Tu Ne Cede Malis

Rules provide, as it were, safe bounds for behavior in a relatively unbounded world. Institutions are the social crystallization of rule-following behavior or, in other words, the overall pattern of many individuals following a similar rule.

— Gerald P. O’ Driscoll, Jr. and Mario J. Rizzo, The Economics of Time and Ignorance, pg. 6.

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This post was reblogged from Students For Liberty.

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Interestingly, left-of-center pundits are completely ignoring the near academic consensus among economists about the negative effects of bad tax policy on economic growth and production. 23 studies find a negative correlation, and 3 find no correlation.
Interestingly, the Tax Foundation argued that the recent controversial Congressional Revenue Service study finding no connection between tax rates and growth was was so flawed that the “CRS study [was] unpublishable in any peer-reviewed academic journal.” Source

Interestingly, left-of-center pundits are completely ignoring the near academic consensus among economists about the negative effects of bad tax policy on economic growth and production. 23 studies find a negative correlation, and 3 find no correlation.

Interestingly, the Tax Foundation argued that the recent controversial Congressional Revenue Service study finding no connection between tax rates and growth was was so flawed that the “CRS study [was] unpublishable in any peer-reviewed academic journal.” Source

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The Tools - Practical Success, Metaphysical Failure

[The Tools by Phil Stutz & Barry Michaels - Random House, 2012]

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While it may be atypical on this blog for a dissection of what many would consider a “self-help” book, this piece warrants an exception. Far from ‘merely’ being a motivational guide, this book is much broader in scope - in order to have a grasp of the psychological system Stutz and Michaels builds throughout the book, one must accept the philosophical and ultimately spiritual foundations they build alongside it.
While the authors attempt to form a far reaching pragmatic psychology with its own metaphysical and epistemological implications, their attempt to bridge the gap between pragmatic concerns and a greater metaphysical system ultimately falls short.

The journey begins with Barry Michaels, a troubled psychotherapist who is concerned about the profession’s lack of useful techniques to help their patients in improving their life problems. Instead of focusing on solutions to these problems, traditional psychotherapy - still deeply wedded to the Freudian vision - rather, focuses on their origins. Feeling that this was ineffective at actually improving the lives of his patients, Michaels eventually meets Stutz, who forcefully argues for pragmatic ‘tools’ that he argues generates fantastic improvements in his patients. This meeting eventually led to the two crafting the system expounded upon in the book.

Interestingly, much of the book is spent praising the effectiveness of the tools instead of actually elaborating on the tools themselves. Early on, my suspicion was that the authors were compensating for a deficiency in their psychological theory by doing so. This suspicion ended up being spot on - the tools themselves are interesting and probably even effective, but despite the book’s title, they are not what the book is actually about. Rather, it is the authors’ philosophical claims that are the most intriguing. Their central thesis is that the tools do not work in the sense most people would think they do, with the individual using them and yielding a better psychological state. Instead, the tools connect one to “higher forces” that once accessed, allow one to maximize their potential and solve their issues.

Little is said of the nature of these forces, except in the context of the tools themselves. For example, one tool is called “The Reversal of Desire”, which is used to improve people’s aversion to pain and tendency to maintain a Comfort Zone. The tool is quite simple - imagine a cloud in front of you that exemplifies all of the pain on is feeling, and yell out that you desire it. The tool is reversing the desire of comfort to a desire for pain. Whatever the merits of this tool are (which seem good to an extent), the important point for Stutz and Michaels is that this tool connects to a specific “higher force”, the force of Forward Motion. All things, according to our authors, “are evolving into the future with a sense of purpose” (34). We tap into said “higher force” by consistently using the tool. The other four tools are very similar - each have a specific higher force attached that one works through and gains strength from.

The justification of “higher forces” given by the authors is not an original one. These forces are “higher” because “they exist on the plane where the universe orders and creates, giving them mysterious powers. These powers are invisible, but their effects are all around you” (34). Here, Michaels and Stutz are arguing for a metaphysical spiritualism, which posits non-physical or material forces that guide all that happens in the universe. As the book progresses, they specific a “Source”, which is the generator of all that is good in the world (164).

