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Its the recalculation that leads to the excess demand for money. As I understand Arnold, you can avoid the excess demand for money by printing more money, but if the underlying cause is a coordination failure, having extra money doesn't relieve "the" problem. It just limits the effects of not having enough.

So which is "the" problem? "recession" stands in for a "recession in the growth of real output", not a general glut of goods. You've done a bait-and-switch in this post!

So I don't think excess demand for money is the theory of everything. Its a theory of a uniform decline in the price-level which is basically a tautological statement.

So again: why is real output slumping? That's where recalculation deserves some credit, but yes its also true that an excess demand for money can cause real output to slump.

Nick, your argument appears to be that a general glut is *equivalent to* an excess demand for money. That seems entirely logical, but it says nothing about causation. Does causation appear anywhere in your line of reasoning?

I'm very confused about what a general glut would look like. Could someone describe a situation in which a general glut would exist (involving a small number of goods)? That would be great.

[edited to remove italics around "equivalent to" NR]


Sorry, I failed at html.

Hi, Nick. It is hard to think of a counter-example in human history where there is a glut in a non-monetary economy. But I wonder how you would characterise the honey-bee economy, which produces so much honey that bee keepers are able to harvest the surplus continually without doing any damage to the hive. Might that be an example a glut in a non-monetary economy? In this example, I would say that the glut is simply caused by excessive supply of labour and insufficient demand (within the bee hive) for honey.

Just a thought!

"But I just can't buy it as a full story of recessions. It's the general glut thing that's missing. Stuff gets easier to buy in a recession, and stuff gets harder to sell. That's an essential part of what makes it a recession. To say that stuff is harder to sell and easier to buy is meaningless outside a monetary exchange economy. In a barter economy, selling stuff is buying stuff. When you are trying to sell you are trying to buy at the very same time. A thing can't be harder or easier than itself."

I totally don't buy this paragraph.

In a barter economy, John writes detective stories and needs a haircut, David is a hairdresser and wants something to read. Recently, David has gone off detective novels and won't read them. As a result both John and David are underemployed and sitting around, and their consumption has fallen too, and they're both desperate. If I'm willing to give John a haircut, he'll write an extra-special detective story for me. And if I'm willing to write David an interesting novel, he'll give me an extra-special haircut. It's very easy to "buy" and very hard to "sell," precisely because a Recalculation is going on. But because there's a mismatch between production and desire, the barters cannot take place. What no-one knows (not even David) is that he would really enjoy reading horror novels. Once everyone figures that out, and John works out how to write them, the economy is going to be fine.

Nick,

You show why Walrus’ law doesn’t work in a monetary economy.

Kling says it doesn’t necessarily work in a barter economy either:

“If you took money out of the picture, the construction worker and the college student would still be unable to solve their problem.”

Then he says money is only PART of the solution:

“When it comes to the failure of wants to coincide, the existence of money is part of the solution, not part of the problem.”

So he is arguing that money is a necessary but not sufficient part of the solution.

You agree at one point - but then you also seem to argue that money is not only necessary but sufficient - i.e. there is no recalculation scenario that dominates over the effectiveness of money as a solution. Which is it for you?

And:

“More precisely, if there were a centralised Walrasian auctioneer, trading every good for every good in one big market, and not allowing trade to begin until he had found the market-clearing vector of prices, then Walras' Law would be true.”

But Kling disagrees with that as well - recalculation dominates.

Then:

“That Walras' Law doesn't work in a monetary exchange economy is obvious.”

Kling doesn't disagree with that.

Then:

“The calculation problem doesn't solve itself. It takes people to solve it. The price system helps them solve it. Monetary exchange helps them solve it.”

Kling doesn't disagree with that.

“But I just can't buy it as a full story of recessions. It's the general glut thing that's missing.”

Which is it? I'm very confused on where you stand about the relationship between recalculation and money solutions. Are you saying that there is no Kling recalculation story that can't be resolved with money, or not? If not, you must be agreeing with him.

Someone should tell Kling that house building is now behind the curve. The excess supply of houses should already have been worked off in a normal market. The problem is that households have too much debt because the prices they paid for LAND were too high (including the much greater number who brought existing houses).

And another issue I have with the "it's just recalculation" crowd is that they need a dynamic explaination of how the recovery starts. Do new industries quietly grow until they take over the economy. Or do existing industries mostly recover?

But I still have a question for Nick here.

Distribution matters. It is not enough to "create more money" on the books of financial institutions. That won't work. You need to distribute it. All the people who are madly trying to grab money, and trying to grab money to make up for the hole in their balance sheets (i.e. not to buy things but to pay off debts, or accumulate other financial assets). Isn't this missing from the story. What does the Walrasian auctioneer do with financial assets? It is not enough to just have consumer goods and money, you need financial assets to tell the whole story.

... I can find very few economists who believe it, and I've been trying hard to get them to believe it.

Here’s my suggestion: stop trying to make your case by explaining how your view differs from that of Scott Sumner, Arnold Kling etc. No doubt they are good people in their way, but they don’t provide a sufficiently clear statement of their models to enable readers to see just what the issue is. Instead, take something out of a serious textbook as your starting point. Specifically, take Chapter 18 of Mas-Collell, Whinston and Green (especially section 18C). Those authors dot their teas and cross their eyes, as Krugman would say. They provide a clear starting point for discussion.

Jon: at the margin, in a recession, it's the excess demand for money that limits output. If that excess demand for money were removed, output would rise, until it hits the new limit imposed by recalculation. If that recalculation limit were removed, output would rise, until it hit the new limit imposed by available resources and technology and tastes.

Output and employment fell badly in Germany and Japan in 1946. That wasn't a recession. That was bombing plus recalculation. (Unless my history is very wrong).

Blikk and Salem: here's my story. It's a monetary exchange economy, because there's no double-coincidence of wants. Start in equilibrium, then cut the stock of money. Everyone stops buying, because each is trying to rebuild his stock of money. Apples producers want bananas but can't sell their apples and so won't buy bananas. Banana producers want carrots, but can't sell their bananas, so won't buy carrots. Carrot producers want apples, but can't sell their carrots so won't buy apples. Each one tries to conserve his money. Barter can't work (unless all 3 find each other in one place and do a 3-way deal).

Salem: In your story, if it's a barter economy, there's an excess supply of detective novels matched by an excess demand for haircuts. It's not a general glut. Haircuts are in excess demand.

anon: I have edited my post to make it clear exactly where I begin to disagree with Arnold. Right near the end.

reason: Maybe, you think that the excess demand for money is caused by an excess demand for financial assets. Like Brad DeLong's story.

"But I just can't buy it as a full story of recessions. It's the general glut thing that's missing. Stuff gets easier to buy in a recession, and stuff gets harder to sell. That's an essential part of what makes it a recession. To say that stuff is harder to sell and easier to buy is meaningless outside a monetary exchange economy. In a barter economy, selling stuff is buying stuff. When you are trying to sell you are trying to buy at the very same time. A thing can't be harder or easier than itself."

Naturally you could have a recession in a barter economy, but in that case things are both harder to buy *and* to sell (say due to increased transaction costs, etc.). Never really thought it before, but a recession with money things really are different.

Thanks for the post!

I think you have a double-barrelled version of the same resistance to your argument so far.

The first is that the recession is caused by an excess demand for safe assets, rather than a excess demand for money (DeLong). It just happens that the demand for safe assets spills over into money.

The second is that the recession is caused by recalculation rather than the excess demand for money (Kling). Money assists with the required recalculation process.

These are similar in that they both view the excess demand for money as a by-product or symptom of the primary cause, rather than the cause itself.

Nick:

Your point that recessions _are_ situations where it is hard to sell and easy to buy is important.

Jon's claim that no, recession is output falling suggests one source of confusion.

The puzzle is why is it that in a world of scarcity we have a situation where there are unemployed resources? People want goods and services. People want to provide resources to produce them.

If a plaugue wipes out 50 percent of the population, or bombing destroys 25% of the capital stock, and production falls--what is the puzzle?

If people decide they don't want to work as much and would rather enjoy long weekends or a longer retirement, output falls. What is puzzling?

Pollution is considered such a problem that producing goods and services is greatly restricted. Output falls. This is a puzzle?

We live in a world where everyone has every good they good use. We produce too more of some of them and they have to be hauled to the dump. Output is reduced so that disposal problem doesn't have to be repeated. What is the puzzle?

But, we live in a world of scarcity. Many people could use additional amounts of many sorts of goods. They have resources that could be used to produced them (and have in the past.) But, now, they are producing less. They are consuming less. But they want to produce more and consume more. That is a puzzle.

Finally, there is a change in tastes, technology, etc. People want more of some things and less of others. The ability to expand the production of the goods people want is limited in the short run (low elasticity of supply.) Production can be expanded more effectively over time as new workers are trained, appropriate capital goods are produced and so on. Elasticity of supply rises over time. But in the contracting industries, it is possible to cut production immediately (though not necessary.) Yes, this is going on all the time, and the economy is in the middle of some elasticities of supply rising, and industries shrinking, and growing and so on.

Still, we can imagine it happening more or less. That creative destruction can be more intense sometimes. And so, these adjustments--people being put out of shrinking industries and the growing industries having caught up yet. Perhaps real output can fall.

But is the notion that structural unemployment and other adjustment costs (like specfic capital being lost and new capital goods slowly constructed) can vary really so special?

The puzzle, again, is when the demands for some things shrink and nothing grows. Or the growth in demand is less than the decrease. Or, most incredibily, the demand for everything falls.

And all of this in a world of scarcity.

What is the answer? Monetary disequilibrium.

"I can find very few economists who believe it, and I've been trying hard to get them to believe it."

But wait ... what Kling actually said was "... or something like it." Perhaps it is true that narrow monetarists, who believe that recessions can only be caused by an excess demand for the medium of exchange *as a medium of exchange*, constitute a minority of economists. But economists who believe that a general glut can only be caused by an excess demand for the medium of exchange *for whatever reason* - i.e. "something like it" - are surely the majority, for they include economists who believe that recessions are caused by a general demand to shift consumption into the future, and such time-shifting is only possible in the presence of money.

That is a pretty technical point of difference, and you yourself remarked on how small is the disagreement between you and DeLong (say) in a previous post. As Kevin Donoghue remarked, you have not explained yourself very clearly here.

Nick wrote:


Salem: In your story, if it's a barter economy, there's an excess supply of detective novels matched by an excess demand for haircuts. It's not a general glut. Haircuts are in excess demand.


I think Arnold's argument is not correctly described by Salem's story. An equivalent story would be something like:


In a barter economy, John writes detective stories and needs a haircut, David is a hairdresser and wants something to read. Recently, David has gone off detective novels and won't read them. John's needs also changed: he wants a modern haircut, one that is fashionable with story writers - but David only does conservative, old-style haircuts.

As a result both John and David are underemployed and sitting around, and their consumption has fallen too, and they're both desperate.


If I'm willing to give John a modern haircut, he'll write an extra-special detective story for me. And if I'm willing to write David an interesting novel, he'll give me an extra-special old-style haircut.

