"Deficiencies of aggregate demand are always and everywhere a monetary phenomenon". There's an excess supply of newly-produced goods, and an excess demand for money. But what exactly does an excess demand for money mean? And what does it mean for the effectiveness of monetary policy?
Aggregate demand for goods is a demand for those goods in terms of money. At least, that's true in a monetary exchange economy, where all goods are bought and sold for money -- the medium of exchange. If we have a deficiency of aggregate demand, as most macroeconomists believe we currently do, that means that Say's Law ("supply creates its own demand") is currently, as an empirical matter, false.
In a barter economy, where people offer to buy goods by offering to sell other goods, Say's Law would be true. The excess supply of some goods would be matched by an equal value of excess demand for other goods.
In a monetary exchange economy it is well-understood that Say's Law can be false. There can be an excess supply of goods, if it is matched by an equal value of excess demand for money.
That last sentence is true, but misleading. The reason why it is misleading is not well-understood at all. In a monetary exchange economy there is no such thing as a unique excess demand for money. There are as many excess demands for money as there are markets. And the aggregate of those excess demands for money does not represent the quantity of extra money that people want to hold.
Let me briefly re-cap one of the conclusions of the "disequilibrium macro" literature of the 1970's. I mean Clower, Patinkin, Leijonhufvud, Barro-Grossman, Benassy, Dreze, etc. (I am going to avoid taxonomic debates over exact definitions of "Say's Law", Say's Principle", Walras Law" etc., because there seem to be as many taxonomies as there are economists who have thought about these issues carefully.)
People (and firms and governments) face budget constraints. If people formulate their demands and supplies of goods reflecting that budget constraint, then we get Walras Law. The individual's planned purchases of goods must be financed by planned sales of goods, including money. So the value of each individual's excess supplies of goods must equal his excess demand for money. Aggregate across all individuals (plus firms and governments) and we get Walras' Law: the value of the excess supplies of goods must equal the excess demand for money.
So Say's Law is false, because it forgets money, and Walras' Law is true, because it remembers to include money.
But that's not right either. Or rather, it would only be right if we are talking about notional excess demands and supplies. A notional demand or supply of apples is the amount of apples that people would want to buy or sell if they ignored any constraints on the quantity of other goods they were able to buy and sell. Notional demand and supply functions are what you get when you maximise utility subject to the budget constraint and subject to no other constraints on how much you can buy or sell.
Walras' Law is true if it is interpreted to be speaking about notional excess supplies and demands.
But if we are out of equilibrium, there will be excess demands in some markets, and/or excess supplies in other markets, and people will not be able to buy or sell as much as they want to, because they won't always be able to find willing buyers or sellers. They will be quantity constrained. The insight of Clower and Patinkin was to recognise that quantity constraints in one market will spillover into demands and supplies in other markets. If I want to buy apples, but can't because there's an excess demand for apples, I might decide to buy pears instead. If I want to sell labour, but can't because there's an excess supply of labour, I might decide to buy less carrots.
In disequilibrium, people (and firms and governments) face quantity constraints as well as budget constraints. If people formulate their demands and supplies of goods to maximise utility subject to their budget constraint and subject to quantity constraints, we get constrained (or effective)demand and supply functions, not notional demand and supply functions.
I go to the supermarket with $10 in my pocket planning to buy $10 worth of apples and no pears. Those are notional demands. Excess demand for apples $10, and excess supply of money $10. Walras' Law applies. But when I get to the store there are no apples, so I re-maximise my utility function, including that quantity constraint, and decide to buy $10 of pears. Excess demand for apples $10 (because I still want the apples). Excess demand for pears $10 (because I can't buy apples). Total excess demand for goods (apples plus pears) $20. But what's the excess supply of money corresponding to that excess demand for goods? $20? But I only have $10 in my pocket.
I go to the labour market with $0 in my pocket, planning to sell my labour for $100 and then visit the supermarket and buy $100 of groceries. These are notional demands and supplies. Excess supply of labour $100, excess demand for groceries $100, excess demand for money $0. Walras' Law applies. But when I get to the labour market I can't sell my labour, so I re-maximise my utility function including that quantity constraint, and don't go to the supermarket. Excess supply of labour $100, excess demand for groceries $0. But what's my excess demand for money? $100? But I don't want to hold money; I want to spend it on groceries. But the supermarket never gets that signal.