Epistemically, the knowledge of these forces is gained by the phenomenological experience of its practitioners, which isn’t an uncommon way of justifying the plethora of (often conflicting) religious and spiritual beliefs by billions around the globe. While the authors maintain the pretense of openness by encouraging skepticism, the solution to such skepticism by essentially using the tools until one believes the forces are real. Michaels, who was a skeptic of the forces for years, admits to this - “I fought back in the only way I knew how - with pure, dogged persistence. I practiced the tool over and over again…I did this for months” (224). The experiences are eerily similar to religious conversions or attempts to convince oneself of religious belief. While the authors spend time doing multiple drive-by’s on the epistemology of science, they fail to improve upon the traditional religious epistemology and never answer common critiques of knowing by pure “feeling” alone. While it may be true that the tools sketched out by the authors work on a pragmatic level, attributing such success to metaphysical forces that have no backing for their existence outside of appeals to the spiritual or faith is quite a large leap indeed.

The book also crafts an implicit theodicy by answering why human beings face adversity in the world. Adversity exists in order to build the internal strength and virtue of the individual despite those obstacles, in a nut shell. While this explanation may work on a general level, it fails from the level of perspective. For example, while on could argue that the recent Sandy Hook shootings serve to improve the inner strength of the families, community, or nation, one cannot say the same about the victims themselves. Stutz and Michaels use the experience of Holocaust survivors as an example, but this deliberately obfuscates the problem - the survivors survived. What about those that didn’t? How were they internally improved?

While the metaphysical and epistemological foundations of the book are faulty, the authors should be commended for the scope and relative rigor of their work. Their approach to psychology as a spiritual problem-solving apparatus is not entirely novel - the authors themselves point to Carl Jung as their most notable inspiration. The Jungian notions of collective unconscious and archetypes are intimately wrapped up in their work; the tools themselves are inspired by similar techniques pioneered by Jung.

Continuing the call of moving clinical psychology in a more pragmatic direction is the legacy Michaels and Stutz leave us in the book, which is a noble goal and one that is successfully furthered despite the problems with the philosophy and spiritualism the two also endorse. While clinical psychology could do without the Post-Modern Spiritualism posed by the authors, an emphasis on practical solutions for problems in patient’s lives is one the discipline cannot survive without.

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Prudence, Moral Sentiment, and Economic Growth

            One of the most vital contributions Adam Smith brought to economic thought was his analysis of the aspects of civil society that were necessary for the proper functioning of a market economy. Originally a moral philosopher, Smith’s analysis of moral virtue in The Theory of Moral Sentiments generated the backdrop for his work on the inner workings of the market system. Apart from his postulation that the market exhibits equilibrating tendencies, his work on inherent moral sentiment is perhaps his most long-lasting contributions in economic science, despite its apparent disappearance in contemporary neoclassical economics. Perhaps one of his most important moral virtues in context of economic growth is that of prudence. In his analysis of what drives economic growth, Smith clearly grounds his investigation in frugality. In doing so, we see a clear example of his work on moral philosophy informing his work as a political economist.

            Adam Smith was greatly influenced by the Physiocratic economists that preceded him, especially Quesnay. In particular, Smith was interested in the Physiocratic notion of the net product, or produit net. In the Physiocratic system, the net product is the surplus generated by the production and sale of agricultural commodities; it was, in essence, a rent (Blaug 28). This was of particular importance for policy, as the Physiocrats recommended a “single tax” on the net product, as part of it was pure rent going to the land owners, generating no impact on the rest of the system. It would not harm agricultural production, which was of particular importance to the Physiocrats as it was the productive sector. Commerce and trade were considered ‘sterile’ – no net product is generated from these sectors (28). Smith would take this insight and expand the productive sectors to include manufacturing and trade (Eltis xxxiii). While the Physiocrats posited the agricultural sector and a growing net product as the source of economic growth, or the “progressive state”, Smith (as well as nearly all of the Classical economists) argued that capital accumulation was the driving force behind economic progress.

