The textbooks say that money serves as: store of value; medium of account; and medium of exchange. Arnold Kling seems to miss the importance of the fact that money is a medium of exchange. Worse, he misunderstands me, thinking that I am one of those economists who makes a big deal of money's role as a store of value. I don't. I'm a medium of exchange nut. Worse still, he claims Clower and Leijonhufvud as intellectual ancestors, on his side of the debate aginst me! Clower especially emphasised the role of money as medium of exchange, and Leihonhufvud followed suit. They are my ancestors, not Arnold's!
The good that serves as medium of exchange in a monetary exchange economy is like the city that serves as the hub of a hub and spoke model of airlines. If Peoria is a spoke, and Peoria is closed, nobody can fly to or from Peoria. If Atlanta is the hub, and Atlanta is closed, nobody can fly anywhere. Money is like Atlanta; every other good is like Peoria.
Let's tighten the analogy a little. Suppose all flights are round trip return flights, from A to B and back to A again. And airlines insist that there must be an equal number of passengers on the two legs of a round trip. If 100 people want to fly from A to B, but only 60 people want to fly from B to A, then the airline uses a 60-seater airplane for the round trip and only allows 60 people to fly from A to B. No empty seats allowed. This is how exchange works. You can't trade A for B unless you find a partner willing to trade B for A. In this case there's an excess demand of 40 seats from A to B.
If there are n-1 spokes, with the nth city being the hub, each of the n-1 spokes has a unique excess demand (or supply). But the nth city has n-1 excess demands.
Suppose we start in equilibrium, with balanced flights. Then 10 new people decide they want to take a one-way trip to Atlanta, to live there. (Or 10 fewer people who had previously been planning to leave Atlanta decide to stay there after all.) That initial excess demand for seats to Atlanta screws up the whole system, affecting people who had merely wanted to fly between Peoria and Washington. If I can't fly from Peoria to Washington, because I can't find a seat on Peoria to Atlanta, then you can't fly from Washington to Peoria. Under a point to point model (barter exchange) our Peoria/Washington flight would balance, even if Atlanta was unbalanced.
That's the vision of monetary exchange I got from reading Clower. So I was surprised to see Arnold Kling cite Clower and Leijonhufvud, when arguing for his vision against mine.
Arnold puts forward a "re-calculation" theory of recessions. When there is a shock to relative demands or supplies of goods, it takes time for the economy to re-calculate the new efficient allocation of resources.
The way a market economy re-calculates is by changing prices in response to excess demands, and by people responding to those changed prices. In a monetary exchange economy, the prices will be money prices, and the excess demands will be those of a monetary exchange economy, where money has n-1 excess demands and all the other goods have just 1 excess demand. You can't try to understand how a monetary exchange economy re-calculates by ignoring the central role of money as medium of exchange. It would be like trying to understand why air traffic gets gridlocked in bad weather while assuming a point-to-point model. "Peoria and Washington are both open, so why can't people fly from Peoria to Washington?". Because Atlanta is closed, that's why.
Sure, the structural unemployment that follows a relative demand or supply shock may be part of the problem in many recessions. And if you see excess supply in some markets, and excess demand in others, that's probably the main part of the problem. But that doesn't seem much like what's happening now.
If you see passengers waiting in Peoria, Washington, Las Vegas, etc., etc., then check what's happening in Atlanta.
"Rowe, like many economists, has a very hard time imagining anything other than a frictionless economy with instant movement to general equilibrium. In that (mythical) economy, a shift in demand between industries cannot possible lead to unemployment. In order to explain unemployment, these economists posit a shift in demand toward a non-produced good, and they leap on money as an example.
I am explicitly attacking this tradition, which I associate with Keynes, of making a big deal of money as a store of value. In this view, as long as the supply and demand for money are in balance, there can be no unemployment. In my view, the supply and demand for money could be in balance, but if the supply and demand for different forms of capital (houses vs. small businesses) is out of whack, there can be unemployment."
Nope. Not me. Not guilty.
First, if prices adjusted to clear markets instantly, without frictions, my view of excess demands for money would be nonsense. And it is only the frictions of transactions costs that explain why people use a hub and spoke system like monetary exchange anyway.
Second, a shift in demand (or supply) between industries can and will cause structural unemployment (the LRAS curve shifts left temporarily). No doubt that's part of the current recession. But I don't think it's the major part.
Third, and most importantly, I don't make a big deal of money being a store of value. Land (and lots of other goods) is a store of value, and a non-produced one at that. But an excess demand for land cannot cause an excess supply of everything else (yes, I am contradicting Walras' Law). An excess demand for the medium of exchange, however, will cause an excess supply of everything else.
Arnold also writes:
"Inflation rates are very sticky. A major change in the trend inflation rate requires a regime change, which changes people's expectations. That process of changing expectations takes years."
Yep. Absolutely. (Indeed, the major thing wrong with the Calvo model of price adjustment used by New Keynesians is that it has price level inertia but not inflation inertia.) And this stickiness of the price level and rate of inflation is why changes in the level and growth rate of the demand or supply of money can have large real effects. I don't just agree with Arnold here; I have to agree with Arnold here. My theory of monetary disequilibrium wouldn't make sense otherwise.