« Has the Bank of Canada shifted from credit easing to quantitative easing? | Main | Deflation: a less clear and less present danger »

Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

“You cannot accumulate credits or debits at the central exchange. Otherwise, those credits or debits would be a new medium of exchange... if intrinsically worthless paper money continues to be used as a medium of account, there must be some sort of demand to hold money.”

So where did this paper come from?

Maybe the paper is a relic of the days when it used to be used as a medium of exchange. The central exchange took over money's role as a medium of exchange, but fortunately a new demand for the paper as bling appeared at just the right time.

"Imagine that Ebay and Craiglist merge into some giant centralised barter exchange. "

You have the monopoly problem, but otherwise it works fine.

Demand and supply futures of barter pairs will be listed according to past price history. Automatic spread sheet functions will average prior history and determine the value of a given trade in terms of a share of the value weighted average of previous trades.

In short you get an advanced money, a fully electronic unit of exchange.

To eliminate the monopoly problem of e bay and craigslist, Google will invent the point and click credit card.

You have just eliminated the future as well. People have no way to save for their retirement either! People can still buy and sell assets, but with out credit, they will have to be financed directly out of current income, directly to the seller. So it is not so much eliminating money as a means of exchange that did the trick, it is eliminating money as a store of value (and this was always clear to me - not to you?)

Having read your whole post, I realise now it doesn't make any sense. If there is no way to convert saved money to current goods and services, what purpose does an interest rate serve?

Seriously,
Nick, you have gone way off track here. It is the intertemporal issue you should be looking at, the demand for money is just a means to that end.

reason: People can save money-as-bling (money as a unit of account). It works just as well as a store of value, as today's money. True, you don't need it as a medium of exchange, but then you can wear it, if you want. In a "liquidity trap" ("bling trap"?), people might be satiated with the desire to wear money as bling, but could still hold it as a store of value at the margin.

And all the other forms of savings still exist: shares, corporate bonds, government bonds, real capital goods, houses, land, cans of beans.

There are as many forms to hold savings as there are today. (OK, there aren't any chequing accounts, but that's only because I couldn't figure out a way to wear a cheque book showing your bank balance).

Matt: yes, I forgot about the Ebay/Craiglist monopoly problem. Nationalise it; regulate it; or forget it and allow GoogleBart to provide threat of competition to keep transactions fees down.

"It works just as well as a store of value, as today's money."

Confusing. How can it be a store of value, if its not a medium of exchange?

I.e., is it still a medium of exchange, even if its not the only medium of exchange?

Nick,
but then I don't understand (like anon) how this bling is any different from money. If I can exchange it for goods and services on Ebay, then surely it is (or would become) money. Now the interesting question is how does borrowing work? If there is no medium of exchange and the relative price of goods is constantly changing - what do I promise to pay back?

Nick now SERIOUSLY, why is inflation a bad thing? If money is just a unit of account for barter, then it doesn't matter in the least whether its value is stable. It is only because we make money today and spend it tomorrow that inflation is a problem. Similarly deflation is a problem because if I borrow to invest today, but can never get the same number of units of account back from the returns to that investment (to repay the loan), I'll never invest.

And the Keynesian view of what triggers a recession is that people for whatever reason, on average decide together they want to increase their holding of money and so spend less today. This only makes sense, if they can spend that money in the future.

Could the current crisis even occur in this no medium of exchange world?

Supposing the financial crisis is something like this: For reasons we'll ignore bankers lose their minds and lend lots of money (medium of exchange?) to be invested in essentially non-productive assets (residential houses, plasma TVs, etc... ). They suddenly return to sanity and realize that they made a huge mistake; the future productivity they were counting on to repay the debts (with interest) are unlikely to materialize in any acceptable time frame. Crisis ensues.

If there is no medium of exchange, it wouldn't be possible to borrow against expected future productivity. And it wouldn't be possible to make the mistake of investing in activities/assets that fail to produce sufficient returns to repay debts. So I don't see how the crisis dynamic can get started in the first place.


anon: "Confusing. How can it be a store of value, if its not a medium of exchange?"

I don't see what's confusing. In today's world, money is a medium of exchange, a medium of account, and a store of value. It is (almost) the only medium of exchange, and (almost) the only medium of account, but it is only one of many stores of value. I can use government bonds as a store of value, or indexed bonds, or commercial bonds, or GICs, or shares, or jewelry, or houses, or antique furniture, or sahres, or land, or cans of beans, or whatever. Almost any good (except maybe pure services) can be held as a store of value. Some are better, some are worse than money.

In my imaginary world all those things could still be held as stores of value, including the money-as-bling jewelry. The only thing special about money-as-bling is that it is the medium of account, and so it's nominal value is perfectly safe. But then a government bonds is as safe, and gives a higher return. And an inflation-indexed bond is safer still, in real terms.

anon: ".. is it still a medium of exchange, even if its not the only medium of exchange?" and
reason: "...then I don't understand (like anon) how this bling is any different from money. If I can exchange it for goods and services on Ebay, then surely it is (or would become) money."

In a monetary exchange economy, only one good serves as a medium of exchange. You buy things with that one good, and sell things for that one good. In a barter economy, every good can be bought or sold for any other good. Some people would describe this as saying that every good serves as a medium of exchange. So the money-as-bling is just one of many goods you can swap for any other good. Everything (including money-as-bling) can be swapped for anything else.

How could borrowing and lending work in a world without a unique medium of exchange? Like this: I want to borrow $100 from you so I can buy a bike, and promise to pay you back next year at 10% interest. Today, you offer to sell $100 worth of beans (say) to the central barter exchange, and tell them to credit my account. I offer to buy a $100 bike, and tell them to debit my account the $100 you just lent me. (And some third party, in the simplest case, swaps his bike for beans). Next year I sell $110 worth of apples to the central exchange, and you buy $110 worth of hay, and I tell them to transfer $110 from me to you, as a bookkeeping record only.

reason: "Nick now SERIOUSLY, why is inflation a bad thing? "
For two reasons (in my imaginary world):
1. inflation is a tax on wearing bling, and so reduces the pleasure people get from wearing bling. (Actually, I'm not sure this "shoeleather cost" of inflation works any more, since bling is presumably a positional good? Never mind).
2. Because it makes the medium of account function of money-as-bling less useful, since it's like having a metre rule which gets a little bit shorter every year.
OK, 3. Because unanticipated fluctuations in inflation cause transfers of income etc.

Nothing new here on the costs of inflation. Just the usual story (except for potitional bling).

reason: "And the Keynesian view of what triggers a recession is that people for whatever reason, on average decide together they want to increase their holding of money and so spend less today."

BINGO! (or very close to bingo!)

What exactly do you mean by "money"? Medium of exchange? Or unit of account? Or store of value?

And is this really, or exclusively, a "Keynesian" view?

If you define "money" as medium of exchange, then it's my view. And you should replace "Keynesian" with something like "true and proper Keynesian and Monetarist and all sensible people"!

The financial assets you listed have value because they constitute claims on money in the context of the normal use of money – including value in exchange.

The real assets you listed have value because they constitute claims on some sort of real utility. That includes jewelry for its cosmetic value or precious metals for various reasons.

If money is not a medium of exchange, but is a store of value, exactly what is its value if it is not as a medium of exchange?

Are you actually comparing the value of money as paper ex its value in exchange with the value of jewelry? Do you then compare both to the value of tulips? It seems to me jewelry or antiques are in a far different category than money as antique paper.

"Some people would describe this as saying that every good serves as a medium of exchange."

I think you answered the question right there. Obviously, money retains its characteristic as a medium of exchange in your pretend world. It's just not the only medium of exchange.

And given that it retains its characteristic as a medium of exchange, the whole thing probably amounts to a contradiction - it's hard to believe that money as a medium of exchange wouldn't gravitate to become the primary medium of exchange, given its natural liquidity properties in its use as a medium of exchange.

anon: "The financial assets you listed have value because they constitute claims on money in the context of the normal use of money – including value in exchange." True. What about a contract to deliver oil next month? That's a financial asset, but not a promise to deliver the medium of exchange.