            Smith argues in the Wealth of Nations that the agricultural sector has constant returns, while manufacturing exhibits increasing returns (Eltis xxxii). As each worker increases their productivity and their capital requirements grow (leading to an increase in wages and rent), the constant returns in agriculture drive down profits, with a mature economy making capital per worker even higher (xxxii). This inevitably leads to a slowdown in the rate of growth, eventually leading to the ‘stationary state’ (xxxiv). Wages will then be driven back down to their natural, sustenance levels (xxxiv).  This process begins anew when capital accumulation begins to increase once more.  Smith equates savings with investment in his model; he by implication denies that a speculative or precautionary demand for money could lead to a wedge between savings and investment (Blaug 55). What is particularly interesting about this position is that Smith never poses a mechanism for savings and investment to be coordinated – they are set equal exogenously. Later economists would develop a loanable funds market that hypothetically coordinates the two via the interest rate – instead, we must analyze Smith’s moral work to see where the propensity to save is generated (55).

            Smith primarily relies on a Protestant work ethic in order to explain why and how inclined people are to save (55). In book I, chapter 4 of The Wealth of Nations, Smith argues that “the principle which prompts us to save, is the desire of bettering our condition….[which overcomes] the principle which prompts to expense, the passion for present enjoyment” (Smith WN I.IV). This person would in all likelihood be a manufacturer, as they have the ability to reinvest earnings into fixed capital (Blaug 55).

            Smith’s views the propensity to save as ultimately rooted in the virtue of prudence. Smith defines prudence as “the care of the health, of the fortune, of the rank and reputation of the individual, the objects upon which his comfort and happiness in this life are supposed principally to depend” (Smith TMS VI.i.4). Smith goes on to describe people’s natural inclination toward loss aversion: we naturally wish preserve what we already have over attaining greater advantages at a risk (TMS VI.i.4). By engaging in saving, the prudent individual is caring for one’s resources while concurrently aiding in generating the Smithian progressive state. Smith, in his discussion on the accumulation of capital in The Wealth of Nations, argues that everyone has a natural inclination toward frugality; he goes as far to say that it predominates our actions greatly (WN II.iii.28). Frugality is a natural corollary to the moral virtue of prudence; if one is prudent, one would exhibit the principle of frugality in order to tend to one’s fortune and health in the most efficient manner possible.  This point can be compared to the more contemporary notion of time preference – individuals who are not short-sighted will tend to be more frugal, as their long-term outlook is the most prudent way to determine their best course of action. Naturally, these individuals would have a low time preference: they would abstain from consumption in the present to save for the future, increasing investment and capital accumulation. The alignment of the virtue of prudence and frugality with the progressive state of society is in stark contrast to the Malthusian (and later Keynesian) Paradox of Thrift: individual prudence leads to a net economic benefit to society, not a net harm.

            The underpinning of economic growth in individual prudence and frugality is just one example of Smith’s moral philosophy making a large impact on his economic analysis. Smith heavily emphasizes an individual’s feeling of sympathy and reflection in crafting his theory of moral sentiments. An individual feels sympathy via the usage of their imagination; they are able to place themselves in the shoes of the individual they are sympathizing with using this capacity (TMS I.II.21). People also develop a tendency to view their actions from the view of the ‘ideal spectator’ or an objective account of the dilemma they face (TMS III.1.71). In the words of Smith, “The view of the impartial spectator becomes so perfectly habitual to him, that, without any effort, without any exertion, he never thinks of surveying his misfortune in any other view” (TMS III.1.71). These virtues become especially important in Smith’s generation of the market system – the institutions of bartering and exchange (which Smith argues we have a natural propensity to engage in) are predicated on a mature civil society in which people see the benefits of engaging with other people in a peaceful manner. The Hobbesian state of nature would be absent of the virtues that compel individuals to feel sympathy for others. Smith’s moral philosophy is not a disconnected theory without any implication on the actions of economic man; on the contrary, his moral philosophy is vital and necessarily precedes any attempt to fully understand the actions of any individual in human society.

          Smith’s work on moral philosophy is required reading for any economist attempting to fully understand the foundations of Classical political economy, particularly from a Smithian perspective. By looking at Smith’s rooting of economic growth in the moral virtue of prudence and frugality, we see an excellent example of how Smith relies on the moral underpinnings of civil society and of the individual in generating an economic system that benefits all people - one that can be analyzed as a set of predictable, equilibrating tendencies. In other words, the invisible hand is itself attached to a civil society grounded in the moral sentiments of sympathy, prudence, and human reason.