It's very easy to "buy" and very hard to "sell," precisely because a Recalculation is going on. But because there's a mismatch between production and desire, the barters cannot take place.

Once John works out how to write horror stories and David works out how to give a punk style haircut, the barter economy is going to be fine.

The 'medium of exchange' is not a necessary prerequisite for a recession, and "general glut" recessions can occur in barter economies just as well. That is what Arnold argues via his "double coincidence of wants" point. So I think Arnold's criticism of your original statement was justified.

One could argue that it is harder for barter economies to enter recessions: there's no money and there's no debt, it needs a significant mismatch of output versus demand in multiple major categories of products for a general glut to occur. In barter economies 'general gluts' are probably limited to major changes in external parameters, which dramatically shift the 'graph of needs/wants': an ice age, an earthquake, extinction of a key animal, depletion of a key resource (bronze), etc.

In modern economies, the flexibility of money makes it also more flexible for problems to accumulate: bad debt can accumulate and overconsumption of the wrong type of product can occur as well. Once there's a demand shock caused either by a sudden turn of luck for an over-rated piece of key commodity (like housing), or a sudden debt shock caused by a sudden (and self-accelerating) deleveraging spiral, there's a general glut. (The world economy may be experience both of these shocks at once currently.)

These types of phenomena probably do not occur in barter economies.

Barter economies have their own special problems though: the cost of trade is very high if the graph of needs/wants is very complex (which it is for a modern society), and seasonal/cyclical fluctuations in demand and supply cannot be buffered at all. (without some sort of medium of exchange.) Barter economies 'live for the moment' pretty much and there's no 'insurance' against fluctuations at all.

Nick,

I really don't agree that in my barter economy there is excess demand for haircuts. The issue is price, in real terms. Let's examine the real prices.

Suppose that 1 unit of time is worth 1 util to everyone as leisure, and in 1 unit of time everyone produces 1 unit of their goods. John values 1 unit of haircut at 2 utils, and previously David valued 1 unit of detective story at 2 utils. So they were happy to trade, and let's posit they did so on a 1-1 basis, each accumulating a 1 util consumer surplus. Now, with David's change in preference, he values 1 unit of detective story at 0.1 utils. So for John, he would have to give up at least 10 units of his time to get 1 unit of haircut, which he is not willing to do, as it would be negative utility (-8 utils). So now David and John both work 1 unit of time less. Economic output is down by 4 units, and "wellbeing" is down by 2 units.

Now look at the market for haircuts. Previously, John was willing to sell 1 unit of haircut for 1 unit of interesting story, gaining 1 unit of surplus. Now, he's underemployed, and you could drive a better bargain - you could get (say) 1.5 units of haircut for 1 unit of interesting story. John is lowering his barter demands, which means that haircuts are oversupplied, they are in a glut, but he just can't make a trade. Saying there is excess demand for haircuts has it backwards.

There IS a market with excess demand, the market for "interesting stories," but this is not a properly formed market because it is poorly specified. We do not know what stories David will find interesting. Indeed, the kind of stories already on the market are overproduced. In fact, the price signals for John suggest he should reduce production, when in fact what he needs to do is reassess his product.

I agree with you 100% that a sudden and massive demand for money would produce a glut. Where I disagree with you is that I think that a large-scale recalculation could also produce a glut. It is an empirical matter what is actually going on.


Salem: it's not just demand for money that matters to the depth of a glut, but also the distribution of money (debt and assets).

If everyone has an equal amount of money (the distribution is a constant function) then changing demand for money is an invariant to the economy.

But if the money distribution function is very assymetric it's different. If there's a significant number of actors with lots of debt, and if a lot of money is concentrated in the hands of a few actors, then a deleveraging shock can create a glut: those who would be willing to consume cannot (they cannot increase their debt), and those who have the resources don't increase consumption (there's just a few of them).

There's an actor level mismatch of 'want' and 'can'.

And that is what may be happening currently: 80%+ of the money equivalents are concentrated in the hands of the top 1% earners plus the top 500 corporations.

That is faced against tens (hundreds ...) of millions of consumers, hundreds of thousands of small corporations and small-time producers (workers).

That kind of assymetry cannot end well, because 'future demand' is set by those hundreds of millions who actually consume - but they cannot consume. So a deadly spiral of lack of demand, overcapacity and deleveraging gets underway.

In such a scenario increasing the monetary base will help, but if and only if that money ends up in the hands of those willing to consume.

Otherwise it ends like in Japan (the increased supply of money ended at the banks, never got to those who'd be willing to consume) or it ends like the Great Depression (where there was no increase in the supply of money at all, due to the gold standard being upheld up into 1932).

Translation for the US today:

- tax cuts for the rich probably wont help. (they don't consume the extra money but save most of it - because they are affected by the general psychology and because their marginal willingness to consume is much lower - it gets harder to consume money as you have more of it.)

- payroll tax cut - probably a good call

- QE1: probably a good call, the non-tax-cut components of it

- QE2: probably not so good call [the money may stay stuck at the banks] - but nothing else left for the Fed

Salem wrote:


Now look at the market for haircuts. Previously, John was willing to sell 1 unit of haircut for 1 unit of interesting story, gaining 1 unit of surplus. Now, he's underemployed, and you could drive a better bargain - you could get (say) 1.5 units of haircut for 1 unit of interesting story. John is lowering his barter demands, which means that haircuts are oversupplied, they are in a glut, but he just can't make a trade. Saying there is excess demand for haircuts has it backwards.

The thing is, there is excess demand for haircuts, from David - he is just unable to pay for it with his own labor.

I.e. there's a product quality crisis in the detective story writing industry, which spills over to its main trade partner, the haircut industry.

Thanks Mike. And it's only by arguing with people who disagree with me that has forced me to think through explicitly just why I find their explanations of recessions so unpersuasive, and focus on the ease of buying, and difficulty of selling.

anon: Yep. I feel like I'm fighting a war on two fronts. One one side, against Keynesians who accept the general glut idea, but aren't convinced about the role of the excess demand for money. And on the other side, those who don't really accept the general glut idea.

Kevin: I'm not familiar with that book. If I laid out a formal derivation and then critique of Walras' Law, and suggested an alternative, "Nick's Law", would that work?

Bill: Yep. Arnold says that almost everyone more or less believes the excess demand for money story. Sometimes I think it's just you and me!

Phil: When I really get into it with Brad DeLong, yes, I find out there isn't that much difference between us. Brad basically gets it theoretically (though we can still disagree on details of the story in particular cases). But Brad, although everyone thinks he's a Keynesian, always seems to turn Monetarist when he's in a foxhole fighting Says' Law. He starts talking about velocity. But yes, this post is not clear on those issues. It really needs to be read in conjunction with my other post, the response to Brad. But I can't fight on two fronts at once.

"But Brad, although everyone thinks he's a Keynesian, always seems to turn Monetarist when he's in a foxhole fighting Says' Law. He starts talking about velocity."

A completely false statement. Just mentioning velocity doesn't mean he's turned monetarist.

Nick- Great post. I am still in the DeLong corner on this one. As I see it, a big group of safe assets MBS, for example, were suddenly considered unsafe and became illiquid. They went from being decent substitutes for money to being very poor ones. Consequently, demand for money and other close substitutes went up.

Let me also ask this, for clarification, if money is only a medium of exchange and never a store of value is your contention that general gluts could happen? It seems *obvious* that it is the desire of people to move demand from time period to time period that make general gluts possible.

White Rabbit -

I did not see your earlier post when I posted mine (teach me to refresh before I post). I disagree that it is necessary for the haircut market to become disconnected for my example to work. I think my example with the real prices shows how this would work (and of course it works just as well with nominal prices). Just one sector becoming disconnected is simulating a fall in AD, because those workers have lost the ability to purchase. And so we have a general glut, but with unemployment concentrated in the sector which became disconnected. To me that's what the current situation looks like, with the disconnect obviously being in housing/construction.

As I am unpersuaded by your theory that the current situation is caused by a demand for money, I'm not buying your remedies, but I do note that the evidence suggests that tax cuts for the rich are more stimulative than for the middle class, who would just use the money to de-leverage.

As for the notion of whether there is "excess demand" for haircuts, I am not interested in getting into some semantic argument. I simply note that the production of haircuts has fallen, and so has the marginal price. From the point of view of an economist examining the data, it certainly LOOKS like a glut, however you want to categorise the true nature of supply and demand.

Woolsey: The puzzle, again, is when the demands for some things shrink and nothing grows. Or the growth in demand is less than the decrease. Or, most incredibily, the demand for everything falls.

And all of this in a world of scarcity.

What is the answer? Monetary disequilibrium.

Again, we not only live in a world of scarcity in this time period, but lived in one in previous time periods and will continue to live in a world of scarcity in the future. People know this, of course, and so borrow and lend to each other to smooth that out based on uncertain estimates of wants, needs and capacity.

It seems to me, that in this case it should not be terribly surprising that during particular time periods demand for somethings shrink and this is not offset. Problems arise when some people have sold too many of their present claims on resources in the past, while others then find out that their future and present claims are not as valuable as previously thought. The recalcuation is then the recalculation of conflicting claims on present and future resources.

Phil Koop: Unless other safe assets are a perfect substitute for money (and they're not, as you can't spend your T-bill at the grocery store) it doesn't really matter how the excess demand for money arises. The central bank always has the power to eliminate it by increasing the money supply. This is easy and nearly costless to do.

Not every economic fluctuation is due to bad monetary policy, but that's no reason to tolerate the ones that are.

There was barter beween detective novels and old fashoned haircuts.

There is a change in tastes. The writer doesn't want old fashioned haircuts. He would like a modern haircut, but no one is providing those. The demand for old fashioned haircuts is zero. They aren't scarce. The supply of detective novels is also zero. The writer offers none for old fashioned haircuts. How is he desparate? He hates his long hair? Apparently not as much has he hates an old fashioned haircut.

The barber no longer likes to read detective novels. He wants horror novels, but these don't exist. And so, detective novels aren't valued. They are no longer scarce. The supply of old fashioned haircuts falls to zero because there is nothing the barber wants to sell them for. Desperate? How? Because he is bored? No, evidently prefers to do nothing than read one more detective novel.

There is no general glut of goods. Both the supply and demand for all goods have fallen to zero. There is no scarcity.

In a money economy, both the barber and the writer could offer their products for sale for money. And they can't sell. And there is nothing they want to buy.

However, there is nothing they want to buy. Nothing is scarce.

They are willing to sell their current products for money on the speculation that someone might appear. They want to save and in this economy, they do so by accumulating money. But there is no scarcity. Production should drop to zero.

In the real world, we do have scarcity.

"In a monetary exchange economy, with n goods including money, there are n-1 markets."

How about in the monetary exchange economy we have now, with n goods including medium of exchange, there are n-2 markets because one medium of exchange is currency and the other medium of exchange is demand deposits created from currency denominated debt?