The reason I wanted to model money as a medium of account as jewelry is because doing so gave me a plausible story where the quantity people wanted to hold was strictly proportional to it's value, so I could still get a demand for money-as-bling function Md=P.L(y,i) that looked exactly like a normal demand for money function, where money is a medium of exchange. Otherwise, make any real good you like serve as medium of account, like tulip bulbs. It won't change my imaginary economy much. It's just that the quantity theory of money won't hold exactly if we use tulips. If you double the quantity of tulips, will the value of each tulip exactly halve? Probably not exactly. In my money-as-bling story, it would halve exactly.

".... it's hard to believe that money as a medium of exchange wouldn't gravitate to become the primary medium of exchange, given its natural liquidity properties in its use as a medium of exchange."

I agree. It is no accident that we have gravitated to a world where there is only one medium of exchange, and it's the same good that is also unit of account. That's always a problem when you want to tell a story about an imaginary world. Why isn't it exactly like the real world? Ummmm. Suppose it is difficult to remove money-as-bling from your body piercings?? So it's hard to use as a medium of exchange? Ebay/Craiglist has lower transactions costs than removing bling from your body?

A thought-provoking model - I'm still working through some of the thoughts it has provoked. One of them is this slightly different way of looking at the Keynesian idea of excess saving:

People (for whatever reason) decide they prefer to keep a bit more stuff for tomorrow and consume less of it today (perhaps there is reason to doubt future productivity and therefore the value of goods owned today becomes relatively greater). Thus, people who own durable goods such as bicycles, antiques and cans of beans are less willing to exchange them for perishable goods such as bread, flowers and labour.

The price of bread, flowers and labour should fall, of course, but the idea of sticky prices implies that it won't fall right away. And why should the absence of money make any difference to this? If I'm used to getting twenty cans of beans or a third of a bike for one hour of work, presumably that's the exchange rate I will offer on Ebay, and it won't clear. I might decide to reduce it after a few days, but by that time the labour is permanently gone (or my bread and flowers have gone off). Thus, potentially productive resources are wasted, or equivalently, we have a recession.

I'm not sure why you want to keep money-as-bling in the model at all - I guess if you want to assume that money is available as a unit of account, then it might arise from that. But that aside, does the above explanation work?

You state that "there cannot be a general glut of labour and goods" but, in the sticky prices version, why is this the case?

Thanks Leigh!

I wanted to keep money-as-bling as the medium of account in the imaginary world so that it would stay as close as possible to the real world, with only one exception: barter vs monetary exchange.

I really can't decide whether the use of centralised barter rather then decentralised monetary exchange would make prices any less sticky. Under some stories prices are sticky because exchanges are decentralised. It's harder to get information on market-clearing prices, excess supplies and demands, etc., when you have decentralised exchange. Under other, "menu-cost" stories, it makes no difference.

Anyway, in my post I assumed it made no difference to whether or not prices would be sticky. Let's stick to that assumption.

"You state that "there cannot be a general glut of labour and goods" but, in the sticky prices version, why is this the case?"

Start in full employment equilibrium. Hold the price of output fixed, and nominal wages fixed, so the real wage stays the same. Now have the stock of money-as-bling. (This is the same as doubling all prices and wages, holding the stock of money-as-bling constant.)

There's a drop in the real quantity of money-as-bling, so there's an excess demand for money as bling. But so what? Firms' labour demand curves (W/P=MPL) are the same. Households face the same budget line and indifference curves between leisure and consumption of newly-produced goods. So we get the same tangency as before. (OK, it might not be exactly the same, if a change in the quantity of real bling changes the MRS between leisure and consumption goods, but that will be a tiny second-order effect.)

Sure, people want to by less newly-produced consumer goods and more bling, but they can't buy more bling (because nobody wants to sell bling), so they shrug their shoulders and buy the same amount of newly-produced consumer goods. You could never get inoluntary unemployment where MPL>W/P>Marginal disutility of labour. Because if you did, unemplyed workers would just swap labour for goods, and both workers and firms would gain.

It's very different in a monetary exchange economy, where money is really money. If there's an excess demand for money, each individual can always get more by buying less goods. They can't in aggregate of course, but their attempt to do so results in firms' being able to sell less. So firms hire less labour. Even if MPL>W/P, there's no point in hiring more labour if you can't sell (for money) the extra output.

All this was known back in the 1970's. I'm doing nothing new here. But it seems forgotten, and never properly integrated into macro theory. The New Classical revolution distracted everyone.

“In a world without a medium of exchange, the involuntarily unemployed workers with an excess supply of labour would just barter their labour directly for firms' excess supplies of goods, as long as the real wage were at the correct value. A general glut of labour and goods is impossible. It doesn't matter if there's an excess demand for money-as-bling because the real supply of money-as-bling is too low, or because the natural rate of interest is negative. It won't cause unemployment.”

I don’t follow this. If there is an excess demand for MAB, isn’t there deficient demand for other output?

BTW, isn’t it also important somehow that MAB is an asset rather than part of output per se?

Nick,

If you get a chance I'd like to get your comments on:

http://canucksanonymous.blogspot.com/2009/05/is-lm-explained.html

and particularly:

http://canucksanonymous.blogspot.com/2009/05/this-post-picks-up-where-is-lm-post.html


I do see how lending can happen. In your example, I need $100 worth of stuff to barter for my bike, someone has the full $100 worth of stuff to barter already and we make a deal as you describe. The full production of $100 has already happened, but the lender doesn't need it right now so we swap (for a fee). Say my crop fails and I can't pay back the lender, he can at least be given the bike.

What I don't see is how fractional reserve lending can happen. What would be the mechanism for me to get $100 worth of stuff today from someone who only has $10 or $3.33 worth of stuff on hand (which really belongs to someone else)?

Adam: I commented on the first, before seeing this. Am gathering my thoughts before commenting on the second.

BTW, I strongly recommend Adam P.'s blog; and those two posts in particular are right on this subject. See the links in his comment above.

anon: "BTW, isn’t it also important somehow that MAB is an asset rather than part of output per se?"

Yes, absolutely. It's really interesting when you use a newly-produced good as money. Any excess demand for money, that might normally cause an excess supply of newly-produced goods, is beautifully self-equilibrating. Think of it as the unemployed getting jobs producing money, which both directly and indirectly cures the unemployment. I read a proposal once that we should use ordinary house bricks as money (OK, a bit heavy to carry around, but do you really need to carry them? Compare the Yap stones (very large stones used as money; there's on at the Bank of Canada, about 2 metres tall). Keynes was sort of onto this with throwing banknotes down a disused mine and letting workers dig them up. Gold only does this a bit, because the new supply of gold is not very price-elastic compared to existing stocks.

Back on topic:

anon: "I don’t follow this. If there is an excess demand for MAB, isn’t there deficient demand for other output?" Yes, by Walras Law (or, there has to be an excess supply for something, and lets assume it's output).

But Walras Law is wrong. Or, more precisely, Walras Law is only true for "notional" demands and supplies. "Notional" demand (or supply) is the quantity people would like to buy (or sell) UNDER THE ASSUMPTION THAT THEY CAN BUY AND SELL AS MUCH OF EVERY OTHER GOOD AS THEY LIKE. But when prices are not at equilibrium levels, we will have excess supply in some markets, so sellers won't be able to sell as much as they want, and excess demand in other markets, so buyers won't be able to buy as much as they want. So people will be "quantity constrained" in their purchases and sales of other goods. So "notional" demands and supplies (the Walrasian demands and supplies) are irrelevant in disequilibrium. Instead, people will re-maximise utility, subject to their budget constraint, PLUS ANY CONSTRAINTS ON ACTUAL SALES AND PURCHASES. (A worker who cannot sell his labour, for example, will buy less consumption).

There is an excess demand for money as bling, and an equal NOTIONAL excess supply of output. But when people find they cannot buy more bling, they forget that notional excess supply of output. They revise their plans, taking into account the fact they can't spend their income on buying more MAB. So they spend it on extra output instead. The CONSTRAINED excess supply of output is zero. We still have an excess demand for MAB, but no offsetting excess supply anywhere else. Yes, I am violating Walras Law. It's wrong.

Patrick: "What I don't see is how fractional reserve lending can happen." If you mean "fractional capital reserve banking" there's no problem. A bank both borrows and lends, and has some of its own equity. If you mean "fractional currency reserves", nor do I. Not easy to think of a story where private banks produced money-as-bling.