References

Blaug, Mark. Economic Theory in Retrospect. 4th ed. Cambridge: Cambridge University Press, 1985. Print.

Eltis, Walter. The Classical Theory of Economic Growth. New York: St. Martin’s Press, 1984. Print.

Smith, Adam, Edwin Cannan, and Max Lerner. An Inquiry into the Nature and Causes of The Wealth of Nations. Canaan ed. New York: The Modern library, 1937. Print.

Smith, Adam. The Theory of Moral Sentiments. Oxford [Oxfordshire: Clarendon Press ;, 1976. Print.

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Market Monetarism and The Liquidity Effect

One of the hallmarks of the Market Monetarist school of thought when compared to traditional monetarism is the affirmation that market participants have rational expectations regarding monetary policy and future growth of nominal GDP (Christensen 5). Markets are efficient, and contain information regarding these expectations that are useful in determining whether monetary policy is too tight, too loose, or on target (6).

The traditional means of determining the status of monetary policy is inflation targeting via the indirect manipulation of the Fed Funds rate in Open Market Operations. Prior to the original Monetarist counter-revolution, the consensus was that monetary policy was considered ineffective, as any increase (decrease) in the supply of money would decrease (increase) short-term interest rates via the liquidity effect, spurring an endogenous fall (rise) in money velocity. In other words, the equation of exchange (MV=PY) was used in a Keynesian fashion, with changes in M being offset by a corresponding opposite change in V (Thornton 66). On top of this, an interest-rate inelasticity of investment meant that the liquidity effect yields small increases in growth: “money can’t push on a string” (67).

Friedman, among others, attacked the velocity instability hypothesis, and returned the Quantity Theory to mainstream recognition during the Monetarist counter-revolution. Monetarists favored using a money growth rule to stabilize the price level or inflation (Christensen 24). The 1970s saw a push toward inflation targeting as the effect of the Lucas Critique rippled through macroeconomics - a permanent Phillip’s Curve tradeoff was illusory,  and a credible inflation target had to be set to disinflate due to the implications of rational expectations (71). The resulting instability of money velocity also had some question the validity of monetarist conclusions.

Market Monetarists, on the other hand, are critical of the usage of monetary aggregates in determining monetary policy, and agree on the instability of money velocity. Markets expectations make money supply changes affect current demand with a “long and variable leads” instead of lags. As Market Monetarist Scott Sumner eloquently argues,

Monetary aggregates are neither good indicators of the stance of monetary policy, nor good policy targets. Rather than assume current changes in (the money supply) affect future (aggregate demand) with long and variable lags, I assume current changes in the expected future path of (the money supply) affect current (aggregate demand), with almost no lag at all” (Sumner).

Interest rates are also bad indicators of a monetary policy stance, something Market Monetarists and traditional Monetarists are in agreement on. Friedman, among others, references rising interest rates in the 1970s and falling interest rates in the 1980s as evidence that the liquidity effect is more than offset by corresponding price level and income effects. In the Market Monetarist framework, this is a direct implication of its emphasis on market expectations: a rise in the supply of money (with a given velocity) will make actors expect an increase in NGDP, yielding rising nominal interest rates, a rise in the yield curve, and rising commodity prices (Christensen 6). However, work by current Fed Chairman Ben Bernanke asserts that the liquidity effect merely diminished, but did not disappear, in the 1980s by using a Value at Risk (VAR) model (Bernanke 36).

The 2007-2009 Financial Crisis supports the Market Monetarist view, as the Treasury yield curve inverted (signalling market expectations of a fall in NGDP), falling commodity prices, and a collapse in the stock market. While it remains a source of controversy that the liquidity effect may be more than offset by income and price level effects, it still stands that interest rates remain at best a shaky indicator of monetary policy.

Market Monetarism provides an alternative targeting approach in focusing on nominal Gross Domestic Product. This would essentially be a focus on PY in the equation of exchange by growing M in ways other than mere targeting of the Fed Funds rate. While this may be a superior method relative to naive Keynesian presumptions about the liquidity effect, it begs the question as to where interest rates play a role. This is precisely where Wicksell’s distinction between natural and market rates of interest should be integrated into the analysis - indeed, some Market Monetarists such as Woosley and Beckworth are open to this idea (Christensen 9).