"If barter were nearly as easy as money, then an excess demand for the medium of exchange would not cause a recession. People would just switch to barter, and the economy would carry on as normal, with a slight increase in transactions costs."

Do barter economies have savings? Do barter economies have retirement?

if i were to hazard a guess, in barter economies one owns "productive assets" or rights to cash flows coming from them, rather than "savings" defined in a nominal sense. if i owned a herd of cows, i could rent them out for health care.

As long as you have at least one a market for non-produced goods (e.g. bond markets), then a disequilibrium in the bond market can cause a general glut of all produced goods. Therefore you don't need a violation of Walras' law as long as you have bond markets.

And it's not hard to come up with barter economy models in which this happens.

In general, you would imagine that the most sensitive part of the system would be the bond markets, since you are relying on people's predictions of the future, the goods being sold have zero production cost, no one is really sure how much utility these goods will deliver, and yet it is critical that they be accurately priced. Also, these markets tend to have demand increase with price (you buy the asset because you think others will want to buy it, too).

That is a flashing red light, saying -- "look here for the cause of recessions!"

Why keep asserting that *only* a desire to save in the form of the medium of exchange (whatever that means) is so central? Are you saying that barter explanations of general gluts don't exist, or that they are so fundamentally inapplicable that we should ignore them, in which case, why?

Nick: I'm not familiar with [Mas-Colell, Whinston and Green, Microeconomic Theory]. If I laid out a formal derivation and then critique of Walras' Law, and suggested an alternative, "Nick's Law", would that work?

It’s not the sort of book you become familiar with. It’s much too magisterial to permit familiarity. It sits on my shelf, which sags under its weight, and gazes down at me in a reproachful manner. I would never have bought it but for the fact that a local bookshop went bust, so I got it for €5, which fits the classic definition of a bargain – something you don’t want at a price you can’t resist. Anyway, if you’re in the library you’ll find Section 18C is well worth a look. It works through examples of Cournot competition and a trading-posts model (from a 1997 paper by Shapley and Shubik) to show (this is my summary, not the authors’) that the Walrasian budget set, and hence also Walras’ Law, emerge quite naturally as a special case in models which are also capable of generating nasty, non-Walrasian outcomes.

For me, the moral is that you can get sort-of-Keynesian results (not to be confused with results which Keynes would have endorsed or even dreamt of) from an idealised barter model by introducing a requirement for money. But you can also get them in other ways, for example by allowing for ‘thin’ markets. My conclusion, which is subject to change if and when I learn more, is that ‘Keynesian’ ideas are not fundamentally about money.

Incidentally, the main reason I’ve looked at that particular section of the book is that it mentions the Clower cash-in-advance constraint. I haven’t seen another microeconomics text which ventures that far into macro territory. But maybe some others do? I admit to being out of touch.

Nick: "... when he's in a foxhole fighting Says' Law ..."

Well, he's got your back at the moment: he's just linked, with approbation, to this post.

... a 1997 paper by Shapley and Shubik ....

Whoops! Actually 1977: Trade using a commodity as a means of payment (JPE).

Salem wrote:

As I am unpersuaded by your theory that the current situation is caused by a demand for money, I'm not buying your remedies, but I do note that the evidence suggests that tax cuts for the rich are more stimulative than for the middle class, who would just use the money to de-leverage.

Well, the article you linked to states:

The high-income group increased total spending by 77% of the value of their stimulus checks. The low-income group increased total spending by 128% of the value of their stimulus checks.

That means that it's almost twice as effective of a stimulus to send checks to low-income groups than to high-income groups.

The middle class might be even less willing to spend that money, but at that point I think the methodology should really be considered: these numbers were based on a $300 Bush-era check sent in 2008 - well before the crisis fully unfolded.

Now we have a fully developed panic and scare, fully developed unemployment, plus we have tax cuts that go well beyond $300. Will a rich family spend 77% of say a $100,000 tax cut? In current sentiment I call that unlikely - and the cited study does not examine that question.

OGT: "Let me also ask this, for clarification, if money is only a medium of exchange and never a store of value is your contention that general gluts could happen? It seems *obvious* that it is the desire of people to move demand from time period to time period that make general gluts possible."

That's a good question, and a hard one.

I've argued in the past that stores of value per se don't cause recessions. An increased demand to save in the form of land, or bonds, or antique furniture, wouldn't cause an excess supply of newly-produced goods, unless it spilled over into an excess demand for the medium of exchange.

It's hard to think of a medium of exchange that isn't, to some extent, also a store of value. In a discrete time model we can perhaps imagine a money that must be spent before the end of the period. I don't think you could get a general glut in that case. But my mind is not clear on this.

In Arnold's barter examples, and in the examples that Salem gives, we need to distinguish between: demands and supplies of goods that currently exist; demands and supplies of goods that don't currently exist. I would work if someone gave me an elixir of youth in exchange. There's an excess demand for the elixir of youth, and an excess supply of my labour in exchange for that elixir. No general glut.

Jeff wrote:

"Phil Koop: Unless other safe assets are a perfect substitute for money (and they're not, as you can't spend your T-bill at the grocery store) it doesn't really matter how the excess demand for money arises. The central bank always has the power to eliminate it by increasing the money supply. This is easy and nearly costless to do.

Not every economic fluctuation is due to bad monetary policy, but that's no reason to tolerate the ones that are."

Actually, T-bills are money, and I will show why. I define "money" to be any instrument denominated in the medium of exchange (dollars) whose value can be ascertained now or in the future with certainty. A T-bill which has zero default risk and negligible interest rate risk due to its short term nature is money. I can sell it at the bank for a clearly-known value, put the proceeds in my chequing account and spend them.

Money is any instrument with a definite Net Present Value in dollars. If it has interest rate risk, default risk or both, it isn't money. It it bears inflation risk, it isn't money either. That's why 5-year GIC's aren't money, even though they qualify on all other grounds. Same with Canada Savings Bonds.

T-bills have zero default risk, negligible interest rate risk and negligible inflation risk. They're money.

The problem with the current recession is that many market participants tried to use high-rated commercial paper, (Asset backed commerical paper and the like) as money, thinking they had negligible default risk when in fact the default risk was anything but negligible.

Nick:

I fully agree - the medium of exchange function comes before the store of value function of money. Stores of value are not useful as money because they are stores of value - they must also possess the ability to be a useful medium of exchange.

The question: "if money is only a medium of exchange and never a store of value is your contention that general gluts could happen? It seems *obvious* that it is the desire of people to move demand from time period to time period that make general gluts possible." is not quite nonsense, but misses the point about general gluts nearly entirely. Why would the entire world decide to put off consumption for the future when this additional consumption would actually increase their future wealth?

Or in other words, why would the world as a whole decide to pass up a free lunch? Because that is what the world is doing right now - passing on the only free lunch. Some economists think: there cannot be a free lunch, so there cannot be a general glut. However, by any reasonable intrepretation of the data, there is a free lunch - the question is what to do with it.

I think the point you are trying to make is if the medium of exchange becomes a "too good" store of value, it loses the "medium of exchange" trait. For example, if money made 20% per year in real terms, would anyone want to use it as a medium of exchange? Of course not - it would be too valuable for this use.

In general, we want a medium of exchange that stores value about as well as real world goods. If it is much worse, then we get inflation. If it is far better, then we get deflation. But the real problem comes when there is great uncertainty about the future value of real assets, and the medium of exchange is a good to very good store of value. Then you get a general glut.

I have actually had this argument/discussion many times, and people tend not to understand it very well.

I would also argue that the "ability to extinguish tax liabilities" comes before these two traits, but that it besides the point you are trying to make.

Determinant: I nearly fully agree. T-bills are money. Ask the CME, or really anybody who uses T-Bills on a regular basis. I also have a much larger theory about how these depressionary recessions start. They start when there isn't enough money to satisfy the trading that needs to be done. People start to use other things as money-like assets. In the late 1990s, you could use stock to buy other real world assets. Once people found out that this wasn't real money, then the entire scheme collapsed. Then real estate combined with CP became money like.

But it isn't money, and cannot extinguish tax liabilities. It all comes down to what you can "trade" your "money" for easily. And the one thing about real money - you always, always know you can go give it to the tax collector, and they will accept it in trade. No other asset has that 100% odds of being a negotiable instrument accepted at full value, except real money.

Hello Nick!

"Stuff gets easier to buy in a recession, and stuff gets harder to sell. That's an essential part of what makes it a recession. To say that stuff is harder to sell and easier to buy is meaningless outside a monetary exchange economy. In a barter economy, selling stuff is buying stuff. When you are trying to sell you are trying to buy at the very same time. A thing can't be harder or easier than itself."

What exactly do you mean by easier to buy and harder to sell?

I am thinking, if it's easy to buy things, surely all the sellers will be happy?

mickslam: "In general, we want a medium of exchange that stores value about as well as real world goods. If it is much worse, then we get inflation. If it is far better, then we get deflation. But the real problem comes when there is great uncertainty about the future value of real assets, and the medium of exchange is a good to very good store of value. Then you get a general glut."

I think that is a good/interesting way of looking at it.

Take a simple world in which central bank currency is the only medium of exchange. We would normally think of monetary policy as the central bank varying the quantity of currency, while holding the own rate of return on currency fixed (at 0% in nominal terms). But (practical issues aside) there is no reason why we couldn't think of monetary policy as the central bank varying the rate of interest on currency, while holding the quantity of currency fixed. (My previous post, when I imagined an increased demand for milk, when cows are money, is like an increase in the rate of interest of currency, because even though the cow yields the same quantity of milk, the milk is more valuable).

But the real world has elements of both. Currency doesn't pay interest, but banks' reserves at the Bank of Canada do pay interest, at a rate set by the Bank of Canada. And balances in chequing accounts (which are media of exchange) may pay interest (sometimes in the form of the bank not charging you fees if your balance is over $X), but that rate of interest is not under the direct control of the central bank.

And it makes me wonder if there could be some monetary system in which the own rate of interest on money would adjust automatically (rather than needing to be set by the central bank) to eliminate the possibility of excess demands or supplies of money, even while the quantity of medium of exchange adjusted in response to entirely different reasons. I think Bill Woolsey argues that a system of competitive media of exchange could do this. Bill?

Hi James! "What exactly do you mean by easier to buy and harder to sell?"

Ah. That's something that is hard to define and measure *exactly*. I mean the same thing as people who talk about there sometimes being a "buyers' market" (easy to buy, hard to sell), and sometimes a "sellers' market" (easy to sell, hard to buy). But I don't know of any exact definition for those words either. And that same distinction seems to correspond, at least crudely, with the economists' distinction between markets in excess supply (buyer's market) and excess demand (sellers' market).

In the housing market, for example, if you are trying to buy a house, there's a trade-off between: the price you pay; whether you get a house that's very close to the sort of house you want; and how long it takes you to find it. The longer you are willing to wait/search, the better the price, and the closer to what you were wanting. And the slope of that trade-off depends on whether it's a buyers' or sellers' market. Similarly the seller faces a trade-off between price and expected time to sell.

