violate the mint owner’s promises about the content of the coins he was issuing. But upon becoming the sovereign, the owner could avoid any legal liability by annulling his legal obligation to those he had defrauded.

A mint-master who sought to overthrow the existing regime could inhibit money’s role as a unit of account by debauching it while increasing one’s wealth in the process.  Given this threat, monopolization of the production of money is not only an opportunity for a sovereign to profit, but also to keep political competitors at bay. A sovereign might well feel justified, then, in establishing not only a monopoly over the mint, but also establishing legal tender monopoly.

This sort of problem appears to be reflected in the writing of Nicolas Copernicus. In his “On the Minting of Money”, he argues,

It would be advantageous therefore for there to be only one common mint for all Prussia, in which every type of money would be stamped on one side with the insignia of the lands of Prussia: they should have a crown at the top, so that the superiority of the kingdom would be recognized. On the obverse, the insignia of the duke of Prussia could be seen under the crown above it.

A charitable interpretation suggests that Copernicus was worried about mint-masters in Prussia threatened the stability of the Prussian empire by minting debauched currency. If this was the case, the defense argument may have been at the forefront of Copernicus’ mind. It is also possible that Copernicus had in mind that Prussian leadership would consider his suggestions. Whether or not a mint-master would successfully destabilize the ruling regime before going out of business is another question entirely. Hume seems to have had something similar in mind, though his worry concerned the extension of credit by private banks, as opposed to dishonest coinage. Not only did he suggest that a single bank should regulate the credit stock – presumably the Bank of England – he even suggested that it is the job of the sovereign to ensure its modest increase.

The good policy of the magistrate consists only in keeping it, if possible, still increasing; because, by that means, he keeps alive a spirit of an industry in the nation and increases the stock of labour, in which consists all real power and riches.

Again, this seems to be a case of an economist acting as a policy wonk. Perhaps Hume should have looked north to the hills of Scotland to notice the relative stability of its freebanking regime. (The end of Hume’s life coincides with the early years of relative stability under the free banking regime in Scotland.) Economic stability promotes political stability. Hume’s emphasis on internal stability and progress fits well with Glasner's theory.

               Defense is important both to the internal politic and in foreign affairs. While the former likely served as the primary impulse for state monopoly, the latter was served by it.  Even in a regime that typically promotes policies supporting sound money, major wars tend inevitably to devalue the currency. When a nation enters into war, the monetary system becomes a tool by which resource can be coordinated toward the war effort. Glasner mentions that this was a recurring theme in the ancient world. We also witness this in modern and early modern wars. Whether one considers the depreciation of the continental during the American Revolution or that of the British pound during the Napoleonic wars or the widespread suspension of the gold standard during World War I, modern governments have a habit of funding wartime expenditures via monetary inflation much like their counterparts in antiquity (Hawtrey 1947, 69, 92-105; Webster).

Whatever the cause of a fall in a currency's value and whether or not that fall in value is justified by circumstance – such as war – the effect of manipulation of the monetary unit alters the composition of the money stock in circulation. When devalued money of a particular nominal value circulate alongside coins of the same denomination but of different, more highly valued composition, there arises a an increase in the costs of barter. Agents engaged in exchange must consider the value of a coin’s metallic content. For example, imagine that we have two coins that weigh 1 oz and have different compositions. Coin A is 4 parts silver and 1 part gold (or in other words, 4/5 of an oz silver and 1/5 oz gold). Coin B is 4 parts gold, 1 part silver. Assuming that gold is worth more than silver, coin B is worth more than coin A. Since it is convenient to trade with coins of the same denomination, agents will continue to trade with coins of this 1 oz denomination, but they will tend to remove the coins with more gold from circulation. These coins serve as a store of value – defense against inflation – while the cheaper money is employed as a medium of exchange. Of course, coin A might also serve as a store of value, but the chance of continued devaluation makes ownership of the coin A more attractive for this purpose. This outcome is typified by Gresham’s law.

Having considered the emergence of a state monopoly over money, the analysis has been primarily concerned with premodern and early modern institutions. This leaves us to consider whether or not a state monopoly over the production of money - at least base money - is justified. Glasner closes by suggesting that, in the least, the state can no longer claim that a needs of national defense justifies for the monopoly as monetary policy has come to be a tool for the promotion of "high employment and economic growth." Thus, we have an explanation of the emergence of a state monopoly over money rather than an explanation of its continuance in the modern era.