Further improvements in the Market Monetarist apparatus include a full integration of Wicksell’s interest rate distinction, and a fruitful dialogue between Market Monetarism and the Free Banking school (whose roots are in Wicksell’s distinction and Monetary Disequilibrium Theory more generally).  The fundamental tenants of Market Monetarism, that monetary disturbances matter and that market expectations are the most effective way of generating effective monetary policy, are robust propositions that will, if defended thoroughly and integrated effectively,  quite possibly pave the way to Christensen’s “Second Monetarist Counter-Revolution”.

References

Bernanke, Benjamin S and Mihov, Llian, June 1998, “The Liquidity Effect and Long-Run Neutrality”, NBER Working Paper No. 6608, pp. 1-36.


Christensen, Lars, September 2011, “Market Monetarism – the Second Monetarist Counter-Revolution”. Market Monetarism 13092011

Sumner, Scott, February 2011, “Monetarism is Dead, Long Live (Quasi) Monetarism”, http://www.themoneyillusion.com


Thornton, Daniel L. “How Did We Get to Inflation Targeting and Where Do We Need to Go to Now? A Perspective from the U.S Experience”.  Federal Reserve Bank of St. Louis Review, January/February 2012, 94(1), pp. 65-81.

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Misunderstanding Say’s Law of Markets

by Garrett Watson, St. Lawrence University

This piece is also generously cross-posted on Lars Christensen’s blog The Market Monetarist.

           Few ideas in the history of economic thought have achieved a level of perplexity and criticism than Say’s Law. Perhaps one of the most misunderstood and elusive concepts of the Classical economics, Say’s Law of Markets, first postulated by John Baptiste Say in 1803, underwent considerable support and eventual decline after its assault by John Maynard Keynes in The General Theory. Many of the fundamental disagreements we observe in historical debates surrounding macroeconomics can be traced to different conceptions of how Say’s Law operates in the market economy and the scope used in the analysis. By grasping a thicker idea of Say’s Law, one is able to pinpoint where disagreements in both macroeconomic theory lie and judge whether they necessarily must be dichotomized.  

            Say’s Law is best known in the form Keynes postulated it in The General Theory: “supply creates its own demand” (Horwitz 83). Despite the apparent eloquence and simplicity contained in this definition, it obscures the genuine meaning of the concept. For example, one may interpret this maxim as meaning that whenever one supplies a good or service, it must be demanded - this is clearly untrue (83). Instead, Say’s Law can be interpreted as saying that the ability to produce generates their ability to purchase other products (84). One can only fully grasp Say’s Law when analyzing the nature of the division of labor in a market economy. Individuals specialize in producing a limited range of goods or services, and in return receive income that they use to buy goods and services from others. The income one receives from production is their source of demand. In other words, “all purchasers must first be producers, as only production can generate the power to purchase” (84).  This idea is intimately linked to the Smithian idea that the division of labor is limited by the extent of the market (89).

            The result of this fascinating principle in the market economy is that (aggregate) supply will equal (aggregate) demand ex ante as demand is equally sourced by previous production (Sowell 40).  Another important point made by Say’s Law is that there exists a trade-off between investment and consumption (40). In contrast to the later Keynesian idea of falling investment leading to a fall in consumption and therefore aggregate demand, an increase in investment means falling consumption, and vice versa. This idea can be analogized to Robinson Crusoe abstaining from consumption to build a fishing net, increasing his investment and his long-term consumption of fish (42). Therefore, a higher savings rate pushes up investment and capital accumulation, increasing growth and output (as Smith eloquently argues) (40). In another stark contrast to Keynesian analysis, there is only a transactions demand for money, not a speculative nor a precautionary demand (40). The implications of this are that money cannot affect real variables; it is a veil that facilitates transactions only - money is neutral (Blaug 148). Finally, Say’s Law also shows that there cannot exist a “general glut”; an economy cannot generally overproduce (Sowell 41). While relative over and under-production can occur, there is no limit to economic growth (41).