In a buyers' market, sellers find it hard to sell, but are really happy when they succeed in selling.

Nick wrote:

I mean the same thing as people who talk about there sometimes being a "buyers' market" (easy to buy, hard to sell), and sometimes a "sellers' market" (easy to sell, hard to buy). But I don't know of any exact definition for those words either.

That's a concept that pure monetarism does not really cover - and it occurs in real-life all the time.

A transaction needs 3 elements: the meeting of buyer and seller (market), the setting of the right price (price discovery), plus the willingness of both seller and buyer to enter into a transaction (willingness to transact).

There can easily be markets where prices are 'sticky' and spreads are high - where, despite demand, prices are not moving because sellers are unwilling to sell below a certain price, for various reasons.

In a stock/auction market this would be equivalent to the trading book being 'thin' either upwards (buyer's market), or thin downwards (seller's market). The lack of intention to transact results in fewer limit orders being in the books in one direction.

Two things can happen in that situation: either the price collapses (there's sellers willing to sell at any price - for example because they are panicking), or there's no sellers willing to hit the lower prices and the price freezes up and the spread increases.

Note that there can be these two starkly different outcomes, from the same initial condition of supply, demand and price.

This is something where mechanics based on price, money, demand and supply alone are not enough - it's the intent and expectations of individual actors that matters as well.

This is a common phenomenon in markets of non-perishables. With perishable commodities there's a natural 'timeout' for transactions due to the limited life-time of the commodity. For something like houses this timeout can be near infinite - people routinely wait a decade or two before giving up and selling their houses.

(There can also be artificial freeze-ups of markets: when a few actors own most of the goods, and there's an accounting reason why they don't want the central 'price' to fall - even if they cannot transact. For example banks in the US have a vested interest in not seeing housing prices collapse further. They will keep houses on inventory and not sell them - because mark-to-market accounting keeps them solvent on paper.)

Btw., this phenomenon is probably the best real-life refutation of the hypothesis of rational expectations. (If actors truly 'knew' what to expect in the future, on average, they would never need to wait with transactions speculatively ...)


"What exactly do you mean by easier to buy and harder to sell?"

Any market, at any moment when there is no actual trade, has an asking price and a bid price, separated by a bid-ask spread.

“Easier to buy and harder to sell” means - more volume willing to sell at the asking price than volume willing to buy at the bid price.

White Rabbit: "That's a concept that pure monetarism does not really cover - and it occurs in real-life all the time."

Yep. Or rather, no simple macro model covers at all well. (It's not just monetarism, which, anyway, really disappeared 25 years ago.) But search models try to come to grips with it. Buyers and seller have to search for each other. Sometimes it's relatively easier for a buyer to find a seller and relatively harder for a seller to find a buyer, so we call that a buyers' market. (And in illiquid markets, it's hard for *both* buyers and sellers to find each other).

anon: Yep. Though I would say "at *or near* the asking price". But that definition only really works for auctions of identical goods. It doesn't work so well for houses, used cars, or labour.

"One one side, against Keynesians who accept the general glut idea, but aren't convinced about the role of the excess demand for money."

???? I think the argument is over the definition of money. I'm sure both Keynes and Krugman (and me) believe that an excess demand for money leads to a general glut.

Isn't a better way to put this - a general glut arises when some people want to earn now and consume later to a greater extent than all other people are prepared to consume now and earn later (either by borrowing or running down their assets). Money/more or less liquid assets are what facilitates this.

"Isn't a better way to put this - a general glut arises when some people want to earn now and consume later to a greater extent than all other people are prepared to consume now and earn later (either by borrowing or running down their assets)."

No, that's not a better way to put it.

You're just talking about the existence of aggregate savings, on their own savings don't cause a recession. The recession is caused when some of the savings are not invested. The issue is equally a lack of investment demand as a lack of consumption demand, and empiricaly it's the investment demand that usually falls short in recessions.

Nick,

Chequing deposits earn exactly zero interest.  Insured overnight savings deposits earn token interest only (5-10 basis points), even when rates were at 4.5%.  Check page 8 of the BOC's href="http://epe.lac-bac.gc.ca/100/201/301/weekly_fin_stats/2007/070720.pdf">weekly statistics from July 2007.  You really shouldn't think of any of this stuff as interest bearing at all.

Adam P,
now we are arguing about the definition of "consume". Sorry, if I wasn't clear. And yes you are correct about investment usually leading the move to recession. (Read this excellent piece:

http://blog.andyharless.com/2009/11/investment-makes-saving-possible.html

But in that case it is just the corporate sector rather than the household sector that is trying to do the intertemporal shift. I was speaking more generally.)

Nick
Right on cue http://krugman.blogs.nytimes.com/2010/12/15/what-is-money/

reason:

I recall Andy's post from when it came out, at the time I rather suspected I'd helped write it, see the following comments on this blog from a few days before Andy's post:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/accounting-and-economics-and-money.html?cid=6a00d83451688169e20120a6bb020e970b#comment-6a00d83451688169e20120a6bb020e970b

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/accounting-and-economics-and-money.html?cid=6a00d83451688169e20120a6bb1041970b#comment-6a00d83451688169e20120a6bb1041970b

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/accounting-and-economics-and-money.html?cid=6a00d83451688169e2012875bcf4f6970c#comment-6a00d83451688169e2012875bcf4f6970c

http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/11/accounting-and-economics-and-money.html?cid=6a00d83451688169e2012875bd3edc970c#comment-6a00d83451688169e2012875bd3edc970c

@Determinant and Mickslam:

Money is the medium of exchange and it's price is fixed, by definition, at 1. T-bills are neither. It's certainly true that when interest rates are low, T-bills are as good a store of value as is money, and due to their short maturity, their prices are close to 1. Both of these characteristics make them a close substitute for money, but they still aren't money. I say again, money is the medium of exchange. You don't pay for things with T-bills, you pay with money.

If all short-term government debt is money, then why don't we experience massive inflation when the government runs a large deficit, and massive deflation when it runs a surplus? You know the answer. We're accustomed to seeing deficits create inflation in third world countries because they monetize the debt. If they didn't do that, they, like Japan and the U.S., would see increasing public debt with little or no inflation.


Nick:

Seller's market and buyer's market is not a "search" problem - i.e. it's not a price discovery problem, it is not an information propagation inefficiency problem.

It is an actor intent problem. Even if perfectly informed, sellers might not sell at current market prices (which is generally seen as the current average of last transacted prices) - and wont sell at marginally higher prices either. The bid/ask spread goes up and it goes way beyond the cost of transaction.

Transactions are voluntary, thus 'intent', 'future expectations' and 'uncertainty' enters the picture and those are pretty hard to model.

It is not true that price discovery alone will match up transacting parties. There's a hard to measure metric of 'liquidity', which is often controlled by human behavior, not by price and other market parameters.

And it's a deeply relevant metric. Part of the horrors in mid/late 2008 were caused by "interbank trust" vanishing, which caused interbank loan liquidity dry up, which caused certain big players getting squeezed. That big scare (magnified by the media as well) helped kick-start the psychology of prioritizing savings and thus started the deleveraging, started the recession and started the deflationary spiral as well.

It's not a phenomenon that can be explained by monetary mechanisms alone.

Nick, I don't doubt that excess demand for money is an important problem. I've been at the fore of this issue calling for a more expansionary fed policy since the earliest days of the 2008 crisis.

But look, you and wooley seem to be caught on a semantic nail. A recession in output can have other causes and the price level can fall for other reasons. Just because the U3 BLS numbers say their are unemployed people does not mean there are unemployeed resources and therefore a scarcity violation. When you're trapped in a snow storm and thirsty you don't eat the snow, when you're lost at sea and thirsty you don't drink the water. Either one being the path to death.

So it goes with factors of production during a recalculation. You naively suppose there is slack but really those idle factors arent factors at all. It's just your cognitive bias of functional fixatedness that assumes they are. If we go through a fad of building houses in the desert, then the fad ends we can hold the houses idle or lower their let rate or liquidate them. If the houses could be valuable later, then letting them on the cheap may incur too much depreciation. So we leave them fallow. Real output today falls and we have unused resources.

Now you tell me that that's one factor but not all factors.

Is that a practical complaint, no. Is that a fatal complaint, no. Future expectations can idle factors of production today even in a barter economy. So I think this narrows your claim quite a bit.

In an evenly rotating economy a general glut is due go an excess demand for money.

Hello Nick!

With regards to my question about ease of selling and buying, it seems totally dependent on expectations and preconceived notions of worth.

For example with houses, it's only a buyers market if people think the houses are worth more than the going market rate, and likewise, only a sellers market if people think houses are selling for more than the market rate. However, what concerns me, is that whenever there is a sale, there is a purchase, and whenever there is a purchase, there is a sale. Every time a buyer thinks they got a good deal, surely the seller thinks they also got a good deal (otherwise they wouldn't do it). Sure there are exceptions, but we are talking about aggregate so I hope we can ignore them. It follows, that for every person who thinks it is a buyers' market, there is another person who thinks it is a sellers' market.

For example, if I think a house is worth 300,000, but I see it selling at 200,000, I will happily buy it, thinking it's a buyers' market. But the person who sold it to me (ignoring the exceptions) clearly thinks the house was worth 200,000 or less. If I own a house, and think it's worth 300,000, but I could sell it for 500,000, I think it's a sellers market, but obviously the person who bought it off my thinks the house is worth 500,000 or more.
If my example makes sense, surely only half or less the people could be considered rational.

Look forward to your thoughts!

James

James:  If the housing market was clearing the price history would be a martingale.  But it's not. The market clearly trended downwards in what became a very predictable manner and housing forwards were in backwardation.    There was no way to arbitrage it since you can't short physical houses which is why the trend could persist.  So liquidity collapses and bid/ask widens.  A small number of buyers transact at the ask (every day another sucker...) but soon learn the meaning of buyer's remorse as the market continues to trend downwards towards equilibrium.  The fact that a few people momentarily felt OK about their purchase has nothing to do with market efficiency.

Nick:

I'm afraid that I'm having a terribly difficult time following your discussion of Walras' law.

There are, of course, theorems that prove the validity of Walras' law under a set of maintained assumptions. So when you say that the law is false, you obviously mean that one or more of these maintained assumptions is violated. Evidently, it is the assumption that prices are market-clearing that seems to be the problem. This assumption is, of course, nothing more than part of the standard solution concept that is applied to competitive market settings (centralized markets with price-taking agents).

Or, is it more than this? Do you also take issue with the assumed market structure; i.e., the idea that all trade occurs in a centralized market? The way your discussion proceeds leads me to believe that you have in mind some decentralized exchange process. Can you be more precise about the nature of this "monetary economy" that you speak of?

Perhaps you have in mind sequential pairwise meetings, as is the case in standard search models? But in those models, prices are determined not by an auctioneer, but by bilateral bargaining. And I'm not even sure that it makes sense to speak of Walras' law in such an environment. (That is, telling us that Walras law is false is a nonsensical statement).

