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
where
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.
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.
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