If you leave your coat at the theatre cloakroom, they give you a receipt. "IOU one coat" written on a bit of paper. A coat keeps you warm and dry. A bit of paper with "IOU one coat" written on it won't keep you warm and dry.

Money functions as a medium of exchange. A bit of paper with "IOU one dollar" on it can (sometimes) also function as a dollar. Unlike an IOU for a coat.

Not sure if this trick could work for money as bling. Don't think it matters. Fractional reserve banks are not an essential part of macro.

Hmm. I think I see what you mean, but I am still not convinced that people would re-maximise utility as easily as you say. You say that your model works with or without sticky prices - true. But I think the existence of sticky prices is exactly the parameter that determines whether your model behaves like the real world or not.

If I restate my understanding, perhaps it will clarify:

There are two possible sources for sticky prices: one is decentralised exchange, one is menu-cost (in which category I would include money illusion and the cognitive anchoring that individuals have to historical prices). I believe that both are at play in the real world.

Your hypothesis removes the decentralised exchange issue by assumption. This removes one source of stickiness. If you assume away the menu-cost option (which I think you are doing by allowing consumers to instantly re-maximise), then Walras's Law becomes true and recessions can no longer occur in your model.

If you retain the menu-cost assumption (which, again, I'd explain more in terms of the cognitive biases of individuals) then I think you still have recessions because you still have a market that doesn't reach equilibrium, at least not immediately.

I could express my whole assertion very simplistically as follows: sticky prices are responsible for recessions; your model makes prices less sticky but doesn't remove the problem entirely - therefore recessions are less serious but can still happen.

A little too simple, I know, particularly the idea that sticky prices are the sole cause of recessions. But do you think I'm misrepresenting the impact of your model?

In any case, I think this answers your implicit question "what has changed between the real world and this model?" The answer is: the model has made prices less sticky. I don't think you can just treat stickiness as an orthogonal fact to the model - it seems to be intrinsic to what you are proposing.

Sorry if I'm harping on about this! Writing it out helps me understand my own mental model if nothing else.

Leigh: you misunderstood me. When I was talking about whether a decentralised system of monetary exchange was part of the cause of sticky prices, that was a digression. In the main point of the blog post, I just assume that prices are sticky, or fixed if you like.

Sure, sticky prices are a necessary condition for a general glut. So assume prices are fixed. The main point of my blog post is that fixed prices are not a sufficient condition. You need sticky prices PLUS monetary exchange to get a recession with excess supply everywhere. Sticky prices plus barter won't do it (or not as much, or not to the same extent).

When I talk about people re-maximising, when they are faced with a quantity constraint on how much bling they can buy, I don't mean they change prices. Keep prices fixed. They re-maximise in deciding how much newly-produced output to buy. They re-maximise on quantities demanded and supplied; I'm holding prices fixed by assumption.

I made a post that somehow got lost, where I argued that this E-bay barter economy could never work, because we would still not get instant clearing. The problem is TIME. I can't sell me services instantly in terms of a single day, it just doesn't work like that. My services are lumpy and require infrastructure. I won't necessarily accept any price that rules on a given day, given that my services are lumpy and I might get a better price tomorrow. Similarly, some of the goods on offer are not available today, but can be delivered AND paid for at some time in the future. I keep arguing, this is what is missing from this whole argument. Time is not properly incorporated into it. (And I am definitely not an Austrian believer!)

reason: I agree that the centralised barter has difficulties. Which is why we don't see it, and use a medium of exchange instead (except in a few minor cases). But I'm not sure if you have identified the reasons. I can sell serves today, but actually provide those services tomorrow.

The underlying problem is one of trust. Will I get paid? Will I deliver the services? Will the services be any good? Paying cash at the same time you take delivery of the goods lessens those problems, but it does not eliminate them.

But we can IMAGINE those difficulties away, can't we? That's all I need for my thought-experiment.

Nick, Sorry to come in so late, but why are workers who get laid off able to barter their labor for goods if wages and prices are sticky? Another way of asking this question is why can't they do that now? Couldn't a laid off worker go paint the house of the president of GM in exchange for a car? Even under a monetary system? Yes, they couldn't go work in the auto factory and be paid in cars, but that's because we are assuming sticky wages in the auto factory. I have trouble seeing how removing the medium of exchange makes unemployment less of a problem, unless it makes wages and prices less sticky (which is certainly possible.) Is that your argument?

Scott: glad you finally arrived!

This is an important point, especially for a monetary economist like yourself.

It's not about removing the medium of exchange making prices (and wages) less sticky.

Start in full employment equilibrium. Assume prices and wages are absolutely fixed. Now halve the supply of money. Real wages are exactly the same (by assumption). The MPL curve is the same. The Marginal Rate of Substitution curve between consumption goods and leisure (the labour supply curve) is exactly the same (assuming utility function is separable in real money balances, so that a fall in M/P does not affect the MRS between consumption goods and leisure).

So why should a fall in M/P cause a fall in employment? The whole of microeconomic theory is screaming at us that employment should not change, if MPLabour=W/P=MRS consumption vs leisure. (We get the same tangency point in {Y.L} space between the firms' production function and workers' indifference curve, and the budget line (whose slope is the real wage) still intersects that tangency point. Yet macroeconomics says that employment and output will fall if you hold prices and wages fixed. How come we get totally different answers from basic micro and basic macro?

Answer: because micro implicitly assumes barter exchange of labour for consumption. And macro implicitly assumes monetary exchange. People buy C with money, and firms buy L with money. Starting in full employment equilibrium, hold W/P constant, but reduce M/P. People want to hold more M/P, so they buy a little bit less C. So firms are now sales-constrained, so they hire less L, even though MPL exceeds W/P (because what is the point of hiring L is you can't sell the C it produces), so employment and income fall, so people buy even less C, and so on.

If we could do barter, a fall in M/P, given W/P constant, would not cause unemployment. There would be an excess demand for M/P, but nothing else would happen.

Why don't we do barter? I have nothing to add to the usual difficulty of getting a double coincidence of wants story.

The fact is, that barter exchange is so appallingly inefficient, relative to monetary exchange, that even when a shortage of the medium of exchange causes the terrible problems of the Great Depression, only a very few people still ever resort to barter to get out of those problems, and though the resort to barter does happen, and indeed is PREDICTED to happen by my perspective here, it doesn't help people very much.

[By the way, am I right in saying there was a big surge in barter during the 1930s?]

I am determined to convince you of the importance of this medium of exchange story, Scott. I wrote this post with both you and Adam P as my imaginary readers!

Oh good - I thought this discussion would probably have run out by now but am happy to see it revived.

Nick - thanks for your response to my previous comment, it is clearer now. I agree that your model would reduce if not eliminate recessions; but I'm not sure that this effect arises from the replacement of monetary exchange with barter. It seems to me that it's the introduction of a centralised exchange that does it.

I guess that the existence of money as a medium of exchange does imply decentralised exchange by its nature. The exchange of labour for money is separated by design from the exchange of money for beans. So barter and centralisation are associated, but I think it's worth distinguishing between them.

Perhaps rather than centralised exchange, the real innovation here is forcing people to buy something every time they sell something else (and vice versa). Does this have an implication for velocity of...well, not money I guess - but velocity of stuff. If this model forces velocity to automatically adjust in a way that it doesn't do in the real world, that could explain some things.

I suspect this could be the answer to your question about the difference between micro and macro. Simple micro assumes no time lag in the satisfaction of wants; in other words, velocity automatically and implicitly adjusts to the quantity of output required to maximise utility. Macro brings in velocity as an independent parameter (well, sort of independent). In a macro model, velocity is sticky too - cutting M/P in half does not automatically double velocity, thus output falls. (Not trying to revive the three-month old debates about whether MV=PY is an accounting identity or a behavioural rule! But clearly V and/or Y are affected by behavioural responses to money and prices).

This has been a very good way to bring out some of our unrecognised assumptions about money and the economy. Looking forward to more debate, and/or to the next crazy model you come up with.

One other thing (though I guess you are excluding this from the model by assumption): in this economy, wouldn't money-like instruments arise in the private sector anyway? You have allowed individuals to borrow from each other; those IOUs have a value and could be used as a medium of exchange. But I think this is beside the point.