Anything you can say to clear my thoughts on this matter would be greatly appreciated. I am enjoying the general discussion.

Hi David: yes, I wasn't as clear as I should have been.

Walras' Law holds trivially in market clearing equilibrium, since all excess demands are zero. And so they must sum to zero.

Here's a sketch of what I mean:

The standard proof of WL goes like this: a consumer with endowment vector E maximises U(X) subject to P(X-E)=0. Aggregate that budget constraint across all individuals, and you get WL.

The whole vector of demands X is determined in one decision. That makes sense provided: there's one big market, where every good can be exchanged for every other good; the individual expects he can buy and sell as much of every good as he wants.

But:

1. Suppose he gets to market, and finds he can't buy any apples, because there's an excess demand for apples. His demand for apples is still determined as above, but he reformulates his demand for every other good by maximising U(X) subject to P(X-E)=0 AND a=0. So you get a demand function for every other good coming out of that second doubly-constrained maximisation problem, and a demand function for apples coming out the first problem. So when you add up all the excess demands, they violate the budget constraint. Simple example: I go to the store with $5 planning to buy $5 worth of apples, but there is none. So I buy $5 of pears instead. So I demand $5 of apples, plus $5 of pears, but only supply $5 of cash.

2. There is not one big market where all n goods can be exchanged for any other good, and n excess demands. There are n-1 markets, where each of the n-1 non-money goods can be exchanged against 1 good, which we call "money". The apple market has an excess demand for apples, which equals the excess supply of money in the apple market. So there are n-1 little Walras Laws, one for each market.

There are n-1 excess demands for money, and if you add them all up, you will only get the sum of the excess supplies of all the other goods if no individual expects to be constrained in purchases or sales in any of the markets. But, if the price vector is not at market-clearing equilibrium, somebody won't be able to buy or sell as much as he wants to, so will re-formulate his Utility maximisiation in all the other markets taking those quantity constraints into account.

Don't know if that's any clearer.

James: remember though, a house in Ottawa is worth a lot more to a person who wants to move to Ottawa because he's just got a job in Ottawa, than it is to a person who wants to move away because he just got a job somewhere else. So both gain by the deal, in any market.

Nick: I see a crack in the clouds. Let's see if I'm following.

Consider a standard choice problem, max U(x) s.t. p(x-e)=0. Suppose there is a unique solution x(p). We add up the demands and solve for p* in the usual way; x(p*)=e. We may without loss interpret x as a vector of time-dated commodities, and p as a set of intertemporal prices. The choice of numeraire is irrelevant. If there are n goods (n dates), then there are n-1 prices. You might want to say n-1 "markets," but that's not quite right. There is a single market; it opens at the beginning of time and clears immediately. As time unfolds, claims are simply redeemed as they come due. There is no need for a medium of exchange, obviously (which I define, btw, as an object that circulates as a means of payment).

You want to consider the following thought experiment. Imagine that an agent enters the world thinking that he has to solve the choice problem above. Consider some p that does not clear markets. At the given p, the guy was planning to buy x1(p) at date 1. To support this planned purchase, he has issued claims against his future endowments. But imagine that x1(p) is not available. Then what does the guy do?

Your assumption is that he re-optimizes from date 2 onward...subject to the same price vector (?)...and proceeding as if date 1 goods and prices never existed (it is now date 2, after all). The new solution to his choice problem (ignoring x1) is x'(p); which will generally be different that the original solution x(p). So, of course, if we add over all the x(p), x'(p), x''(p), etc...we get nonsense. In particular, Walras' law does not hold. (Not too surprising, since we are no longer describing a Walrasian market structure).

Something tells me that I am missing a part of your argument. In particular, I'm not sure where money fits in here. I have assumed that people can keep their promises, so their time-dated claims can be used to purchase whatever they want as time unfolds. The problem arising above appears to have nothing to do with money, per se.

Also, I wonder what you assume about peoples' expectations. Do they anticipate these trading difficulties? Sorry for all the questions. Let me know if they are peripheral to the main point you are making.

Nick and K:

Hello K! I am afraid your answer was too technical for me, and also suffers from a similar problem that brings me to...

Nick!
I was hoping to use houses just as an illustrative example, rather than *specifically* talk about problems associated with houses. Substitute in any good. The idea is that whenever a transaction occurs, both the buyer and seller think they got a good deal, making it difficult to characterize what exactly a buyers market is, or a sellers market.

This is all really a roundabout way of trying to illustrate that I really don't see the difference between bartering and buying and selling within this specific context. (I obviously understand the general distinction).

You seemed to imply that this sort of idea of a buyers and sellers' market was unique to a system using money, my feeling is that the situation is the same. The fundamental idea is that there is a buyer and a seller, whether they get a good or service in return or money in return shouldn't really matter. My conjecture is that the idea of a buyer's market and seller's market is just in people's heads about what they actually value the good at.

I.e. if there is a bumper crop of rice, there is now a "buyers market" because the farmer is willing to accept less goods and services for his rice. The towns folk are happy because they valued the rice higher than what they can get it for now. However, maybe you weren't ruling this out? I suppose that is my question.
Are you suggesting a barter economy rules out buyer's and seller's markets? (and thus the equivalent recession you implied)

Thanks, and look forward to both your thoughts!

"Simple example: I go to the store with $5 planning to buy $5 worth of apples, but there is none. So I buy $5 of pears instead. So I demand $5 of apples, plus $5 of pears, but only supply $5 of cash."

So I'm allowed to post demand for $10 worth of goods when I only have $5? That's not what is usually meant by a demand curve.

The whole reason it curves is to trace out the way you trade off more of one thing for less of another, and the *trade-off* comes from the fact you have a budget constraint.

How is your example different from this simple example?

I have $10, I demand 4 Porches (price $100,000 each). There is excess demand for Porches.

David: This is really good!

You have understood my objection 1 to Walras' Law exactly. (That objection has nothing to do with money per se). Let me just add that if the price vector p is not at market-clearing, then the sort of problem your consumer faces (being unable to buy or sell as much of x1 as he wants) *must* happen for either the buyer or seller for at least one good.

Your x'(p) is called a "constrained demand function". (Or sometimes an "effective demand function"). Your x(p) is called a "notional demand function".

You have re-interpreted my thought-experiment as a of sequence of dated goods, where the market can re-open in period 2, which is interesting and entirely legitimate, though not the thought-experiment I had in mind. In my thought-experiment, if you found yourself unable to buy x2 for example, you might go back and buy some more x1 (if x1 and x2 were close substitutes), which you couldn't do in your thought-experiment because it would mean going back in time.

What's this got to do with money? Well, because once you recognise that people can re-formulate their plans, taking these quantity constraints into account, then the market structure really starts to matter. For example, suppose your consumer is rationed in x2. In your thought-emperiment, with a dated sequence of markets, he can't go back and re-visit his demand for x1, because that would mean travelling back in time. But in my thought-experiment, he can go back and revise his demand for x1. So when you and I solve the same problem, we will get different answers, because we have assumed different market structures.

A monetary exchange economy has a different market structure from a barter economy. So, if the price vector is not market clearing, we will get different answers for a monetary and a barter economy, just as you and I got different answers above. With n goods, a pure barter economy has n(n-1)/2 markets, where all possible combinations of pairs of goods can be traded. A pure monetary economy will have (n-1) markets.

Take a simple example with 3 goods, where good 1 is money. There is a market 12 and a market 13, but there is no market 23. Assume U() is separable, for simplicity. Assume good 1 is also numeraire (it doesn't matter, of course). Start with the equilibrium p2 and p3. Now double both p2 and p3. What happens? There's an excess demand for 1, of course. So the markets 12 and 13 will both fail to clear. If we were in a barter economy, which had a market 23 as well, we would still get the efficient trades of goods 2 and 3, because the relative price p2/p3 is still correct (I assumed separability). But in a monetary exchange economy, where market 23 does not exist, we won't get efficient trades in 2 and 3. Because to trade 2 and 3, you first have to trade 2 for 1, then 1 for 3. And you will be quantity-constrained in one of those two trades.

Let 2 be consumption, and 3 be labour, and you get an excess supply of consumption and labour, and low levels of consumption and employment, even though W/P is at the market-clearing level.

You ask how expectations of these quantity constraints are formed. Good question. It matters. My answer is "Dunno". The old 1970's literature implicitly assumed rational expectations, though they didn't understand that that was what they were doing. It's the expectations of future quantity constraints that are tricky. "Will I be able to sell my labour next year?" Expected future income may not be a choice variable. It may be determined by a quantity constraint.

Still not sure if this is clear.

This is on-topic, and important. I *want* to explain it to you.

Adam: the apple seller sees I have $5 in my hand, and I really do want to buy $5 of apples, and I would buy them if he had apples to sell. The pear seller sees I have $5 in my hand, and I want to buy $5 of pears, and I really do buy them. The Porsche seller sees me with $5 in my hand, pressing my nose against the window, and tells me to get lost, because he knows I wouldn't buy it if he offered me one at $40,000.

Yes, the $5 demand for pears is in some sense a "false demand", because I wouldn't buy those pears if I could buy apples. But the pear seller doesn't care about that. He might not even know it. And I can't buy apples, so I do buy pears. Eventually, it is true, I might stop going to the apple seller, asking if he has any apples, so we would stop seeing the line-up at the apple store. I'm a "discouraged apple buyer". just like the "discouraged worker" who stops looking for work because he figures there isn't any, and is no longer counted as unemployed.

James: suppose there's a bumper crop of rice, and the price of rice is sticky. In barter, the rice/wheat market would be a buyers' market for rice and a sellers' market for wheat.

In a monetary economy, we never talk about buying or selling money. We talk about buying or selling rice. So the rice/money market is a buyers' market.

James: A price may be above or below equilibrium.  Buyer's market means above, seller's below.  That's not just something in people's heads.  A Soviet grocery store is an example of a seller's market.  It's easy to sell because the price is way too low, but nothing left on the shelves, the opposite of a glut (a buyer's market).  If you buy in a buyer's market you are getting a lousy deal. The fact that it obviously was worth more than that to you at the time doesn't change the fact that there's a very real sense in which you are paying too much.  And the price is probably going to drift down and you are more likely than you would have been in an efficient market to end up regretting it.

To be more clear about my comment above:  a martingale is a process whose current value is it's future expected value.  A backwardated forward curve means that you can contract now to buy something in the future at a price that's lower than the current price.  Clearing means exactly all the supply is being sold; i.e. no neighbourhoods full of boarded up houses being used by no one; no line ups for bread.

Nick wrote:


The old 1970's literature implicitly assumed rational expectations, though they didn't understand that that was what they were doing.


I don't think the hypothesis of rational expectations is defensible.

It claims that on average economic actors do not get 'surprised' irrationally, they act in their own perceived rational future interest on average.

In reality irrational "surprises" happen all the time. Some of the worst crashes in history were negative surprises snowballing - say the '89 crash - with little 'real economy' basis in the magnitude of the crash. (The May 6 2010 'flash crash' is probably in that category as well.)