In a Walrasian economy there is one big market, where everything can be traded for everything else, so we submit all our demands and supplies in one big unified decision, maximising utility subject to the budget constraint only. But in a monetary exchange economy, with N goods (excluding money) there are N markets (where each of the N goods trades for money), and we face N decisions. (Benassy's "multiple decision hypothesis", rather than Clower's "dual decision hypothesis", because Clower thought in terms of only two markets: goods and labour). In each market, we maximise utility, subject to the budget constraint, and subject to any quantity constraints in all the N-1 other markets.
In a Walrasian economy, with one big market, and a unified decision, Walras' Law is true. The sum of the excess supplies for goods will equal the excess demand for money (though it is hard to see what "money" could mean in such an economy"). But in a monetary exchange economy, with N markets, there are N decisions, and N different definitions of the excess demand for money, each corresponding to one of those N decisions. In each of those N markets the excess supply for that good will equal the excess demand for money in that market. So if we add up the excess supplies of goods and excess supplies for money we will find they are equal. But that total excess demand for money across all markets won't correspond to any economically meaningful concept. It does not represent the extra amount of money that people want to hold.
Now, what's all this got to do with monetary policy in the current recession (if anyone's still reading)?
If the problem is a deficiency of aggregate demand, then firms have an excess supply of output. They want to sell more output at current prices but cannot. Households have an excess supply of labour. They want to sell more labour but cannot. Firms' constraint on sales affects their demand for labour, so their demand for labour is less than their notional demand. Households' constraint on selling labour (plus their lower shares of firms' profits because firms are sales-constrained) affects their demand for output, so their demand for output is less than their notional demands.
So the output market shows an excess supply of output matched by an excess demand for money (by firms). But firms don't want to hold that money; they want to spend it on labour and distribute the remainder to households as profits. And the labour market shows an excess supply of labour matched by an excess demand for money (by households). But households don't want to hold (all) that money; they want to spend (most of) it on output.
What's happening in the bond market? Just as in any of the other N markets, bonds are bought and sold for money. Any excess supply of bonds must be matched by an excess demand for money in that market. But suppose the bond market is in equilibrium, either because interest rates adjust quickly, or because people are indifferent between holding additional bonds and additional money. Then there is no excess demand for money in the bond market.
If you accept my description in the above two paragraphs, then the current recession is a monetary phenomenon. In a barter economy, the households with an excess supply of labour could exchange their labour directly with firms who have an excess supply of output. But in a monetary exchange economy they do not do this, for obvious reasons. We have money, not barter, because an individual worker and firm do not have a double coincidence of wants.
Since the underlying problem is monetary in nature, fiscal policy, if successful, must be a continuation of monetary policy by other means. It is an attempt to reduce the demand(s) for money. It works, if it does work, either by reducing the private demand(s) for money (increasing velocity), or because the government has a lower demand for money than the private sector, so switching demand from the private to government sector increases the average velocity of circulation.
There is an excess demand for money in the output market. And another excess demand for money in the labour market. But this does not mean that firms and households want to hold more money; if they got it they would want to spend it (or most of it). So the central bank would not need to create anywhere near as much money as those excess demands for money would indicate. It is logically conceivable that a single $1 would be sufficient to eliminate trillions of dollars excess supply of goods.
And the fact that the bond market is clearing (or the fact that the one portion of the many bond markets in which central banks currently choose to operate is clearing) tells us nothing about the excess demand(s) for money in the rest of the economy -- in all of the other N-1 markets. If central banks operated in the market for pears, an equilibrium in the market for pears would mean zero excess supply or demand for money in that market, but would tell us nothing about the excess demand or supply of money in the market for apples.
Just because one market is satiated with money does not mean that the economy as a whole is satiated with money. In a monetary exchange economy, there are as many different excess demands for money as there are goods (excluding money). If central banks "run out of ammunition" in one market, they can just switch to one of the other N-1 markets.