Leigh: very good comments.

"One other thing (though I guess you are excluding this from the model by assumption): in this economy, wouldn't money-like instruments arise in the private sector anyway? You have allowed individuals to borrow from each other; those IOUs have a value and could be used as a medium of exchange."

If the centralised barter system is as efficient as I have imagined it to be, then I don't see why people would choose to use anything else as a medium of exchange. But, it would not really be as efficient as I have imagined it to be. That's why people do use money in the real world. So you just have to give me theorist's poetic license, and allow me unrealistically to imagine an efficient centralised barter system!

"So barter and centralisation are associated, but I think it's worth distinguishing between them." Yes. I keep getting sloppy in describing it. Decentralised barter would be horribly messy, because you would have to keep on making exchange after exchange till you finally got to the good you really wanted to consume. I'm comparing real-world decentralised monetary exchange with a purely hypothetical frictionless perfectly-working imaginary centralised barter. (But I'm keeping prices equally sticky in both cases.)

"Perhaps rather than centralised exchange, the real innovation here is forcing people to buy something every time they sell something else (and vice versa)."

No! Think about it! In BOTH a barter and a monetary economy, I always buy something when I sell something, and sell something when I buy something. The difference is that in a monetary economy, one of those two goods is always the same thing -- money. In a monetary economy, one good (the one we call "money") always appears on one side of every exchange. In a barter economy, you get every possible combination of pairs of goods. That's the key. All roads in a monetary economy go through one central hub - Rome (money). If Rome is blocked (there's an excess demand for money), you can't go anywhere else. In a barter economy, you just take the side roads and bypass Rome.

Thinking about this problem in terms of velocity might be useful. If we did, I would adopt the "transactions" rather than "income-based" definition of velocity. MV=PT not MV=PY. You can sort of think of the centralised barter system as having infinite velocity, and then the "money" disappears as soon as all of the day's exchanges have been decided. The computer which handled all the barter exchanges might have some sort of virtual "money" to help it solve the programming problem. I need to think about that one some more.

Fair point, I do "buy" money when I sell my bicycle in the real world. I guess I could revise my wording to refer to goods with immediate utility - the money I "buy" (not being bling-money) isn't relevant to economic output, unlike the beans I would have bought in the barter economy. Maybe I'm splitting hairs a bit.

Then again, this does make me wonder if people in the barter economy would buy lots of cans of beans as a non-perishable store of value in order to keep their options open for future consumption. One of the reasons there can be an excess demand for money is because people are uncertain about both future events and their own future utility functions, and want to retain flexibility/liquidity. Couldn't that happen in your model too?

I think Keynes said something very similar to what Leigh noted.

"Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes -- bank-money, debts at call, foreign money, jewellery and the precious metals generally, and so forth."

http://www.marxists.org/reference/subject/economics/keynes/general-theory/ch23.htm


And the important point is, Keynes attributed the problem with money not to its role as medium of exchange, but to its liquidity-premium. Maybe that's why we call the problem "liquidity trap", not "exchange trap" or "medium trap".
In fact, Keynes wrote above words to criticize Silvio Gesell for missing it, although he admits Gesell's idea as follows is "on the right track."

"Only money that goes out of date like a newspaper, rots like potatoes, rusts like iron, evaporates like ether, is capable of standing the test as an instrument for the exchange of potatoes, newspapers, iron and ether. For such money is not preferred to goods either by the purchaser or the seller. We then part with our goods for money only because we need the money as a means of exchange, not because we expect an advantage from possession of the money.

So we must make money worse as a commodity if we wish to make it better as a medium of exchange."

http://www.appropriate-economics.org/ebooks/neo/part4/1.htm

Himaginary: Good find. Let me quote the passage from Keynes:

"The idea behind stamped money is sound. It is, indeed, possible that means might be found to apply it in practice on a modest scale. But there are many difficulties which Gesell did not face. In particular, he was unaware that money was not unique in having a liquidity-premium attached to it, but differed only in degree from many other articles, deriving its importance from having a greater liquidity-premium than any other article. Thus if currency notes were to be deprived of their liquidity-premium by the stamping system, a long series of substitutes would step into their shoes — bank-money, debts at call, foreign money, jewellery and the precious metals generally, and so forth. As I have mentioned above, there have been times when it was probably the craving for the ownership of land, independently of its yield, which served to keep up the rate of interest;..."

I think Keynes is saying something different. I do not interpret Keynes as saying that these other goods would replace money as a medium of exchange if money were taxed. I interpret him as saying that they would replace money as a store of value.

If my interpretation of Keynes is correct, then he is wrong in the main thrust of his argument. This goes back to my post on why an excess demand for money matters more than an excess demand for antique furniture.

Keynes is worried that there will be an excess supply of newly-produced goods (a general glut), and an excess demand for the money. Would a tax on money fix the problem? Yes and no says Keynes. You could eliminate the excess demand for money, but people might just decide to demand other assets instead (antique furniture was my example), and still not buy newly-produced goods.

He is wrong. As I argued in my previous post http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/why-an-excess-demand-for-money-matters-so-much.html , if there were an excess demand for antique furniture (and the price of antique furniture does not rise to eliminate it), the only thing that happens is that people are unable to buy antique furniture. So they have to buy something else instead. And eventually, that something is either newly-produced goods (which fixes the problem of the general glut), or the medium of exchange, which brings us back to my point, (and Gessel's) that an excess demand for the medium of exchange is the root of all general gluts.

The medium of exchange really is different. You can always get more medium of exchange just by not buying other goods. You can only get more antiques by buying more antiques. And if nobody wants to sell you antiques, you can't, and have to buy something else instead.

(But when Keynes includes bank money in his list, he is closer to my position, because some bank money is a medium of exchange.)

"I think Keynes is saying something different. I do not interpret Keynes as saying that these other goods would replace money as a medium of exchange if money were taxed. I interpret him as saying that they would replace money as a store of value."

With due respect, I think Keynes is saying that these other goods would replace money as a medium of exchange as well.
Here are the reasons why I think so.

1) He noted in Chapter 15 of General Theory as follows:

"In my Treatise on Money I studied the total demand for money under the headings of income-deposits, business-deposits, and savings-deposits, and I need not repeat here the analysis which I gave in Chapter 3 of that book. Money held for each of the three purposes forms, nevertheless, a single pool, which the holder is under no necessity to segregate into three water-tight compartments; for they need not be sharply divided even in his own mind, and the same sum can be held primarily for one purpose and secondarily for another. Thus we can -- equally well, and, perhaps, better -- consider the individual's aggregate demand for money in given circumstances as a single decision, though the composite result of a number of different motives."

As such, he treats money as a multi-functional single-entity throughout this book. Suddenly treating one of the functions separable seems out of the context.

Moreover, he didn't write other goods would substitute "money", but "currency notes". I think he particularly referred to the role as a medium of exchange by that.

2) Gesell advocated stamped money to "make money worse as a commodity" and "make it better as a medium of exchange," as I quoted in my previous comment. So if other goods only replace money as a store of value, and money continues to serve as a medium of exchange, that is exactly what Gesell aimed, and won't be very effective ground of criticism against him.

3) After all, liquidity is an ability to convert itself into other goods. And money's role as a medium of exchange stems from this ability. So if other goods became superior in terms of liquidity, it seems natural for those goods to take over the money's role as a medium of exchange. I don't think Keynes used the word "liquidity" without recognizing such an interpretation.

himaginary: interesting comment. You may be right and I may be wrong in our interpretations of Keynes. Or maybe Keynes didn't make a sharp distinction between a good being or not being a medium of exchange. I do make that sharp distinction.

In any case, if he did mean that (e.g.) land would replace money as a medium of exchange, so that people buy goods with land directly, without first selling the land for money, then using the money to buy goods, then I think he's wrong, but for a different reason. Land is very unsatisfactory as a medium of exchange. It is not very divisible, nor very fungible, and there are very high transactions costs in using land as a medium of exchange. I just don't see land being used as a medium of exchange, in any vaguely normal circumstance.

My guess is that he's not making the sharp distinction that I am.