Some of the worst bubbles in history were positive, irrational expectations snowballing.

These psychological phenomena, if they are large enough, if they last long enough, set a global sentiment and feed back on the real economy - and they do this all the time. They do not average out, unless your time scale is in the thousands of years.

I'd also expect this to get worse in the future. People are more connected to each other than than they used to be, communication and propagation of information is faster and more global than ever before. This, considering that we have fundamentally unstable feedback loops, sets us up for higher volatility.

And yes, acknowledging this also means that 'big actors' like governments or central banks adaptively 'smoothing' out these irrational cycles should be considered as a response: to reduce human suffering - to 'buffer' positivism when it's in over-supply, just to feed it back into the system when negativism rules.

And, given that the phenomenon is human and partly irrational in nature, measuring and controlling it via the money supply alone is not enough.

Nick- Thanks for the answer to my question. It seems both more understandable and plausible to claim that it is the desire of people to 'hoard' a store of value in the face of future scarcity and the dual role of money as a store of value and MOE contributes to demand short falls.

One other question that I think I get from your writing, but want be sure. Is it not only the MOE role of money but price 'stickiness' that is necessary to cause rescessions? Or are those possible in your model even if with perfectly flexible prices as long as there is an MOE (that also serves as a store of value) both necessary and sufficient?

And as a follow up, does your model assume flexible pricing under a barter system? I am not sure that completely makes sense if it does. If the source of price stickiness is search costs or coordination problems, real barter economies might have higher stickiness issues.

OGT: I assume that prices would be equally sticky under monetary exchange as under barter. In practice, they might be more or less sticky in one case than in another. I'm not sure.

Is price stickiness also necessary for recessions? The safe answer is "yes"; an instant fall in the price level would increase the real stock of money to whatever it took to eliminate the excess demand for money. But we can imagine cases where expectations were de-stabilising, so that a fall in prices caused people to expect a further fall, and so increased the demand for money. Not to mention the consequences of increased real value of debts. So the answer might be uncertain. I just assume price stickiness because I think most prices are in fact sticky.

Nick,

I think we can stick to my intertemporal formulation. All we need to do is to assume that the decision-maker, at date 0, goes through thought-experiments concerning what is likely to transpire in the future. (I.e., suppose I get to date t and that no date t goods are available?) We are in the realm of game theory here; not conventional competitive analysis.

What's this got to do with money? Well, because once you recognise that people can re-formulate their plans, taking these quantity constraints into account, then the market structure really starts to matter.

Hmmm. What do you mean by "reformulate plans?" Are people prohibited from formulating a state-contingent plan? I mean, if I understand the environment, I understand that for a given p, my plan to purchase x may not materialize. If I can anticipate all possible future contingencies, then I come up with a state-contingent plan that maximizes my expected utility, subject to those pesky "effective demand" constraints.

Of course, everyone is playing the same game; and they formulate their state-contingent strategies accordingly, taking as given the play of everyone else (standard Nash assumption).

And now, to close the model, we need a solution concept. A Nash equilibrium, I guess.

Not sure what this has to do with needing money. If people can commit, as I have assumed all along, then claims to their endowments will be acceptable for payment.

Let me now move on to your example (sorry, I am thinking on the fly here).

You have a three good example. Let us imagine an intertemporal Wicksellian triangle. Good j=1,2,3 represents output at date j. There are three agents, j=1,2,3. Agent j wants to consume good j. But agent j has an endowment of good j-1 (modulo 3). There is a complete lack of double coincidence of wants here.

Despite the lack of double coincidence, money is not necessary (this is contrary to Kling's assertion--he obviously does not know monetary theory). In particular, an Arrow-Debreu market with 2 relative prices will do the trick. For that matter, cooperative exchange will do the trick too.

Imagine now that agents 2 and 3 lack commitment, but that agent 1 does not. Agent 1 is the person endowed with the asset that pays off in the "long run," date 3. It is natural here to let a claim to this good serve as money, and that agents meet in sequence over time: 1 acquires good 1 from 2 in exchange for money (good 3). Then, 2 acquires good 2 from 3 in exchange for money (good 3). Then agent 3 redeems his money for good 3. This is a monetary economy.

Let's see, instead of 3 agents, assume a continnum of 3 types of agents. Then we can speak of a sequence of competitive spot markets. We use good 3 (money) as the numeraire; so price vector is (p1,p2,1).

OK, you say to start in a competitive equilibrium. Fine. Now, double both p1 and p2. OK, do that. What happens?

Your claim is that in barter (AD market), we'd still get efficient trade in goods 1 and 2 because the price ratio p2/p1 remains unchanged. I am not sure I understand/agree with this statement. The demand for good 1 here depends not only on that relative price, but also agent 1's wealth. And if p1 and p2 double, the purchasing power of agent 1 is diminished (recall, he owns good 3).

I think that I'd better stop here. Remember your post: Why Blogging is Hard? It sure is.

David: "The demand for good 1 here depends not only on that relative price, but also agent 1's wealth. And if p1 and p2 double, the purchasing power of agent 1 is diminished (recall, he owns good 3)."

Agreed. It changes the distribution of wealth in your model, because one person owns all the money.

Here's my model, which gets around that problem:

There are 3 goods: backscratching services, leisure, and gold (worn as jewelry). Separable Utility function U(Y,L,G). Gold cannot be produced.

All agents are identical, except: half the agents only enjoy backscratches on odd days, and the other half only on even days. You can't give and get a backscratch on the same day.

All agents are anonymous, so will only trade backscratches for gold, not for promises of a future backscratch. So gold becomes money. Let gold be numeraire. Price of a backscratch is P

Monetary equilibrium:

1. "Goods market": Marginal Utility of receiving backscratch/P = MU of gold.

2. "Labour market": Marginal disutility of giving backscratch/P = MU of gold.

("MU of gold" really means the MU of one extra bit of gold jewelry worn forever).

With flexible prices, P adjusts to satisfy both 1 and 2, so we get efficiency, where the MU of receiving a backscratch = the Marginal disutility of giving a backscratch.

Now suppose the government raises P above equilibrium (or, suppose P stays fixed and half the gold vanishes).

We get an excess demand for gold, and an excess supply of backscratches and leisure.

Equation 1 still holds, but at a lower quantity of backscratches. (exchange is voluntary, so the short side of the market determines quantity traded, and that's the demand side of both markets.

Equation 2 no longer holds. There is an excess supply of labour. Involuntary unemployment, even though the real wage stays at 1 (i.e if you give one backscratch today you get enough gold to buy one backscratch tomorrow).

Now suppose we drop the assumption that agents are anonymous, so we allow barter. "I will scratch your back this period if you scratch mine next period". We get the efficient quantity of backscratches again.

(I have ignored time preference in the above, for simplicity. This is fine if the "day" is short).

"All agents are anonymous, so will only trade backscratches for gold, not for promises of a future backscratch. "

How is gold not a promise of a future backscratch? It seems that you are imposing a condition on your model that says that there is zero debt -- no one can buy and sell "back-scratch coupons", but they can buy and sell gold. Now given that the market structure is important, shouldn't your market structure be a plausible model of the world?

Suppose you changed your model to allow people to borrow gold from each other. Then, you can imagine someone that wants a backscratch, but does not have gold from performing a previous backscratch to get one today. I.e., they can pull consumption forward, just as the storage of gold allows them to defer consumption.

In your model, it is possible to defer consumption, but not possible to pull it forward. That is why your model has a market disequilibrium. If you allowed people to borrow gold (i.e. go short) as well as to store gold (go long), then the disequilibrium goes away.

Moreover, then you would ask -- do we live in a world in which no one can go short money? The answer is no. They do not have a cash in advance constraint, they have a credit constraint. There is still a constraint, and you still have recessions, but not because of the medium of exchange per se.

This is not to say that you can't formulate models in which an increase in the desire to save in the form of the medium of exchange causes recessions, even if the overall desire to save does not increase.

But I don't think you can formulate such a model in an economy with a financial sector in which you can go both long and short the medium of exchange.

Once you allow that, all that matters is the interest rate, and in an zero-rate context, the last thing that there is an excess demand for is the medium of exchange.

RSJ: That model is not about money vs, bonds. It is about money vs. barter. So adding bonds would merely be a totally unnecessary complication.

If I were talking about money vs. bonds, I would do a different model.

Here's a similar model with bonds in it as well: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/the-is-curve.html

Nick, I will look at the post -- thanks for the link.

But in the specific case of the model presented here, the *only* reason why there is recession is because it is possible to defer consumption, but not possible to pull forward consumption.

Therefore any non-zero increase in the demand to defer consumption must result in lower output, since this demand cannot be balanced by households pulling forward consumption.

If you had bonds, then households could sell bonds and use the proceeds to buy backscratches and all the markets would clear (assuming the bonds were always correctly priced :)) The households would not be constrained by their gold holdings.

RSJ wrote: "Once you allow that, all that matters is the interest rate, and in an zero-rate context, the last thing that there is an excess demand for is the medium of exchange."

That depends on what the real interest rate is. If the real interest rate is -4%, if output is shrinking (or not growing as much), if prices are deflating (or not inflating as much), then there can still be plenty of rational demand for the medium of exchange as well: both individuals and corporations find no better place to put their cash into.

(Not to talk about irrational demand when unemployment is high and the economy is in trouble: the desire for safe, government-guaranteed deposits. That kind of sentiment can catch corporations as well and can induce them to keep more in deposits and bonds than they really should. "Be safe financially" is a strong survival instinct.)

RSJ: "In your model, it is possible to defer consumption, but not possible to pull it forward. That is why your model has a market disequilibrium."

That's not right. everyone has a stock of gold. Each individual can bring consumption forward by reducing his stock of gold. In equilibrium the representative agent is neither increasing nor reducing his stock of gold (except doing one on odd days and the other on even days). It goes into market disequilibrium because I put it there, by fixing prices at the wrong level, and not letting prices fall in response to excess supply of haircuts.

Nick:

Alright, let's take your example. The structure, by the way, is very similar to Townsend's turnpike model. As such, there is no need to stick gold (money) in the utility function; a medium of exchange will be necessary if agents are anonymous.

And, by gosh, can we not just consider a standard OLG model? Of course, in this case (as in Townsend's), we have n = infinity (the number of prices, or markets). Hope this doesn't cause a problem for Walras' law.

So let's consider an OLG model. If agents are not anonymous, then we can support efficient trade; say, by relying on trigger strategies for noncompliance. No money is needed.

But if agents are anonymous, a monetary instrument is needed. Consider a stationary equilibrium; there is a constant price level, P1 = P2 = P3 = ... = P.

Now, imagine that the government (or whatever) to lower P1 < P (a transitory shock). Or, for that matter, consider some arbitrary and random pattern P1, P2, ...

The statement you seem to want to make here is that: [1] given a non-market-clearing price system in a monetary economy, we have excess demands and corresponding excess supplies all over the place. I agree; though I'm not sure what this has to do with the complaints about Walras' law. [2] in a non-monetary (credit) economy, efficient trade is still possible. I agree.