And the market for very short term and very safe and very liquid bonds is a very peculiar market for central banks to be operating in anyway, just because they are so close to money. If we used apples for money, it would be like the central bank operating in the market for pears. At the right relative price, apples and pears might become perfect substitutes, and open market operations might become irrelevant.
Just trying to get my head back into monetary theory and policy after a 2-week vacation.
Nick,
"Aggregate demand for goods is a demand for those goods in terms of money. At least, that's true in a monetary exchange economy, where all goods are bought and sold for money -- the medium of exchange."
I want to see if I can induce any doubt in your mind about the relevance of this. If you just briefly browse The Theory of Money and Credit by Mises, you don't need to pay any attention to the rest.
1. The quantity or supply of money is equal to the sum of the money held by all holders of money at any instant in time. For a given supply of money, this means that everyone is in competition to hold a desired portion of that money.
2. Let's say you are paid $1000 once a month and you spend all of it in a single monthly rent payment. Is it not clear that the degree of your competition for the holding of money depends critically on the relative timing of the two payments? At one end you might make your rent payment the day after you receive your income. In this case, you have a one day demand for holding $1000, with no demand for the rest of the month. At the other end you might make your rent payment the day before your income payment. In this case you have a 29 day demand for holding $1000. In the first case, just $1000 in money supply could satisfy up to 30 people if the timing were carefully adjusted. In the second, just you could be satisfied.
3. You don't actually need to hold money for an extended time to buy goods. You could hold even non-checkable MMF's up until the point where you would need to convert them to actual money for making a purchase.
I'll stop there.
Regards, Don
Posted by: Don Lloyd | April 16, 2009 at 11:45 PM
Hi Don: It's a long time since I read von Mises Money and Credit, but I don't think I say anything here that would contradict Mises' view. True, there is the demand for money conceived as a stock, and the demand for money conceived as a flow. I was not explicit on the stock/flow distinction (I expect I was implicitly thinking in discrete time terms, where everything is a stock), but I don't think I say anything that could not be re-said making it explicitly consistent with that distinction. Money is the medium of exchange. That's what's key.
Posted by: Nick Rowe | April 17, 2009 at 12:04 AM
Nick,
The number one take-away from Mises is that all demand for money is a demand to hold and that the need for holding money would approach zero if it weren't for the fact that the future is uncertain. Otherwise you could invest all your money for interest with a maturity that returns it in the nick of time for a payment.
When a purchase is made all that happens is that the purchase price is transferred from the buyer to the seller. The supply of money isn't changed or even stressed.
Regards, Don
Posted by: Don Lloyd | April 17, 2009 at 01:25 AM
Nick: "I go to the supermarket with $10 in my pocket planning to buy $10 worth of apples and no pears. Those are notional demands. Excess demand for apples $10, and excess supply of money $10. Walras' Law applies. But when I get to the store there are no apples, so I re-maximise my utility function, including that quantity constraint, and decide to buy $10 of pears. Excess demand for apples $10 (because I still want the apples). Excess demand for pears $10 (because I can't buy apples). Total excess demand for goods (apples plus pears) $20. But what's the excess supply of money corresponding to that excess demand for goods? $20? But I only have $10 in my pocket."
This is all wrong. If I go to the store wanting $10 worth of apples and then, on finding no apples, SUBSTITUTE $10 worth of pears then I no longer demand $10 worth of apples. I do not demand $10 worth of apples AND $10 worth of pears. Once I buy the pears there is no longer an excess demand for apples because I don't have any money left. More generally, if I have $10 I might like to have $20 worth of stuff but I can't afford it, nobody would say that this leaves a $10 excess demand for goods. After all, I'd like a Porsche but I don't have enough money. Does that mean that there's an excess demand for Porsches? I don't think so.
Posted by: Adam P | April 17, 2009 at 04:04 AM
Don Lloyd,
I don't believe your model of the transactional demand for money (not the only demand) is realistic. Most people like to have money in their pocket, not just because the world is uncertain (regarding supply and demand) but because they don't know what they want. People LIKE to be able to impulse shop. The idea that they plan all purchases is a fable.
Posted by: reason | April 17, 2009 at 04:52 AM
Don Lloyd,
besides which, what is the point of the story? There is a demand for money that varies according to income and interest rates (of money and near substitutes) stochastically. Is anything else relevant?