            While it was uncontroversial among the Classical economists that there wasn’t a limit on economic growth, several economists took issue with the fundamental insights of Say’s Law (44). One of the most well-known criticisms was that of Thomas Malthus. Malthus was an early proponent of the “Paradox of Thrift” – an excessive amount of savings could generate an economy with less than full employment (43). One could describe the view of Malthus as fundamentally “under-consumptionist” (Anderson 7).  Unlike his contemporaries, Malthus did not view money as inherently neutral (Sowell 41). Other classical economists, such as Smith, argue that money “will not be allowed to lie idle”, effectively dismissing a precautionary motive for holding money and therefore monetary disturbances (38). This is where we see the inherent difference in perspective in the analyses of Smith and Malthus. Smith is focused on long-run conditions of money (its neutrality and importance of real fundamentals) versus the short-run disturbances money can generate in output (39).

          Money is half of every exchange; a change in money can therefore spill over into the other half of every exchange, real goods and services (Horwitz 92). In effect, “The Say’s Law transformation of production into demand is mediated by money” (92). This means that Say’s Law may not hold in conditions in which monetary disturbances occur. John Stuart Mill recognized this possibility and affirmed Walras’ Law: an excess of money demand translates to an excess supply of goods (Sowell 49). An excess money demand manifests itself by individuals attempting to increase their money balances by abstaining from consumption. This therefore generates an excess supply of goods, which some would argue can be self-correcting, given downward adjustment of prices (Blaug 149). Malthus (and later on, Keynes) argues that downward price and wage rigidities (which can be the result of game theoretic problems in firm competition, efficiency-wages, or fixed wage contracts) can short circuit this process, yielding a systematic disequilibrium below full employment (Sowell 65). In terms of the equation of exchange, instead of a fall in V (and therefore a rise in money demand) being matched by a fall in P, the fall in V generates a fall in Y. This point was taken into further consideration by later monetary equilibrium theorists, including Friedman, Yeager, and Hutt.The same analysis can be used to understand the effects of drastic changes in the money supply on short term output, as Milton Friedman and Anna Schwartz would demonstrate in the contraction of the money supply during the formative years of the Great Depression

         When analyzing the large disagreements over Say’s Law, it becomes clear that they stem from a difference in scope: supporters of Say’s Law analyzed the macro economy in terms of long-run stability, while Malthus and others after him focused on short-run disequilibrium generated by monetary disturbances (Sowell 72). Smith and other classical economists, pushing back against mercantilist thought, emphasized that money was merely a ‘veil’ that does not affect economic fundamentals, and that quantities of money ultimately didn’t matter (72). The Malthusian grain of truth regarding disequilibrium caused by monetary disturbances in the short-run does not refute Say’s Law; it reveals the necessity of getting monetary fundamentals correct in order for Say’s Law to cohesively operate. It becomes increasingly clear that once we look at the disagreements through the lens of scope, the two conceptions of the role of money in a market economy need not necessarily be incompatible.

References

Anderson, William. “Say’s Law: Were (Are) the Critics Right?” Mises Institute 1 (2001): 1-27. Mises Institute. Web. 19 Oct. 2012.

Blaug, Mark. “Say’s Law and Classical Monetary Theory.” Economic Theory in Retrospect. 4th ed. Cambridge: Cambridge University Press, 1985. 143-160. Print.

Horwitz, Steven. “Say’s Law of Markets: An Austrian Appreciation,” In Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, Steven Kates, ed. Northampton, MA: Edward Elgar, 2003. 82-98. Print.

Sowell, Thomas. On Classical Economics. New Haven [Conn.]: Yale University Press, 2006. Print.

 

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anarchei:

Minimum Wage

anarchei:

Minimum Wage

(Source: timlebsack)

This post was reblogged from Anarchei.

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The Strange Economics of Money

utilitymaximiser:

If apples and oranges are being exchanged, apples and oranges are moving in opposite directions. People who have apples are demanding oranges and vice versa.

If the price of an orange is 5 apples, the price of an apple is 1/5 of an orange. The price in one direction is the reciprocal of the price in the other direction.

The same is true of money. In the macroeconomy, money is exchanged for goods and services and goods and services are exchanged for money. The price of one unit of goods and services is the price level. The price of money is therefore one over the price level or the reciprocal of the price level - because this is what 1 unit of money will exchange for.