But he's probably onto something with his view that goods vary in their liquidity. I have tried to have a go at understanding liquidity better (what exactly it means etc.). The medium of exchange is the most liquid of all goods. But other than that, I haven't managed to integrate my understanding of liquidity with the role of the medium of exchange. I wish I could.

I think I'm broadly with himaginary here (and probably with Keynes too).

When there's an excess demand for money, what is it that people want the money for?

1. As a store of value, sure - but that is not its primary function, as there are other more effective stores of value - bonds and equities for example, or real estate or factory equipment, all of which usually have a higher return than cash.

2. As a source of liquidity (or equivalently, medium-of-exchange). This is the main reason, I think. As a side-effect it helps to explain why people would demand more money in times of recession: because in a general glut, they become uncertain about their ability to sell their labour and earn resources. (You could argue that in a glut, this is countered by the likelihood of falling prices which reduce the need to hold money; but the risk is asymmetric. It is a much bigger deal to suddenly lose all your income and be unable to buy anything, than if prices move up or down a bit and you can buy a little bit more or less. If asset prices were predictable, you could invest in non-liquid assets instead of money and then sell them when you need to, but they are not (and there are transaction costs in selling assets especially at short notice).) So people want to save more money in a response to incipient recession, thus the recession gets worse and the cycle continues.

In your barter economy, you are preventing people from achieving their desire for liquidity by holding money. You could argue that transaction costs are lower in this model so there is less need for liquidity - probably true, but they're not zero. I'm afraid that you would simply create a black market for liquidity - perhaps in gold, perhaps in money-as-bling ripped out of the body piercings, or perhaps in privately issued bank checking balances. People have a genuine desire for liquidity, and you can't eliminate that demand by just removing the most popular tool for satisfying it. Another way to explain recessions: the demand for liquidity increases, the price of liquidity (that is, the price of all other goods and services in terms of money) does not adjust, and there is a disequilibrium. The barter model has not prevented this happening, it has simply uninvented a social technology and forced people to use suboptimal substitutes.

Two other notes:

First, an excess demand for money can also be explained by a dearth of profitable investment opportunities, reducing the general return on investment and making cash relatively more attractive. This of course fits in with the idea of a general glut, because excess supply of goods explains why there are fewer profitable investments.

Second, it's easier for antiques to adjust in price than money, because only one price needs to change, while a repricing of money requires changing the nominal price of everything (or at least a lot of things). I am becoming more convinced that this is why an excess demand for money is different from an excess demand for antiques - because its price is stickier. This view implies that it's actually money's role as a unit of account which is responsible for the problem, and not its role in exchange or store of value!

But as himaginary points out, it's really difficult to separate these three functions of money. I must go back to my physics textbooks and look again at the implications of gravitational mass being identical to inertial mass - I think that general relativity falls out of that equivalence. Perhaps Keynes's theory comes out of a similar equivalence postulate for money...or perhaps I'm stretching too far. But I think that the several different explanations we have visited in this thread are mostly equivalent: if prices and exchange automatically and instantly adjusted to all changes in demand or supply, there would be no recessions. The fact that they don't can be explained in numerous different ways, but they all result in the same thing.

p.s. it does feel like I'm possibly keeping this thread on life support beyond its natural lifespan. Perhaps we can move onto your IS curve posting now. Or perhaps I should take the weekend off and watch sports.

Leigh: feel free to keep the comments coming here. Or switch to the IS post if it's more relevant there.

"In your barter economy, you are preventing people from achieving their desire for liquidity by holding money."

I would say I am making a medium of exchange redundant, because I have provided them with a (hypothetical, imaginary) better alternative -- a perfect costless system of barter, so they don't need to use money as a medium of exchange.

Gotta go shopping (checks his wallet). Back soon with more. Forget sports; be a true econonerd!

Leigh:

I look at an excess demand for money a little differently. When there's an excess demand for money, what do people plan to do with that money: hold a larger average stock of money? Or spend it on something else? I expect you could also ask: "how long do they plan to hold a larger stock of money?

The costless centralised barter system I imagined doesn't prevent them doing anything they would otherwise want to do. Rather, it lets them do things they could not otherwise do. The unemployed workers, who want to sell their labour for money, but cannot, and the firms with excess supply of goods, who want to sell their goods for money, but cannot, just get together, do a direct swap of labour for goods, at the same real wage, and both sides are better off. They can bypass the old medium of exchange.

Now, could we still have a demand for liquidity in such a model? Good question. Would some goods still be more liquid than others, and people be willing to hold them, at a lower rate of return, because they can swap them more easily? Dunno. Not sure how to model it.

If the medium of exchange were not the medium of account, it would indeed be easier for the price of money to adjust and eliminate an excess demand for money. As I said before, to get a general glut (recession) you need two things: a sticky price of money in terms of goods; barter is too costly to use, so you must use a medium of exchange. Each is a necessary condition, together they are a sufficient condition. The point of this post was to separate out those two effects.

Actually there's no more sports until tomorrow - Monaco Grand Prix and Celtic/Rangers title decider both at the same time, but I think the pub will be showing both.

The more imminent concern is that my girlfriend comes home and catches me looking at revealing pictures of Arrow-Debreu models. But ogling IS curves might be even worse.

Anyway, time flies when you're maximising utility, and I see it's dinner time. I have the beginnings of an intuition about how the barter exchange might interact with liquidity, so I will come back and post again once I've considered it over dinner. Thanks for the interesting discussion.

So all the Glaswegians, orange and green, will be awfu' fu' tomorrow? Good day to avoid the place.

I wish I wasn't so busy, this is a very intriguing discussion. I normally don't do Walrasian economics, so let me do this as a series of questions:

If you cut the supply of bling in half, doesn't Walras say you have excess supply of all other goods? I don't see how you solve that problem with barter. In a simple model where everyone is self employed, they all want more bling, some can't get it, but they also can cut the price of their output in an attempt to get it. So they see their output pile up, and stop working in frustration. Now if you go from self employment to labor and capitalists, I don't see how it solves this problem, if you are still holding wages and prices fixed (in terms of bling.)

I am used to thinking of models where monetary shocks cause all sorts of relative price changes, and those relative price changes explain the output effects. Now you are forcing me to think of a different type of monetary model, one where no relative price is affected by a monetary shock. And then the only shock, less medium of account, becomes a sort of real shock, not nominal shock. We (or at least I) am used to thinking about contractionary monetary shocks as deflation. I think about what deflation would do to real output. In your example, there is no deflation in period one, and you might have neutral deflation in period two if all wages and prices fall equally. So any real effects in period one must come exclusively from the excess demand for medium of account and excess supply of all the other goods. I guess I still don't see how the nature of the medium of account matters. If there is an excess demand for bling, does it matter whether bling is also the medium of exchange, or merely a medium of account? You say it does, as otherwise barter would prevent unemployment. I guess I don't know enough about Walrasian theory to argue with you. But I have this nagging feeling that in your model with no unemployment, goods must be piling up unsold as there is excess demand for bling. Is there some way to explain why your idea doesn't violate the Walrasian idea that you can't just have one market out of equilibrium?

Regarding the Great Depression, I don't think there was any shortage of cash, just a higher real value of cash because the demand for cash rose. So there was no need for barter, Indeed I think barter is more likely at the other extreme, during hyperinflation. I think German real cash balances fell almost 99% between 1920-23. During deflation people hold larger real cash balances, because the opportunity cost is so low. So there's plenty of cash to make purchases.

Scott: " Is there some way to explain why your idea doesn't violate the Walrasian idea that you can't just have one market out of equilibrium?"

Let me try two ways to explain it:

1. Take a normal economy, like ours, with money. Start off in full equilibrium. Hold all prices fixed. Now cut the price of antique furniture (and continue to hold all prices fixed). We have an excess demand for antiques, and, by Walras' Law, an excess supply of other goods. Everybody tries to sell other goods, and buy antique furniture. They fail to do this. So they give up trying to sell other goods, because they know they can't buy more antique furniture. So the excess supply of other goods disappears as soon as people realise they can't in fact buy antiques. (Do rent controls in New York cause a general glut and mass unemployment, for example? No.)

You could say there's an excess demand for antiques matched by an excess supply of money in the antique market, but all other markets can still be in equilibrium.