Sunday, February 8, 2015

The Emergence and Functions of Money

To the lay observer, the existence of money appears to be a given, and this is if they even notice money’s peculiarity. Money is a good, but unlike other goods, its primary use is as a medium of exchange. In the pre-modern era, money was typically linked to a commodity, but in the modern financial system, this is no longer true – at least not for base money. So how does money become an object of its own, delinked from any use value? How does money arise at all?

Given that humans preexisted money, there must have been a time where money did not exist. This is consistent with the framework that we have built over the last several weeks. Remember that analysis starts with agents. These agents have preferences that are revealed as they engage in exchange. Implicit in this exchange is the existence property rights. Every agent has opportunities to engage in entrepreneurial action. This occurs when an agent senses a profit opportunity. She imagines that she can transform the world from its present state into one that she prefers more greatly. She forms an expectation that she will use to frame and guide her action. The agent may prove successful and attain the profit or may break even or even incur a loss. In typical fashion, we can extend this concept to exchange. Two agents, both looking to improve the state of their existence, notice that each has a good desired by the other. It so happens that each wants the good that the other holds so they exchange the goods. Each has improved his lot, although we cannot be sure by how much exactly as there is no such thing as a cardinal utility measure – not even for a single agent. We must take agent action at face value and accept the action as a contextually constrained expression of the agent’s preference.

Barter is easy to accommodate in the model when the agents lacks geography. Action, however, always occurs at a particular time and place. The agent interested in a trade, lets call him agent A must find another agent, agent B, who owns the object of desire and who is interested in trading it for something owned by agent A. Often, this double coincidence of wants fails to arise. The agent can continue looking for a single trading partner, or he can partition his work. Instead of finding only a single agent, he can find a good that is demanded by agent B and trade that intermediate good for the desired good. Over time, the agent might realize that there are one or several goods that most easily accommodate this indirect exchange. First several other agents notice this wise idea and begin to copy the innovation. A small number of goods come to be recognized as having value in exchange in addition to value in use. These goods are different forms of money.

As we have seen, money does not arise by the plan of a single individual. It arises without intention. The goal of agent A was simply to find a good desired by agent B. There is no need for agent A to expect that other agents will adopt his strategy. His goal was simple. As the innovation is copied, the commodity becomes a network good. It gains value because other agents are willing to use it in indirect exchange, and therefore, charge prices in terms of the intermediate good. The good that becomes money comes to serve as a numeraire in which prices are denominated.

What makes for a good money? History provides an answer. Societies have tended to select money that meets 5 criteria. Money must be:

1.       durable
2.       easily divisible
3.       relatively scarce
4.       highly saleable
5.       portable.

These qualities promote the function of money. With these criteria more or less present, money can serve as:

1.       a medium of exchange
2.       a store of value
3.       a unit of account
4.       a standard of deferred payment.

Notice that the criteria for money relate to its functions. Saleability and portability allows money to function as a medium of exchange in the first place. What good is a money that is difficult to carry? Increased portability makes a money more easily saleable and more broadly acceptable. Durability and scarcity promote money’s function as a store of value. Divisibility is closely linked to money’s role as a unit of account. Prices, denominated in the unit of account, are more easily accommodated if money can be divided into homogeneous units. Given a common unit of account, agents can also lend money to one another. This allows an agent to attain a good that she otherwise could not afford or would be unable to borrow. Thus, money becomes a standard of deferred payment.

The development of money represents an innovation in accounting. A common standard or standards of measure allow for an approximation of the socially determined value of a good. These prices fluctuate according to changes in the quantity demanded at a given price or, if we are not in the long run, a given array of prices (in the subjective sense of the word). Likewise, prices fluctuate as quantities available at given prices fluctuate. They also change if either of these factors are expected to change. Thus, prices reflect not only present conditions but also expected changes in these factors. Since prices reflect information about agent valuations, they increase the accuracy with which agents can account for the value of their goods. This promotes an allocation of goods that reflect needs of all agents the preferences and budget constraints of those agents. With the addition of money, our model contains the building blocks requisite for economic calculation and widespread patterns of exchange. Though we shall continue to improve the model, it does, at this point, contain a core capable of extensive analysis of the market order.

Next post: Money and the State