So the basic lesson is that when the value of an economy's medium of exchange is somehow screwed up, this screw up affects all markets--in a way that would not happen in a pure credit economy. If this is the basic idea, then I'm fine with it. Though, now I'm not sure why we talking about Walras's law.

Perhaps you can tie it all together for me?

David: we are on the same page.

Let me relate it to Walras' Law.

In an economy with one centralised market, and n goods, there are n excess demands.

In a monetary exchange economy, with n goods, there are n-1 markets, in each of which one good is traded against money. Let me propose "Nick's Law" for a monetary exchange economy. Nick's Law is trivial, but true.

Nick's Law says that in each of those n-1 markets, the excess demand for the non-money good must equal the excess supply of money *in that market*. P1X1=M1. P2X2=M2, etc. So there are n-1 excess demands for non-money goods, plus n-1 excess demands for money. And those 2(n-1) excess demands sum to zero trivially, since each pair sums to zero in each market.

And Nick's Law has nothing to do with anyone's budget constraint. It follows simply from the fact that people pay for stuff they buy. To answer Arnold Kling's question "Who enforces Walras' Law?". Well, nobody enforces Walras' Law, because it's false. But who enforces Nick's Law? Answer: the cops!

"That's not right. everyone has a stock of gold. Each individual can bring consumption forward by reducing his stock of gold."

What happens when enough people run out of gold?

What happened to my reply(ies) to RSJ?

TMF: they won't, in my model.

I unpublished your other comments because they were off-topic. This post is about money, not debt.

Nick @7:53

"Each individual can bring consumption forward by reducing his stock of gold."

They obtained the stock of gold in period n, by deferring consumption in that period. In period n+3, they reduce their stock of gold and increase consumption. The entire operation is a deferral of consumption by 3 periods, in which households consume in period n+3 what they could have consumed in period n.

*If* the only way to obtain gold is to sell a good (your hypothesis), then the only way to obtain a positive stockpile of gold is to sell goods and not spend all of the proceeds. So in this model, you must first save before you can dissave.

If you start the model of with a helicopter drop of 100 coins in period 0, then there can be 100 gold coins of savings and 100 coins of pulled forward consumption at any point in time. But that's it. You have an arbitrary constraint on savings and dissavings constrained by the quantity of coins. In general, the savings and dissavings desires wont have anything to do with the quantity of coins.

The key here is that the only way to obtain gold is to sell a good and not spend the proceeds on another good.

That is the channel by which demand for gold spills over into disequilibrium in the goods market why you believe that OMO have an effect other than expressed in interest rate effects.

But once you can obtain gold without selling goods -- by selling bonds -- then it becomes possible to both defer and pull forward consumption by amounts far greater than the stock of gold.

As soon as you introduce a financial sector, then is no such thing as an excess demand for money that is not equivalent to an excessively high interest rate.

But in barter markets, you can also have excessively high interest rates (e.g. with corn bonds) that have the exact same effects.

The only place where money is "special" is when you assume both a monetary economy and remove the financial sector -- e.g. no money markets or banks. Or equivalently, you impose a cash-in-advance constraint, so that no can sell a bond and then spend the proceeds in the same period. Or equivalently, you assume that bond holdings are always zero.

But unless you somehow remove the financial sector from your monetary model, you aren't going to get recessions just from an increase in the demand for the medium of exchange in which overall savings demands are held fixed. What is important is the overall savings demands and whether the interest rate clears those demands.

RSJ: A stock of gold exists. All individuals are identical (except for the odd/even timing). Therefore they all have gold.

You can introduce bonds into the model, but if barter is allowed, you can't get a recession. Unemployed backscratchers just scratch each others' backs, even if there is an excess demand for gold, bonds, whatever.

Right, introduce barter and the recession goes away. Introduce bonds and the recession goes away, too.

The recession is only there because you don't have enough gold to meet savings demands.

As soon as you de-couple the ability to save from the (fixed) quantity of gold, then savings demands will be met and the recession goes away.

So the recession in your example was "fake", in the sense that it only existed because you required monetary exchange but didn't allow for money markets. Relax either assumption and the recession goes away.

Or perhaps you changed the model? The gold stock is not fixed, and everyone is not the same; their preferences are the same but their state, in terms of endowments, is alternating.

You have two generations, with those who cannot scratch backs on odd days, and these have more gold on odd days, with which they buy backscratches. The scratching switches some of the gold stocks back and forth between these two groups, in equilibrium.

The general equilibrium is not a micro-equilibrium, in the sense that the gold holdings are constant for each person across time. They alternate. The source of the recession is the assumption that you need gold in order to buy a backscratch, and you don't have it. Introduce money markets, and you can borrow it, buy a backscratch, and the next period you can sell a backscratch and repay the debt (or roll it over). No recession, unless it it due to the interest rate being too high.

OK, the above may have been a little incoherent. Let me try another tack.

In an economy in which half the group can produce output on odd days, and the other half can produce output on even days, and the output cannot be stored, then if you were in a pure barter situation with no bonds, then only those who can produce output would do so, and 1/2 of the actors would go without any output at all times.

Now if you assume diminishing marginal utility, that means that overall utility would be lower than if those who can produce output are able to somehow "sell" their output to those who have nothing to give in return *in the current period*. Therefore, for a given disutility of labor, overall output would be lower in the no-bond situation.

Now, if you add the ability of people to issue IOUs that can be redeemed for future backscratches, then overall output and employment would go up due to the gains in trade.

Similarly, if you convert this economy to a monetary economy, then "money" in this economy is nothing more than an IOU for a future backscratch, Output would again go up.

But gold isn't a particularly good substitute for an IOU, because the total stock of gold is fixed, whereas the stock of IOUs needs to be flexible in order to respond to changing savings preferences. If you only have gold, then a decrease in the demand for consumption goods in the current period could be because people prefer leisure, or just don't want consumption, or it could be because they do want more consumption, but only in a future period. In the former case, it's not a recession. But you don't which unless you have a bond market. The bond market channels the decrease in the demand for present consumption goods into an increased demand for present capital goods, so that the economy does not experience an overall decrease in demand in the present period if there is a general shift away from present consumption and towards future consumption.

So gold satisfies the role of allowing intertemporal substitution, but it doesn't send the right price signals when there is a shift in demand, which is what you expect since your economy is missing a money market.

So the source of the recession is that gold is only a good substitute for bonds if everything is fixed. When preferences or demands change, then gold stops effectively playing the role of bonds, and then you get the recession and you start reverting the lower levels of output and employment that you would see in the no-bond situation.

But given the economy that you described, what is important is that people can create and sell a non-produced good in exchange for the produced good when they are unable to produce. Anything that interferes with this will cause a recession. This has nothing to do with the transaction technology, but with intertemporal substitution, so it is fundamentally all about bonds, at least in the example you described.

RSJ: You have misunderstood it.

In the context of this model, "barter" means "If you give me a backscratch today, I promise to give you a backscratch tomorrow". And the reason they can't barter, and have to use money, is that they are anonymous, so that promise would be unenforceable.

It's a simple way to get monetary exchange into the model. I could have used other ways, like assuming there's a taboo against giving a backscratch to anyone from whom you have recently received one from. These are all just ways to make sure there is no double coincidence of wants, without having a very complex model with multiple goods. The temporal sequence isn't essential. Though we do in fact observe people's money balances rising and falling day to day. But this is very high frequency stuff, not like the much lower lifecycle frequency at which we see people save and dissave.

Now, one picky point: I know that finance people and business people frequently use the words "money market" to mean the market for short term bonds/loans. But when you are talking about models of monetary exchange, it is a really bad idea to use the words "money market" in that way. What you really mean is "bond market". Because in a monetary exchange economy, *all* markets are money markets. Apples are bought and sold against money. But we call that market the "apple market". Similarly, we should call the market where bonds exchange for money the "bond market".

Now, suppose I introduced one extra agent into may model who was not anonymous (say, "the government"). The government could then make enforeable promises, i.e. issue bonds. Depending on the rate of interest offered on those bonds, and whether it would compete with gold, those bonds would be used as money. If I wanted to change the model, so that bonds weren't used as money, so we could distinguish money from bonds, I would need to change the model again. I could assume, for example, that bonds could only be exchanged once a month, when the government office opened to record ownership changes.

Hmm, are you saying that I misread the model, or your intentions of the model? A model is there to enforce consistency; you can't say "well, even though the money holdings are not constant, I'm going to assume that they are." If the model says that they aren't, they aren't.

You have complete freedom in picking what you want to put into the model, but you don't have any freedom in adjusting the outcome. Besides, how hard would it be to say that "aggregate money holdings are constant, but individual money holdings are periodic". The word periodic only has a few more letters in it :)

More seriously, what OLG models tell you is that equilibrium for the economy does not equal equilibrium (in the sense of constancy across time) at the level of the individual. Now this poses a problem when you are constructing a representative agent, but not an insurmountable problem -- your representative agent will not behave the same way as an individual, that's all. The micro individuals (and firms) will have a lifecycle, whereas the representative agent will not. The overlapping lifecycles will lead to emergent effects due to interactions between individuals and firms in different states, and this should be the focus of macro, right? I.e. an individual borrows and repays, but the representative individuals merely maintains a certain debt to income level, in equilibrium. Similarly, government does not "repay" debt, but maintains some debt to GDP level. And firms do not repay debt, but maintain some capital structure of equity/debt. Total debt is not zero, in equilibrium.

About money markets, yes, you are right. But now I get to point out how non-sensical the treatment of bonds is :) Basically, in a model when you say "bond", you mean any financial claim that can be purchased in order to obtain a return across time.

But that includes equity, so you cannot impose a market clearing condition that bond holdings = 0. That is like saying that all financial asset holdings = 0, when we know that even without household borrowing, bond holdings would grow with the market value of the capital stock, and once you add household lifecycles, then you can have additional levels of debt. So you cannot argue that the interest is such that bonds = 0.

That, too, is an example of improperly using a representative agent to model transactions between actors in different states. The firm sells bonds (or equity) and households acquire them, and young households purchase a house on credit, going into debt which they repay when old, and the savings necessary to repay the debt come from the younger generation of borrowers. Similarly, firms that dissave by purchasing capital supply savings to firms that have already invested in previous periods and now need to earn a return on their investment, etc.

I would argue that the most basic models should take this transactional approach, and then accept what the various outcomes can be, in terms of the quantity of bonds and interest rates at any point in time; i.e the aggregate quantities (e.g. total output, total bond holdings, total employment) are derived from a proper accounting of transactions between individuals in different states, rather than imposing wierd ansatz without micro foundations (such as assuming that there is some aggregate "supply" of loanable funds which is an increasing function of the rate of interest), and then deriving the dynamics of the model based on the ansatz, rather than based on what the micro interactions predict.

About running out of gold, I think I need a model with workers and corporations and something "bank like", which does business in currency.