There's a "notional" excess supply of other goods, because people want to sell other goods so they can spend the proceeds on antiques, but there is no "constrained" excess supply of other goods, when people realise they are constrained in their ability to buy more antiques.

2. In Walrasian theory, if there are n goods (including money) there are n excess demands (or excess supplies if negative). And the values of the n excess demands must sum to 0 (Walras' Law). But in a monetary exchange economy, there are only n-1 markets. We observe only n-1 excess demands (or supplies, if negative). Money does not have a market of its own; it is traded in every market. So when we say there is a $10 excess demand for apples, in the apple market, what we really mean is that in the apple market there is a $10 excess demand for apples and a $10 excess supply of money. The "apple market" is really an "apple/money market". And in the pear market, there's maybe a $5 excess supply of pears, matched by a $5 excess demand for money.

What does the "excess demand for money" mean? Where do we observe it? We observe it in all markets.

"I am used to thinking of models where monetary shocks cause all sorts of relative price changes, and those relative price changes explain the output effects. Now you are forcing me to think of a different type of monetary model, one where no relative price is affected by a monetary shock."

Yes. The way I look at it, the relative price changes (because some prices are sticky and others are flexible) are a side-effect of the change in the stock of money. They may either amplify, mitigate, or leave unchanged the adverse consequences of a fall in the real money supply, but they are not essential to the story, more a digression.

For example, draw the classic microeconomic anaylysis to show equilibrium labour supply. Consumption on the vertical axis, leisure on the horizontal axis. Draw in the firm's production function and the household's indifference curve. Draw the budget line so it passes through the tangency. The slope of the budget line is the real wage. Now halve the supply of money, holding P, W, and hence W/P constant. The micro diagram shows not problems. Hours worked should stay the same. But any macro model (MV=PY for example), tells us output and employment will drop by about half. Massive contradiction between micro and macro. Resolution? The micro model implicitly implicitly assumes direct barter of leisure for consumption goods between firm and worker.

Nick, There are two interrelated questions here:

1. Do monetary contractions have real effects primarily because they change all sorts of relative prices (as I argue) or because the lead to excess demand for money (as you argue.)

2. If wages and prices are completely rigid, then there are no relative price changes---so my mechanism is assumed away. Then the question becomes whether the impact (on output) of excess demand for the medium of account depends on whether it is also the medium of exchange.

One initial point--I am not persuaded by the rent control example, because I don't know what would happen if all other wages and prices in NYC were also rigid. So the real world lack of excess supply of all other goods doesn't tell us much about your thought experiment.

1. First question. When you say they "give up trying to sell other goods" in the antique furniture example, why doesn't this make them produce less of all other goods than if they could buy all the furniture they wanted? Or are you arguing that that effect would be of trivial importance? It still seems to me that there is an excess supply of other (non-money) goods, in either case.

2. Despite point one, I do see the intuition behind your argument. You seem to be saying it is the medium of exchange role of money that gives its excess demand such great importance. I presume that means that in an economy with one good, they two cases would be identical. Indeed with one good every single transaction would involve the medium of account. With multiple goods, however, transactions need not involve the medium of account. So if money is also the medium of exchange, do some of those transactions that could occur otherwise (via barter) not occur because of a lack of money (medium of exchange) to make transactions? I'm not sure, and to explain why let me give a roundabout example.

In a different post I mentioned that ISLM had some real world problems such as falling interest rates and rising real balances between 1929-30. You responded by correctly noting the difference between real and nominal rates. But the rising real balances anomaly reflects (in my view) the mistaken assumption in ISLM that prices are completely rigid. Indeed in 1929-30 prices fell faster than M1 and M2.

Now of course you can relax ISLM by making prices just somewhat sticky, and allowing for greater real money demand in periods of expected deflation. And monetary economics is symmetrical, so more money demand is like less money supply. With one exception. If there are larger real money balances, then there is no shortage of money to make transactions---indeed there is more than ever before. Rather people simply prefer the hold more in their wallets because the opportunity cost fell.

In that case it seems to me that the only way that excess demand for money could be causing problems is not by inhibiting transactions, but rather by creating a Walrasian excess supply of all goods other than money---which could then (by assumption) be modeled as a composite good. In other words, even though I model 1929-30 in terms of relative price changes, if I had to do a excess demand for money model, I'm not sure I would have done the model any differently with a medium of account money vs a medium of exchange money.

Maybe it's just that my imagination is defective here, but I don't see the problem in depressions as being "gee I'd like to buy that and sell some other stuff to someone else, but I lack enough medium of exchange" rather I see the problem being an excess supply for everything at once, which (it seems to me) could also occur just as easily with an excess demand for the medium of account.

Having said all that, I still have a very open mind on this issue, I think the odds are more than 50-50 that you are right and I am wrong (for the totally rigid price case--I still think relative price changes are also important in the real world.) I know that the sort of commonsense examples I come up with can be inappropriate in monetary economics. But I'm still not 100% convinced I am wrong.

Scott: this is good. We are getting closer, and are on the same page. This is also forcing me to really think.

"Maybe it's just that my imagination is defective here, but I don't see the problem in depressions as being "gee I'd like to buy that and sell some other stuff to someone else, but I lack enough medium of exchange" rather I see the problem being an excess supply for everything at once, which (it seems to me) could also occur just as easily with an excess demand for the medium of account."

Suppose we start out in equilibrium, where I am holding my desired stocks of medium of exchange and medium of account.

Suppose I want more medium of exchange. There are two ways I could try to get some:
1. Sell more other goods (for money) than I normally sell.
2. Buy fewer other goods (for money) than I normally buy.

Suppose I want to get more bling (the medium of account, that is not a medium of exchange). There is only one way I can do that:
1. Sell more other goods (for bling) than I normally sell.

The medium of exchange is flowing into and out of my wallet automatically with every transaction I make. So I can either increase the flow in or decrease the flow out.
That isn't true for bling (or any other good). If I want more bling, I can only increase the flow in.

Now, here's the important point: in a world where goods are in excess supply, (relative to the medium of exchange, or the medium of account), I am unable to sell more goods. The "short side" of the market determines quantity traded, and in the case of excess supply, the short side is the demand side, so sellers are constrained. But I am always able to buy fewer goods, because as a buyer of goods, I am on the short side of the market, and can buy however much I like.

So, in a world where all goods are in excess supply against the medium of exchange, and I want to hold more medium of exchange, I cannot sell more goods to get more medium of exchange, but I can buy fewer goods to get more medium of exchange. (And if everyone tries to do what I try to do, we all buy fewer goods, which makes the excess supply worse.)

But in a world where all goods are in excess supply against the medium of account, bling, I can only try to sell more goods for bling. But I will fail, since I'm on the "long side" of the market. And so the story ends there.

Wandering off topic, the Keynesian multiplier story is supposed to be a paradox of thrift -- an excess demand for "savings". But it isn't. It's a paradox of the medium of exchange -- it's an excess demand, not for savings in general, but for one very particular type of savings -- savings held as medium of exchange.

Gonna stop here, and answer your other points in another comment.

Scott, again:

Suppose money is both medium of exchange and medium of account. Start in equilibrium, now halve the stock of money.

1. If all prices are fixed, bad things will happen (my point).
2. If some prices are fixed, relative prices change, and bad things will happen (your point, and I agree with it).

The only question to me is whether the bad things are worse in 1 or 2. My answer is "it depends". Both on the model, and on which prices are fixed.

In all the cases I can think of, the bad things that happen in 1 are either equal to or worse than, the bad things that happen in 2. I think that if I thought long enough I could probably cook up a model in which the bad things in 2 were even worse than the bad things in 1. But generally, I would say that allowing some prices to be flexible is usually better than keeping all prices fixed. So relative price changes actually ameliorate, to some extent, the bad consequences of an excess demand for money at the original set of prices.

I can think of one example where 1 and 2 are exactly the same:
Assume there are three goods, output, labour, and money, and a utility function U(Y,L,M/P), and a simple production function Y=F(L), and monetary exchange. In that model (Barro and Grossman 1971), if M falls and P is fixed, we get exactly the same fall in L and Y whether W is fixed or flexible. The only thing a fall in W does is to convert involuntary unemployment into voluntary unemployment. Y and hence L are determined by the requirement that the MRS between Y (consumption) and M/P equals one. W/P does not affect Y.