The price of money is not the interest rate. The interest rate is the cost of holding money per unit of time (more precisely, the cost of holding money measured in money, the number of dollars per unit of time you give up for each dollar you hold). These seem like the same things but they aren’t. If I hold £1 for one year, and the interest rate is 10%, I have given up 10p. I could have loaned the money out and earned interest, but instead I held onto it. The opportunity cost of holding money is the interest rate.

The price of money is determined, like everything else, by supply and demand. The quantity supplied is the amount of currency in circulation; the government can increase the supply of money by printing more of it or decrease the supply by collecting more money than it spends and burning the excess.

But don’t be misled, money isn’t demanded in the same way goods and services are. If I demand a carrot, it’s because of the utility I directly gain from its consumption. Money is different. People don’t value money for its utility per se, but to exchange it for goods and services - for its purchasing power. People’s demand for money is in real, not nominal terms.

When someone sells something, they exchange goods and services for money; and when someone buys something they exchange money for goods and services. Supply of goods and services in a particular market can be seen as the demand for money in that particular market; and the demand for goods can be seen as the supply of money into that particular market.

Why do we hold money at all? If I arranged my life so that income and expenditure exactly matched, I would have no need to hold money; as soon as a dollar came in for something I had sold, it would go out again for something I bought.

This is not the way I (or you) actually live. It is more convenient to arrange income and expenditure separately in the short run, sometimes taking in more than we spend and sometimes spending more than we take in. When we take in more than we spend, our cash balances go up; when we spend more than we take in, they go back down again. So my cash balance functions as a sort of shock absorber.

Demand is not a number but a relationship: quantity demanded as a function of price. The quantity of money demanded (in nominal terms)—the number of dollars you choose to hold—actually depends on two different prices:

  1. First, it depends on the price of money; the higher the price of money—the more it can buy—the less you choose to hold, since the more a dollar can buy, the fewer dollars you require to buy things with. This is determined by the price level.
  2. Second, the amount of money you hold depends on the cost of holding money, or the nominal interest rate.

Imagine an economy with the supply and demand of money in equilibrium. Given that the price of money is the reciprocal of the price level, we will put 1 over P on the y-axis.

Here demand and supply for money is represented in nominal terms. As I’ve already pointed out, people demand money for it’s purchasing power and nothing else — so money demand is in real terms and therefore not a function of the price level.

If Real money demand is nominal money demand divided by the price level, we can plot the demand curve for money as a rectangular hyperbola.  Along this curve, real money demand is constant. Or to those reading who might have taken an economics class — this means that the demand for money is always unitary elastic. This is something that cannot be said for any other good.

The money supply isn’t a function of the price level — and changes in the money supply are discretionary in our current economy because they are controlled by the central bank. We can then represent the money supply as a vertical (perfectly inelastic) supply curve.

We can then represent the equilibrium price level in terms of a supply and demand graph (see further down for a representation of this).

Before we can analyse the effects of a monetary shock, we need to ask — what is the money supply? There are 6 different ways to measure the money supply, depending on what you count as money, but that’s not what’s important here. Every unit of money is in somebody or some legal entity’s cash balance. There is no money half-way between cash balances.

A person’s income is the rate at which money from other cash balances enters theirs, and a person’s expenditure is the rate at which money exits from their cash balances to other cash balances. In a closed economy, therefore, the sum of all expenditures is necessarily identical to the sum of all incomes.

Furthermore, while money flows in one direction, goods, services and bonds flow in the other direction. So when we want to sell goods, services or bonds, we are in fact demanding money. So the supply of tomatoes can be thought of as the demand for money of tomato producers. And inverse can be said of demand — that demand is the supply of money to tomato producers.

It might then be tempting to say that the sum of all the demand for goods, services and bonds is equal to the aggregate money supply. This is wrong.

A single dollar can supply money into many different markets in a given time period. Over the course of a given time period, a person can spend $1 on good X, and then the producer of good X then spends that dollar on good Y. So a single dollar can supply money to different market multiple times in a given time period. And the number of times it can do this in a given time period is the velocity of money.

And the same is true that the aggregate money demand is not equivalent to aggregate supply of goods and services because of the velocity of money.