Posted by: reason | April 17, 2009 at 04:55 AM
Don Lloyd,
I think your post does however illustrate the problem the monetary theorist has today. Just what EXACTLY is money? Mises thought it was clear, I'm not so sure.
Posted by: reason | April 17, 2009 at 05:01 AM
Just continuing from my last comment, the problem with the example is that you haven't said anything about prices. Thus you can't say if we are in or out of equilibrium.
Let's suppose that apples and pears both cost $2 a piece and I have $10. I show up at the store planning to buy 5 apples but only 2 are there. What happens next? In the Walrasian market with flexible prices I bid up the price of apples. Do I bid the price all the way to $5? Probably not, apparently I consider pears a substitute for apples, even though I prefer apples when the price are the same. As the price of apples rises the pears start looking like a better deal, I probably start substituting away from apples and towards pears before the price of an apple hits $5. Of course, in the proper Walrasian market sellers of apples don't have to post a price before the market opens. The prices and quantities are all jointly determined, and all determined at the same time.
Now, if the prices of apples can't change then I buy the 2 apples that are there and, at the posted price, would like to buy 3 more. This sure sounds like an excess demand for apples but I think it's an illusion. If there really is no way to get more apples then no matter how much money anyone offers the vendor he won't sell them another apple because he can't, there are no more. This sounds to me like an infinite price. You can insist that we are out of equilibrium by saying that apples are still priced at $2 but does it really make sense to insist that there is a fixed, finite price for something that isn't on the market?
Posted by: Adam P | April 17, 2009 at 05:23 AM
reason, money is anything that the government accepts as tax payment.
Posted by: Adam P | April 17, 2009 at 05:41 AM
Adam P: Walras' Law is supposed to hold true at any vector of prices, whether it is an equilibrium or a disequilibrium vector. Since I was unable to buy all the apples I wanted to buy, there must have been an excess demand for apples, so I was assuming a disequilibrium price vector in my example. In Walrasian equilibrium theory, the Walrasian auctioneer calls out a price vector at random (prix criee au hazard if I remember the French), collects demand and supply information, and then adjusts prices if there is excess demand or supply (tatonnement), *but does not allow trade to take place until all markets are clearing*. All offers to buy and sell are provisional, and are only binding if the price vector turns out to be the equilibrium one (tatonnement with Edgworthian recontracting). The Walrasian auction is conducted outside of time, not in real time, so no actual trade takes place at disequilibrium prices. The whole point of the "disequilibrium macro" approach (which could also be called "Non-Walrasian general equilibrium (or disequilibrium) theory" is to ask what happens when we drop the assumption of Edgworthian recontracting, and to allow trade to begin at disequilibrium prices, before the auctioneer has finished his tatonnement.
If trade takes place at disequilibrium prices, some markets will be in excess demand, and so buyers will be quantity-constrained, and some will be in excess supply, so sellers will be quantity-constrained. In each case, actual quantity traded = min{quantity supplied, quantity demanded} (the short side of the market rules). We then analyse how those quantity constraints will spill over into demands and supplies in other markets, which affects quantity constraints in those other markets. The Keynesian multiplier process is interpreted as one example of such spillovers. There is excess supply for output, so firms are quantity-constrained in their sales. This spills over to affect firms' demand for labour and other inputs (why hire extra labour if you can't sell the extra output?) so firms' demand curve for labour is no longer the value marginal product curve for labour. (The constrained demand curve for labour will be a very different beast than the notional demand curve for labour; for example, if labour is the only variable input the constrained demand curve for labour will be vertical -- not affected by the real wage -- even if the notional demand curve is downward-sloping). And then workers find themselves even more constrained in thei ability to sell labour, which spills over into their demand for consumption, etc.. Which is just the Keynesian multiplier, analysed formally.
You could say that it assumes quantities adjust more quickly than prices, reversing the standard Walrasian assumption, so you get a tatonnement on quantities first, and then a tatonnement on prices second.