Let's say in year 1 the amount of money is just right vs. the amount of goods. The next year productivity rises 4%, and there are 4% more goods.

Does more money need to be "produced"? If so and the way the system is set up now, is all new (emphasize new) "money" demand deposits?

I've been trying all morning to figure out what's bothering me about this post, and I think I've finally figured it out. What we have is an excess demand for savings. Because our economy is monetized and money keeps well, this generally manifests itself as an excess demand for money; however, one could easily picture a similar outcome in a barter economy.

Let's say in this barter economy, for whatever reason people become convinced that next year's harvest will be much smaller than this year's. They want to save in order to smooth consumption. Obviously, the most obvious solution is for people to keep producing what they're producing, but stockpile it. This doesn't work because some goods are much more perishable than others. Some have higher carrying costs than others. Services could be considered to be instantly perishable. Now, the ultimate impact is not totally unlike in a monetary economy. Overall consumption falls, which means producers of rapidly perishable goods and services suffer, while durable items that could be bartered at a future date continue to be produced. (If you look at historical precedent, it might be hard to find given that most barter societies did not exhibit today's degree of specialization; in most of those people would just shift their own production and most of the output loss would come from people producing goods they're less skilled at producing.)

In a monetized economy, the set of durable goods used to save is much more restricted (generally just money and other financial assets), but the principle is the same.

Victor: "What we have is an excess demand for savings. Because our economy is monetized and money keeps well, this generally manifests itself as an excess demand for money; however, one could easily picture a similar outcome in a barter economy."

I like your comment. You have addressed the key issue. That's what many/most economists think. I think they are wrong.

Let's take a barter economy, with 2 goods: wheat (perfectly storable), and berries (can't be stored at all). No money or bonds or loans or anything else. There is only one market, where wheat is swapped for berries.

Start in equilibrium. Then, as in your example, people expect a bad wheat and berry harvest next year. So everybody wants to save more.

But notice, in this economy, desired savings *is* desired investment. Stores of wheat are both saving and investment. We could equally say that everybody wants to invest more. The demand for wheat, in terms of berries, has increased.

If the price is flexible, the price of wheat rises in terms of berries, but the market still clears.

Now suppose instead that the price is fixed (by law, or whatever). So there's an excess demand for wheat in terms of berries. One produced good (berries) is in excess supply. But the other produced good (wheat) is in excess demand.

As always, if the relative price of two goods is fixed, and there's a shift in relative demand, bad things will happen. But, there is no general glut of produced goods.

Furthermore, we would get similar problems if people suddenly expected a bumper harvest next year (and so want to store less wheat than they normally do). Desired savings = desired investment would fall. The demand for wheat in terms of berries would fall, and we would get an excess supply of wheat and an excess demand for berries.

"But notice, in this economy, desired savings *is* desired investment."

I think this is the key point of dispute. Suppose that there was a barter economy in which desired savings was not automatically desired investment. This would require some form of bonds, of course.

Now, are you saying that

1) Such a situation is impossible in a barter economy
2) Such a situation is possible, but it would not lead to a general glut

?

RSJ: "Suppose that there was a barter economy in which desired savings was not automatically desired investment. This would require some form of bonds, of course."

Or, it could be a durable, non-produced good, like land, rather than bonds.

OK, a simple model with berries, peaches, and land. No money, so each of the 3 goods can be traded with each of the other two.

Start in equilibrium. Then people expect a bad harvest of berries and peaches next year, so everyone wants to save (i.e. buy land). The price of land should rise, relative to berries and peaches, but can't, because prices are fixed. In the land/berry market, there's an excess demand for land/excess supply of berries. In the land/peaches market, there's an excess demand for land/excess supply of peaches. But in the berries/peaches market, there can be market-clearing. Berry producers swap their berries for peaches produced by peach producers. There's nothing to prevent the optimal production of berries and peaches, since there's no reason for their relative price to change.

But if land were used as the medium of exchange (i.e. if there were no berry/peach market), then there would be underproduction of berries and peaches.

To give you the intuition, suppose there were a durable good that everyone wanted to buy, but it didn't exist, so they couldn't buy it. Venus dust. There's an excess demand for Venus dust. But that doesn't prevent full employment. Land is like Venus dust. Sure, it exists, but you can't buy it, because everybody wants to buy and nobody wants to sell (at the fixed price). Same with bonds, in a barter economy.

Nick, I agree with your example, but this isn't the only possible model of a barter economy, and in particular your example does not have a forward looking economy with long-lived capital goods.

Suppose that the bonds are not used to finance the purchase of land, but for the production of capital goods which themselves add to demand.

Imagine an economy of planters and harvesters. Land is free, but it's jungle. You have to pay people to clear the jungle and plant it, and this requires 1 period of time. Once the land is cleared and planted (to keep things simple and avoid depreciation) assume it produces a harvest every period forever.

During the planting period, workers still need to be paid and they still need to eat, but they are not producing anything other than cleared land. You cannot take a piece of cleared land and pay someone with it. You can only pay someone with a claim on the future output arising from the use of the land. If you want, you can think of this as the "missing market" in your barter model.

Enter bonds -- the firm sells consols for corn and uses the proceeds to pay wages (in corn) during the planting season, in which case it creates 1 unit of planted land. When the firm is in harvesting mode, it pays interest (in corn) to its creditors and pays wages (in corn) to its workers.

You have an arbitrage condition that says that the market price of the consols can't be any different than the costs (in terms of wages) of creating more planted land in a given period. Suppose it takes 1 unit of labor to create planted land. Let corn be the numeraire. Instead of assuming that a single firm increases it's own capital stock, assume that each firm has exactly 1 unit of planted land, and the number of firms increases.

Therefore the current period wage, w_n, is going to be equal to the price of consol owed by harvesting firm:

w_n = P_n/(1+R) + P_(n+1)/(1+R)^2 + ….

where R is the rate of interest and P_n is the expected corn profit delivered each period to bondholders. Note that P_n is a function of n, but R is not, because that would allow arbitrage. The interest rate on the consol cannot be expected to change from period n to period n+1.

And this means that if the firms expect low profits in the current period, but higher profits in the next period, then neither the current period wage nor the current period interest rate can adjust to allow the spot markets to clear.

Now you can argue that over the long term, P* and R* will be such that w* is the market clearing rate. But there is no reason to believe that over the short term this would be the case, as both w and R are not determined by the spot markets.

If the consol rate is too high, then the fact that there are a lot of people lining up, willing to be hired for cheap isn't going to lower the wage rate in our model, because the same fact means that the enterprise value of all existing firms is plunging relative to that discount rate, and therefore the surplus value that the firm believes it can obtain from hiring the worker is falling just as fast as the asking wages -- i.e. demand for labor does not increase as a result of a decline in the wage rate if the reason for unemployment is an excessively high discount rate, rather than an excessively high wage rate.

Oops -- the last paragraph should read "the fact that there are a lot of people lining up, willing to be hired for cheap isn't going to lower the unemployment rate in our model", the rationale being that if w is falling, then so are the expected P_n's.

Nick: "But in the berries/peaches market, there can be market-clearing. Berry producers swap their berries for peaches produced by peach producers. There's nothing to prevent the optimal production of berries and peaches, since there's no reason for their relative price to change."

I think your argument is incomplete here. The berries/peaches market only pins down the *relative* prices of berries and peaches. Let's say it's 2 berries for a peach. How does that say anything about the total aggregate level of production of fruit?

All we know is that we should produce 2 berries for every peach to clear that market fine. That can be done with 2 berries and 1 peach or 4 berries and 2 peaches or...

You've still said absolutely nothing to explain why the barter economy can't have a general glut of the fruit if the land is in excess demand.

Adam: OK. But I thought my "Venus dust" analogy explained why you still get the efficient output of berries and peaches.

Let's see, in the berry/peach market, we have the following equilibrium conditions:

MRT berries into peaches = Pb/Pp = MRS berries into peaches

MU berries = (Pb/Pp)MPL in peaches x MULeisure

MU peaches = (Pp/Pb)MPL in berries x MULeisure

The price of land doesn't appear in these conditions. If both Pb and Pp both double in terms of land, it doesn't affect the equilibrium.

In order to affect those equilibrium conditions, you would need to assume that being unable to buy extra land affected the MU of leisure or MU of consumption differently for the peach producers than the berry producers. You would need some sort of asymmetry between berries and peaches.

If the utility functions were separable in berries, peaches, land and leisure, for example, everything should be unaffected.

RSJ: I think I am more or less following your model.

Here's a simplified version.

There are two classes of people: rentiers, who own cleared land and can either consume the wheat it produces, or use that wheat to buy more land; and workers, who clear land and sell it to rentiers, for wheat, and consume the wheat. The only market is where land is swapped for wheat.

In this model, the price of land in terms of wheat is the very same thing as the real wage. It is also the very same thing as the inverse of the (infinite horizon) real rate of interest.

So yes, if the government by law fixes the price of land too high, then it is also fixing real wages too high (and the real rate of interest too low), and capitalists will choose to consume rather than save/invest, and the workers will be unemployed. There's an excess supply of land (and labour), and an excess demand for wheat.

But this is really just the same story as unemployment caused by a binding minimum wage law.

Notice also that even though there's an excess supply of land, it's not a general glut of newly-produced goods, because it's matched by an excess demand for wheat.

Notice also that the unemployment has been caused by the government setting the rate of interest too *low*, not too high.

"In order to affect those equilibrium conditions, you would need to assume that being unable to buy extra land affected the MU of leisure or MU of consumption differently for the peach producers than the berry producers. You would need some sort of asymmetry between berries and peaches."

That's easy to get, you assume that the bad harvest is only for one of the fruits. Suppose it's not a generally bad harvest that reduces peach and berry output by exactly the same amount.

Suppose it's only peaches that are expected to have a bad harvest. Then peach producers want to buy land instead of berries. Thus berry producers can sell their land to the peach producers but not their output. So that's what happens, we get a glut of berries. Berry producers respond by contracting their output and taking more leisure today (this is also their optimal response).

Tommorrow the extra land the peach producers have allows the berry/peach market to clear at 2berries/peach (though less aggregate output as must happen with the bad peach harvest).

Adam: Peach producers will want to sell their peaches for land, not berries. Agreed. But if all prices are fixed, the berry producers will not want to sell their land. So peach producers won't be able to buy land with their peaches. So, facing this additional quantity constraint, they revise their plans, and sell their peaches for berries instead. They do the second best thing. It's better than letting the peaches rot.

But, in general, your point is correct. If prices are fixed, any change in the relative demands or supplies of peaches and berries will cause an excess demand for one and an excess supply of the other, in the market where they are swapped.

Things can go wrong in a barter economy. My point is that in a monetary exchange economy, *more* things can go wrong. You get all the things that would go wrong in a barter economy, plus some other things that cannot go wrong in a barter economy. Introducing (hypothetically frictionless) barter into a monetary exchange economy (even with prices fixed at the same level) is like opening up an additional set of markets, and those additional markets will sometimes allow additional mutually advantageous trades to be made.

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