Suppose that suddenly the government decides to double the money supply; the new dollars are printed up and distributed to the populace as a “free gift.” What happens?

Everyone has twice as much money as before. Since, before the change, people were already holding as much currency as they wanted to, they now find themselves with more currency than they want to hold.

The obvious solution is to spend more than they take in, thus reducing their cash balances and converting the surplus into useful goods.

Oddly enough, this obvious solution cannot work. While each of us individually can reduce his cash balance by spending more than he takes in—buying more than he sells—all of us together cannot. If I buy something, I am buying it from someone else—who is selling it. If I get rid of my surplus currency by giving it to you in exchange for goods, my cash balance falls but yours rises.

Imagine a four-person closed economy and you can see this principle in action in the diagram below. I know that people don’t normally spend all of their income on one person, but the principle still holds true (and that would make the diagram very messy).

What is even odder is that although we cannot reduce our nominal cash balances—the number of dollars we hold—the attempt to do so does reduce our real cash balances. Since we are all trying to buy more than we sell, on net the quantity of goods demanded is greater than the quantity supplied. If quantity demanded is greater than quantity supplied, price rises. The rise in prices of goods (measured in money) corresponds to a fall in the value of money (measured in goods). We have just as many dollars as before, but they are worth less. The process continues until real cash balances are down to their desired level. Everyone has twice as many dollars as before and every dollar buys half as much as before; prices have doubled and nothing else has changed.

Another way of understanding the same process is to think of all markets as money markets. If you are selling goods for money, you are also buying money with goods; if you are buying goods with money, you are also selling money for goods. If actual cash balances are larger than desired cash balances, that means that the supply of money is larger than the demand, so the price of money falls. It continues falling until actual and desired cash balances are equal. In nominal terms, the fall in the price of money raises desired cash balances until they equal actual cash balances. In real terms, the fall in the price of money lowers actual cash balances until they equal desired cash balances.

I have just described how equilibrium is established on the market for money—how quantity supplied and quantity demanded are made equal. In doing so, I have also shown how the general level of (money) prices is determined.

The equilibrium price level is that level at which the real value of the existing supply of money is equal to the total desired real cash balances of the population. If prices are higher than that, then individuals are holding less cash (in terms of what it will buy) than they wish. They attempt to increase their cash balances by buying less than they sell; in the process, they drive prices down toward their equilibrium level. If prices are below their equilibrium, the same process works in reverse to drive them back up.

This description of how the general price level is determined and how it changes is a somewhat simplified one, mostly because I have not discussed what happens while the system is adjusting and have ignored interactions between prices and interest rates; but it is essentially correct, and it will be sufficient for the purposes of this post.

Although I have done here, the period of disequilibrium should by no means be ignored. You’ll notice that when there is an excess supply of money, there is a corresponding excess demand for goods and services (and bonds), as people try to get rid of their excess cash. Milton Friedman codified this in terms of the equation:

In English:

(Money demand - Money Supply) + (Bond Demand - Bond supply) + (Aggregate demand - Aggregate supply) = 0

Or: Excess Money demand + Excess Bond Demand + Excess Aggregate demand = 0

Friedman did not come up with this equation all by himself — this equation has come before through Walras’ Law and Keynesian liquidity preference theory. What he did was add the third term, the excess demand for goods and services (Yd-Ys).

From how I described how the economy moves from one monetary equilibrium to another, and from the equation above, we begin to build up a picture of how monetary disequilibrium can cause a disequilibrium between aggregate demand and aggregate supply, and therefore explain general gluts. Monetary disequilibrium theory is something I plan to cover in future posts.

Sources and articles I’ve plagiarised

Inflation and Unemployment (Price Theory: An Intermediate Text)

http://www.daviddfriedman.com/Academic/Price_Theory/PThy_1st_Edn_Ch22/PThy_1st_Edn_Chap_22.html

Walras’ Law vs Monetary Disequilbrium Theory

http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/04/walras-law-vs-monetary-disequilibrium-theory.html

The Monetarist Transmission Mechanism

http://homepage.newschool.edu/~het/essays/monetarism/monetransmission.htm

All money is helicopter money. Against the Law of Reflux.

http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/09/all-money-is-helicopter-money.html

This post was reblogged from Ordnungsökonomik.

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