For simplicity, suppose we are at the Walrasian equilibrium price vector, then the government passes a law to lower the price of apples, and hold all other prices constant temporarily. What happens? There is an excess demand for apples, so some buyers (including me) cannot buy as many apples as we demand. Faced with a quantity constraint in the market for apples, I revise my demand for pears. *But this does not mean that the excess demand for apples goes away*. I still try to buy apples. What you are saying, when you say "This sure sounds like an excess demand for apples but I think it's an illusion." is putting forward the "discouraged apple-buyer hypothesis" (analagous to the "discouraged worker hypothesis" -- which says that when there is an excess supply of labour the unemployed workers get discouraged from looking for work, since they know there isn't any, and so the excess supply of labour -- unemployment -- disappears). Dreze retained the "unified decision hypothesis" by adopting this same assumption. But it has the bizarre implication, if carried through to its logical conclusion, that markets will clear at *any* price vector, since discouraged buyers or sellers just give up, so excess demands or supplies just disappear. If so, why would the price vector adjust to the true Walrasian equilibrium? Now, there might/must be *something* to the discouraged worker/apple buyer effect, but it can't be 100% true.
Now the Porsche example is different. With apples, I WOULD buy one if one were offered for sale; with Porsches, I WOULD NOT buy one if one were offered for sale. In other words, the ONLY thing preventing me buying an apples is the lack of a willing seller. [Parenthetically, the precise definition of "quantity demanded" (and supplied) is hard to get right, but only teachers of ECON1000, like me, are forced to try to get it right. The US edition of Greg Mankiw's intro text defines it as "the amount of a good that buyers are willing and able to purchase", but this definition gets into a logical contradiction in the rent control example, where he says there is an excess demand for apartments, but buyers are *unable* to buy any more than Qs. So for the Canadian edition I changed it, to drop the "and able". But then I face the Porsche problem. A precise definition would be "would buy, if it were offered for sale".]
The strange thing is, there is a lot of talk in the econ blogosphere about the "resurgence of Keynesian macro", general disequilibrium, and "Dark Age" etc., but I have seen no reference to the one literature that analysed this stuff properly (except, by implication, when Barro said he had actually done research in macro, and was probably talking about his stuff with Grossman in this area). No reference to constrained vs. notional demand and supplies etc. Admittedly you have to be "of a certain age" (50's, comme moi) to have been exposed to this literature, because it flowered briefly, then died with the New-Classical resurgence. The New-Keynesians never mention it, even though it is implicit in all New-Keynesian macro-models, since prices are sticky.
Must go to all-day meeting for First-Year profs. Back later.
Posted by: Nick Rowe | April 17, 2009 at 06:53 AM
Don: on re-reading my post, I definitely have not been as clear as I should have been on the stock/flow distinction. What I was trying to talk about was the excess flow demand for money. It got fudged because I was thinking in discrete time. So you (understandably, and my fault) missed the main import of what I was trying to say, and have gone off in a different direction. I will think about this and try to clarify later.
Posted by: Nick Rowe | April 17, 2009 at 07:14 AM
Nice post
Proves by example why algebra took over as medium of exchange
For the science
Btw
Means of payment
Ie credit adds yet another janus head
Here
Facilitating the
Velocity of a given money stock
But creating defaults and crises of confidence etc
Posted by: paine | April 17, 2009 at 01:56 PM
Maybe, Say's Law is false, because there are markets that do not reach a market-clearing equilibrium price.
If aggregate demand made effective by current stock/flow of money is inadequate to fully employ available resources, can unemployed resources show up before Walras' auctioneer and bid their way back into the money economy? The answer, in the presence of non-clearing markets and "sticky" prices might be, "no".
If the answer is no, can monetary policy, without fiscal policy support, bring the economy to a full-employment equilibrium? Could monetary policy induce inflation in the money economy without drawing into the economy the involuntarily unemployed?
Fiscal stimulus spending has the advantage that it can forcibly increase employment. Is this a distinctive advantage in some circumstances, of non-transitory involuntary unemployment?
Posted by: Bruce Wilder | April 17, 2009 at 03:28 PM
Bruce: If all markets were always clearing, then Say's Law (and Walras' Law) would be trivially true. The real question of their truth or falsity only arises when some (or all) markets do not clear (prices are not at equilibrium). In that case, will it be true that the excess supplies for some goods must be balanced by an equal value of excess demands? Or can everything be in excess supply (where "everything" may or may not include money)?