If we hold W fixed, but allow P to fall, the fall in Y and L won't be so bad.

That's an example where P flexibility matters most.

Here is a second example where W flexibility matters most. Same as before, except the utility function is now U(Y,L,M/W). (It looks weird, but M/W makes as much logical sense as M/P, since we use money both to buy labour and to buy goods). If we halve M, and hold W fixed, Y and L fall. It makes no difference to Y and L if we let P fall as well.

If we let asset prices and interest rates adjust, I think that ameliorates the bad things somewhat. Because if M falls i will rise, reducing the demand for money somewhat.


By the way, to prove my point that wage flexibility has no effect on output and employment in the simple 3 good model, where P is fixed, and the utility function is U(Y,L,M/P), let's look at the case where there is excess supply of both labour and output.

If there is excess supply of output, the level of output is determined on the demand-side, where the MRS between consumption and real balances equals the relative price (one):

MRS(Y,L,M/P)=1

and employment is determined by the demand for labour, so since firms are constrained in the output market (they cannot sell all they want), they just hire as much labour as is needed to produce the goods they can sell:

Y=F(L)

The money wage W does not appear in either equation. So a change in W will not affect Y or L.

But a fall in P will increase M/P and change the equilibrium by changing the MRS between Y and M/P.

Nick, In the first response with bling, can I assume you accept that if there is an excess demand for bling, you get unemployment? I.e. if people want to buy $1 billion more in bling than are being offered for sale, then there will be $1 billion excess supply of all other goods, and suppliers will then reduce the supply of all other goods by $1 billion below the optimal level.

Am I correct in assuming that you are also arguing the excess supply would be greater if there were $1 billion in excess supply for cash (the medium of exchange) because it would also interrupt a lot of transactions that otherwise would have gone through with barter if bling was the unit of account? I take this to be your argument, but just want to make sure.

By picking the 1929-30 example I was trying to force you out of your comfort zone, where short run prices are completely rigid and nominal monetary contractions equal real monetary contractions which reduce the real stock of the medium of exchange. Unfortunately I don't really understand these models well enough to have any confidence in hypothetical outcomes for the thought experiments that you propose. But the following example might give you a better idea of what I think is a typical "monetary shock."

In 1933 the Fed devalues the dollar sharply. Prices rise sharply for four months while nominal wages are stable. Industrial output rises 57%. Little or no change in the money stock, and a fall in real money balances. Why did output soar? Was it because there was more medium of exchange? Or because the monetary shock increased the expected future money supply---the money supply in out years by which time wages and prices would become flexible? In my view the big drop in real wages (as industrial goods prices soared and nominal wages were sticky) provided almost all of the output boost. If nominal prices had been constant, real wages wouldn't have changed, and as I already indicated nominal money didn't change right away, so what would have caused output to rise?

Now I suppose 1933 was an odd year, but in my view it simply showed more clearly what always happens. Major monetary shocks often don't change the current money supply much, but rather change the expected future path of M. That changes asset prices right now. The current recession is an example. The recession isn't because cash or M1 or M2 went down, it's because the expected future money supply 5 years out fell, reducing the expected future price level 5 years out (very clearly evident in TIPS spreads), and the stock market decided quite rationally that if inflation is coming to a screeching stop, and wages are sticky, then profits will plunge and unemployment will skyrocket.
I'm not trying to dodge your question, rather I don't understand the Barro-Grossman model well enough to have any confidence in my explanation. Instead I am trying to give my sense of what is important. It's a typical Chicago approach of assuming perfect competition sets prices (goods or assets) and wages are the only sticky "price." My hunch is that my view is wrong precisely to the extent that monopolistic competition is important, and thus sticky prices are important in the transmission mechanism. With sticky prices you get tight money reducing the real quantity of media of exchange, and that's probably where you get the mechanism that you focus on and that I overlook. But that's just a hunch.

Scott:

"Nick, In the first response with bling, can I assume you accept that if there is an excess demand for bling, you get unemployment? I.e. if people want to buy $1 billion more in bling than are being offered for sale, then there will be $1 billion excess supply of all other goods, and suppliers will then reduce the supply of all other goods by $1 billion below the optimal level."

NO, I certainly do not accept that. (Yes, I am violating Walras Law). To a first order approximation, and the most likely scenario, there will be $0 excess supply of other goods and zero unemployment. This is the really important part of my argument. $1 billion excess demand for bling; $0 excess supply of other goods!

People try to buy $1 billion more bling and $1 billion less other goods. They find they can't buy any more bling (nobody sells), so they give up trying to buy $1 billion less of other goods. So the $1 billion excess supply of other goods immediately disappears.

"Am I correct in assuming that you are also arguing the excess supply would be greater if there were $1 billion in excess supply for cash (the medium of exchange) because it would also interrupt a lot of transactions that otherwise would have gone through with barter if bling was the unit of account? I take this to be your argument, but just want to make sure."

YES. The final excess supply of other goods would be a lot greater than $1 billion, given the multiplier process.

That's the most likely scenario. I would only change my mind if I thought that, unable to buy more bling, they would decide that the medium of exchange is the closest substitute to bling, and so decided to demand an extra $1 billion medium of exchange as a second best.

Let me think about 1933. Yes, you have got me outside of my comfort zone :)

In a nutshell: if people try to buy $1 more of good x, and $1 less of good y, and find they can't buy $1 more of good x, they buy the original quantity of good y instead, as a second best.

This works for any good x, except the medium of exchange.

1933: here's my interpretation.

We start out with fixed money wages, and an excess supply of labour. But the price level has eventually adjusted to its equilibrium, given fixed wages, so demand=supply for goods.

If we want an increase in output and employment, we need two things in this case:

since W/P = MPL, and MPL is diminishing in L? we need a fall in W/P.

A fall in W/P is necessary, but not sufficient. We also need an increased demand for goods. One way to get this increased demand for goods would be through an increase in the supply of M/P, either through an increase in M or a fall in P. But you say neither happened. The other way to get an increased demand for goods is through a fall in demand for M/P. Maybe this is what happened? The increased inflation raised expected inflation which reduced the demand for M/P?

That's the only way I can make sense of it. And it's much the same as your way of making sense of it.

I do like macroeconomics with monopolistic competition. It's the only way I can make sense of the world. And I believe both wages and prices are sticky.

Nick, A few quick comments. The question of which model is best depends to some extent about what we assume about both monetary shocks and wage/price/asset stickiness. Thus your model may work best if one assume rigid wages and prices and an immediate change in real balances, but might work less well under a situation where the expected future path of money changes, and wages are rigid, and commodity and asset prices change quite a bit in the short run. In the latter case the relative price adjustments might well be more important that the medium of exchange effect.

2. You statement that the Walrasian assumption is wrong seems pretty bold. Is it as bold as it seems? And if so have you tried it out in conferences, journals, etc, to get feedback? If it is not as bold as it seems, is it because of some easily explainable trick? I still don't quite see why one can't treat all other goods as a sort of composite, and end up with excess supply of all other goods. But perhaps I should drop this as it isn't my forte. That's why I wondered what other people thought of the idea.

BTW, I agree about the paradox of thrift. It is too much demand for money, not saving. The whole GT has serious problems accounting for the price level. It's a weird sort of real model claiming to be a nominal model.

Scott:

1. Let's write money supply equals money demand as M=L(Y,P,i). If M falls, and P and i don't change, we get the direct effect on Y. If P adjusts down, and/or i adjusts up, that means the effect on Y will be lessened. Fixed W (for example), prevent P from adjusting as much as it needs to, because that would violate the MPL=W/P condition for labour demand.

So what you think of a fall in M causing relative price effects, which in turn cause the fall in Y, I think of as partial flexibility of some prices, which ameliorate the effect of M on Y.

My point about Walras Law is as bold as it seems. There's no trick. But it's not new. Clower knew it way back. So did a lot of economists in that early 1970's disequilibrium macro approach. Benassy knew it best. Peter Howitt taught it to me. Walras Law is true for notional excess demands. But in disequilibrium, people are quantity constrained, and reformulate their demands and supplies taking those quantity constraints into account. And Walras Law is not true for constrained excess demands. Because there's a different utility-maximisation problem in each market, because you consider the quantity constraints in all other markets, but not in the market where you are currently trying to buy or sell stuff. n-1 markets, give n-1 separate utility-maximisation problems.