Say's Law says that if there is excess supply of some goods, there must be excess demand for other goods (excluding money). Walras' Law says the same thing, only including money as one of the goods.
For your second paragraph, I agree.
Third and fourth paragraphs: I am feeling my way towards saying that anything fiscal policy can do to cure deficient aggregate demand, so can monetary policy.
Posted by: Nick Rowe | April 17, 2009 at 05:58 PM
paine: thanks. I think of credit as the same as bonds. When I give someone credit, I get an IOU (or some sort of record, even if just oral, or electronic). A bond is just a bit of paper with "IOU" written on it.
Posted by: Nick Rowe | April 17, 2009 at 06:00 PM
Nick,
Just going back to my original comments on the apples/pears example. I was not putting forth a "discouraged apple-buyer hypothesis". The problem in the example is that you allow me to demand $20 worth of stuff when I only have $10. Even notional demands have to satisfy budget constraints or the whole thing becomes meaningless, the Porsche example was meant to illustrate that more starkly.
Thus, if I show up with $10 and try to buy $10 worth of apples but can't and I'm not willing to substitute anything else, I only want apples, then I agree that, at the posted price, there is an excess demand for apples. But that's not what happens, instead I spend the money on pears. Now I have no money left so you can't say I still have a demand for $10 worth of apples any more than you can say I have a demand for a Porsche and a Gulfstream jet.
Posted by: Adam P | April 18, 2009 at 05:42 AM
Adam P: Let me change the example slightly, both to make the stock/flow distinction (as I should have done for Don), and to make it clearer what I am saying in the apples and pears example.
I earn $10 per week. I go to the farmer's market once a week with my $10. There is a stall selling apples (the apple market) and a stall selling pears (the pear market). I go first to the apple market, try to buy $10 worth of apples, and fail. So I visit the pear market, and buy $10 worth of pears (successfully). Next week the same thing happens, assuming prices don't change, and nothing else changes. So we can have a situation (I want to call it an "equilibrium", but it isn't a market-clearing equilibrium) in which the market for apples is in excess demand, but all other markets are clearing. The apple market gets the signal "produce more apples, raise the price of apples", and the pear market gets the signal "we are in market-clearing equilibrium". And at the end of the week, after I have visited the farmer's market, I don't have any undesired excess of the weekly flow of money sitting in my wallet.
To the auctioneer at the apple market, it will sure look like an excess demand for apples. And I think it is an excess demand for apples. The apple auctioneer is getting the right signal. It's the auctioneer in the pear market who is getting the false signal, because it looks like the pear market is in equilibrium, with a clearing market, and it is in equilibrium, but only because the apple market is out of equilibrium. If the apple market cleared, so I was no longer quantity-constrained, my demand for pears would drop, and the pear market would go into excess supply.
My decision at the apple market ("buy $10 of apples, and no pears") respects my budget constraint. My decision in the pear market ("buy $10 of pears, no apples. because there aren't any") also respects my budget constraint. But my decision in the pear market respects my constraint on apple buying as well as my budget constraint, while my decision in the apple market ignores the constraint on buying apples.
In Walrasian GE theory, we model consumers as choosing all demands and supplies simultaneously, subject only to the budget constraint. In non-Walrasian general disequilibrium theory, with a monetary exchange economy, and N markets, we need to model the consumer as making N decisions, each one subject to the budget constraint, plus potentially binding N-1 quantity constraints in all the other N-1 markets.
I taught this in Cuba, where the economy was in repressed inflation with generalised excess demand, and shortages everywhere. You take your monthly 200 pesos, try to buy $200 of one good, fail, try to buy $200 of a second good, fail, try to buy $200 of a third good, fail, and eventually get lucky and buy $200 of a fourth good. $800 monthly demand for goods, with only $200 monthly income. The Cuban consumption function (consumption demand as a function of income) is a very weird beast, with an average propensity to consume of 4.0. Now of course, you can say that 3/4 of that demand is a "false signal" to markets, but it is nevertheless a true signal in each market, *given the quantity constraints in other markets*. The quantity constraints in the Cuban output market also spillover to affect labour supply. "Why work, when you can't buy anything with your wages?". Which creates a repressed inflation multiplier effect, reducing the production and supply of goods still further.