It all got forgotten in the 1970s, when people forgot disequilibrium. God, am I the only person alive who remembers it?

If you accept that the paradox of thrift is really about excess demand for money rather than saving, you really accept my point about Walras Law!

There is one other way to salvage Walras Law.

Suppose there's an initial excess demand for bling and excess supply of other goods. But people are unable to satisfy their excess demand for bling, so buy other goods instead.

I would describe that as the excess demand for bling remains, but the excess supply of other goods disappears. So Walras Law is false.

But you could also say (as Dreze said, IIRC) that people give up trying to buy bling, so the excess demand for bling disappears too. (Think of it as the "discouraged bling buyer hypothesis" like the discouraged worker hypothesis which says that some unemployed workers give up looking.

Unfortunately, this interpretation has the unfortunate consequence that all markets will always have zero excess demand, even if prices are fixed. If there is excess demand buyers give up trying to buy; if there is excess supply, sellers give up trying to sell, so the excess demand or supply always disappears without prices needing to change.

Scott:

You are in error. You are just too used to "assuming" that product prices are flexible and wages aren't. A decrease in aggregate expenditures causes product prices to fall in response to the lower demands of products and the resulting surpluses. However, wages are sticky. So, real wages rise. And there is a decrease in the real demand for labor.

Fine. But how hard is it to imagine that product prices don't drop. Perhaps there are binding legal price floors on everything. It doesn't matter.

Then falling nominal expenditures results in falling demands for products. Firms sell less and produce less. The hire less labor beause they need less.

Now, if wages fell and prices didn't fall, then it is true that maybe firms would substitute labor for capital a bit, but they wouldn't produce more output because they couldn't sell it. Because by assumption, then didn't lower their prices.

Patinkin covers all of this pretty well.

Nick:

The money as bling is just confusing people. Of course, I read the comments and it seems like there are people who read this as if you are advocating that we get rid of money.

Forget the quantity theory business. Barter economy. What happens when there is an excess demand for equities matched by an excess supply of currently produced commodities? Or bonds?
I think the answer is that frustrated buyers shift to other goods.

Suppose people must borrow much less and pay down their debts? Suppose there are a lot of bankrupctcies?

Looking at what would happen in a barter economy would help show that none of these things cause "general gluts" except to the
degree they impact the supply and demand for the medium of exchange.

For folks like Scott and I, what happens when there is an excess demand for the medium of account? The price level needs to drop to clear that market. But, if it doesn't, frustrated medium of account buyers purchase other goods.

Anyway, I think you are on to something about the problem necessarily being the medium of exchange and not the medium of account.


Scott:

You _know_ that your Depression story of an increase in the price level and lower real wage, and a large increase in industrial production involved a large decrease in the demand for money.

It is the quantity of money and the demand to hold the quantity of money that matters.

Sometimes I am wondering if you don't drift back into the fixed velocity, changes in M2 determine nominal income version of monetarism.

To say that a gold devaluation does not impact M2 doesn't mean that it has no monetary consqeuences. If it is going to impact nominal expenditure in the economy, it must have monetary consequences. Expected future nominal income impacts current nominal income through changes in the current demand for money. And there are limits to this effect. Imagine the money supply is near zero now. And is expected to be really high next year so that nominal income is high. There is no way that nominal income will be high now because there is next to no money to spend.

Bill: I am so glad you found your way to this post, and comments. I was hoping you would.

I am very relieved to see someone understand what I'm talking about.

But maybe (unfortunately) you understood what I was talking about because you knew it already? You clearly have at least some familiarity with this literature, from your discussion of the vertical labour demand curve when firms are sales-constrained in the output market. (a la Patinkin, then later Barro and Grossman).

"Anyway, I think you are on to something about the problem necessarily being the medium of exchange and not the medium of account."

I have made several posts trying to get this point across, in various ways. This was one direct attempt: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/why-an-excess-demand-for-money-matters-so-much.html?cid=6a00d83451688169e201156f7bab5e970c

The same point crops up again when I look at the IS curve: http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/05/the-is-curve.html

To my mind, the whole multiplier process should be understood as the consequences of an excess demand for money, not an excess demand for "savings". Only a desire to save in the form of money causes the multiplier process. And by "money" here I mean the medium of exchange.

I'm really not sure what to do with this argument, and would appreciate your advice. Is it just a minor "dark age", where people used to understand this stuff, but nearly everyone has now forgotten it? Or is it partly new?

And you think that "bling" doesn't really work to help people understand it.

I could try a head-on frontal assault on Walras Law. It would go something like this:

In an economy with n goods (including money, if it exists), Walras Law says that the value of the n excess demands sums to 0.

But in a monetary exchange economy there are only n-1 markets.
But in each market there are 2 goods traded. If a market is in disequilibrium, one of the 2 goods is in excess supply, and the other is in excess demand. So there are 2(n-1) excess demands. So how can Walras Law say there are n excess demands, that add to zero?

Etc. What do you think? Is this new to you? Worth exploring?

Nick,

Your Walras law argument doesn't further your case becaue nobody is denying it. We all agree that the problem is that the excess saving is being held as money instead of flowing into real assets. We all also agree that this is a problem exactly because money is the medium of exchange.

We only disagree on one point. By phrasing it as an excess demand for money you appear to imply that supplying enough money, only for a short time, can stimulate now while still avoiding inflation later. This is simply false.

There is no amount of money that won't just be held at current rates of return. The only way to stimulate is to lower the expected real rate of return to holding money.

Thanks Adam. That helped me.

I agree those are two separate questions. The policy "increase the money supply" does not follow immediately from "a general glut is an excess demand for medium of exchange". They might be linked (I think they are), but you can believe one without the other. I need to keep them separate, and try perhaps to make a separate argument for the link.

Still, I'm not sure what to do with my Walras Law/Medium of Exchange argument. Leave it be (I've already made the point)? Or try to develop it, perhaps just by making a post summarising the whole thing, since some of the points only came out in response to comments?

Well Nick, that's the thing. My comments of your Walras Law/medium of exchange argument have been of the form "Nick you're missing the point", not "this is logically flawed".

Basically, the primitive demand is for real savings and money is the chosen medium only because it's risk-return profile looks better than the available real investment options.

Thus, the reason I prefer the phrase "excess real savings demand" is because money is being held because it has a risk-return profile that is, right now, prefered to real investment as a medim of savings. Thus, the solution is to make it's risk-return profile less attractive. Promising inflation lowers the return, taking large amounts of systematic risk on the central banks balance sheet makes money riskier (in the sense that if things go really bad the central bank must inflate to stay solvent, it's a state contingent promise to inflate).

This has everything to do with the supply of money expected in the future, perhaps contingent on the prevailing state of the world. It has nothing at all to do with the money supply today.

That said, I never said that if money was not the medium of exchange then any of this would be a problem. Like I said your post 'could the natural real rate really be negative?', nobody says a negative real rate would be a problem in a world without money. However, in a world that has money full employment will always require that the real return on money remain below the natrual real interest rate (or money is given some aggregate risk so it acquires a real risk premium).

I occurs to me that the whole crux of my argument is stated in the last sentance of the above post and so I should emphasize it:

IN A WORLD WITH MONEY FULL EMPLOYMENT REQUIRES THAT THE EXPECTED REAL RETURN ON MONEY STAY BELOW THE NATURAL REAL INTEREST RATE (OR MONEY BE GIVEN SOME AGGREGATE RISK SO IT ACQUIRES A REAL RISK PREMIUM).

The point is that it's all about risk and return of money vs real investment. Nothing at all to do with the quantity of money, except in so far as the time path of the money supply determines its real return.

Nick,

My claim that monetary policy can't break a liquidity trap without accommodating a certain amount of inflation is explained here:

http://canucksanonymous.blogspot.com/2009/06/phillips-curve-in-liquidity-trap_01.html

The comments to this entry are closed.

Search this site

  • Google

    WWW
    worthwhile.typepad.com
Blog powered by Typepad