Our problem is the opposite. Generalised excess supply. Firms get a "false signal" in the output market. People want to buy goods, but don't, because they can't sell their labour.
Posted by: Nick Rowe | April 18, 2009 at 06:57 AM
Don: I have now cleared my head. Let me fix the stock flow problem.
When we write a budget constraint, we have to be careful not to have stocks and flows in the same equation (I was not careful). Since we normally think of the demand for goods and the supply of labour as flows, we must make sure that we also think of the demand for money and bonds (and everything else) as a flow too. So when I say "my demand for money is $10" for example, I mean (or should mean) that I want to *increase* my stock of money by $10 *per week* (or per day, or whatever). I was talking (or should have been talking) about the *flow* demand/supply for money -- the rate at which I want to increase or decrease the stock of money in my pocket.
Posted by: Nick Rowe | April 18, 2009 at 07:05 AM
“When we write a budget constraint, we have to be careful not to have stocks and flows in the same equation (I was not careful). Since we normally think of the demand for goods and the supply of labour as flows, we must make sure that we also think of the demand for money and bonds (and everything else) as a flow too.”
This seem extraordinarily fundamental, Nick.
Personally, I find consistent visualization of the stock/flow distinction for money particularly challenging. For some reason, I get derivatively blurred.
It would be interesting to see you do a post constructing an algebra of stocks and flows as it relates to goods and services, real assets, financial assets, and money (to the degree that money is a unique kind of financial asset). It would be informative to develop some sort of framework that ties together stocks, flows, and velocity. E.g. financial assets including money have velocity; flows can recur using the same stock. Goods and services aren’t driven by the same notion of velocity. Flows can’t recur using the same output. Thinking about such a post reminds me of the kinds of conceptual posts you were doing on debt (gross and net stuff, etc.) It would be very interesting. You might get another headache, though, particularly so soon after vacation. And maybe what I’m suggesting is closer to a 600 page textbook than a post.
Posted by: JKH | April 18, 2009 at 09:47 AM
JKH: I'm not sure whether I can do a good job on that. But I will have a think about it, and may give it a try.
The simplest (but unsatisfactory) way to do it is like this:
There is a flow budget constraint:
p.c = w.l - d(m+b)/dt + i.b (a person plans to finance his continuous flow of nominal consumption demand (p is price of consumption goods and c is quantity demanded per unit of time): by selling a flow of labour (w is the wage and l the flow of labour supplied; by running down his stock of money and bonds (m is the stock of money, b is the stock of bonds, so (m+b) is his wealth, and d(m+b)/dt is the rate at which that stock of wealth is increasing per second); and interest earnings on bonds i.b.
And there is a separate stock budget constraint (portfolio balance constraint) which allows him to make jump-changes in the composition of his portfolio: md + bd = m + b (where md is stock demand for money, bd is stock demand for bonds, and m and b are the existing stocks).
But it's unsatisfactory because if you had perfectly smooth continuous flows of income and expenditures, with flows of pennies coming into and going out of your pocket every second, it is hard to see why we would hold a stock of money. We hold stocks of money because income and expenditure flows are discrete and lumpy, not smooth continuous flows over time.
Posted by: Nick Rowe | April 18, 2009 at 12:22 PM
Nick,
I imagine your flow and stock budget constraints are fairly standard items in the economist’s toolkit. The framework makes sense.
I’d be interested in your thoughts about how the Federal Reserve’s balance sheet expansion fits into the flow/stock budget constraint framework. It seems that with its credit asset expansion, the Fed has responded to an increased demand for money in the stock sense. It’s substituting for those who no longer want to hold risky bonds, for example. But the Fed’s credit asset expansion has created an increased stock of money, which should respond to an increased demand for money in the flow sense as well.
The terminology “demand for money” still seems awkward. If people choose to hold money rather than buy goods or bonds, that would seem to be an increase in the demand for money. But if the velocity of money is high, more people are using the same stock of money to support more transactions, which seems like an increased demand for money as well, even though it’s effectively the converse idea to the standard definition.
Posted by: JKH | April 18, 2009 at 11:55 PM