The quick and dirty way of putting money into macro

This post is really about maths, dark ages, and understanding macro.

There are two ways of putting monetary exchange into a macroeconomic model: the proper way; and the quick and dirty way. Keynesians generally use the quick and dirty way. That's OK. But there may be problems if people don't understand what you are doing.

There's a lot to be said for the quick and dirty way. It's quick, even if it is dirty. It's a perfectly defensible short-cut that does the job quickly and simply, even if it's not perfect. The biggest problem is not that it's not perfect; it's that people may not realise you have introduced monetary exchange. Precisely because it's so quick and easy, they might not realise you've done it. Sometimes even the model-builders themselves might not realise they've done it. The biggest danger is that people will think it's a model of a barter economy, when it isn't.

Suppose you start with a non-monetary real business cycle model, and you want to introduce money into the model.

The proper way is to introduce trading frictions or transactions costs explicitly into the model. Then show that people in the model will find it cheaper or easier to do monetary exchange than barter exchange.

The quick and dirty way is simply to assume that barter is prohibitively costly, while monetary exchange has zero transactions costs. You ban barter. You ban all markets except monetary markets.

In a barter economy with n goods, there are n(n-1)/2 markets, where each of the n goods can be swapped directly for each of the n-1 other goods. (You divide by 2 because if there's a market where you can swap apples for bananas, that is also a market where you can swap bananas for apples.) In a monetary exchange economy, with n goods (including the good that is used as the medium of exchange), there are only n-1 markets, where money can be swapped for each of the n-1 other goods.

The quick and dirty way of introducing monetary exchange into a macro model simply amounts to "banning" a whole slew of those n(n-1)/2 markets. The only markets that are allowed to exist are the markets where one good ("money") is traded against each of the other goods. You write down the supply and demand functions, or equilibrium conditions, for the n-1 monetary markets, and you don't write down the equilibrium conditions for the other "banned" markets, because those markets don't exist.

The trouble is, anyone looking at the model may not realise what you've done. They don't see what isn't there. They don't see what's missing. They don't see that you have implicitly assumed a monetary exchange economy. Because you didn't say you were doing it. In fact, you may not even realise yourself that you have done it. Because we live in a monetary exchange economy, where each good (except money) has one market, and one price, it's natural for us to think this way. We didn't see the rabbit go into the hat. We might even think it's still a model of a barter economy, because nobody ever said explicitly that the barter markets were banned.

Let's take an example.

There are two goods: apples and bananas. And two time periods: today and tomorrow. That means there are really 4 goods: apples today; apples tomorrow; bananas today; and bananas tomorrow. With n=4, there are n(n-1)/2=6 markets. Apples today can be traded for: bananas today; apples tomorow; and bananas tomorrow. That's 3. Bananas today can be traded for: apples today (already counted that one); bananas tomorrow; and apples tomorrow. That's 2 more. And apples tomorrow can be traded for bananas tomorrow. That's 1 more, making 6 markets in total.

With 4 goods it's tempting to say there are 4 prices, but we can make one good the numeraire, and measure all prices in terms of that numeraire good, and say there are 3 relative prices. That's conventional wisdom. But it's wrong.

There are 6 markets, so there are 6 relative prices, one for each pair of goods traded in each of the 6 markets.

How do we get from 6 down to 3 relative prices? How do we make conventional wisdom correct again? We introduce arbitrage. If the 6 relative prices were out of line, there would be an infinite excess demand or supply in some of the markets, which would bring the 6 relative prices back in line.

But arbitrage only works if you can buy and sell as much as you want. If the relative price in one market is sticky, and is away from the market-clearing price, there will be excess supply of one good and excess demand for the other. So some traders won't be able to trade as much as they want to at that price, because they won't be able to find someone to take the other side of the trade. Arbitrage only works if prices are allowed to adjust to market-clearing levels.

But in a barter economy there are more markets than are needed. If people want to swap apples today for bananas today, but can't, because the price in that market is stuck at the wrong level, they just work around it, by trading apples today for apples or bananas tomorrow, then trading those for bananas today.

Now let's introduce money into this economy using the quick and dirty method. There is money today and money tomorrow. That's now 8 goods, and 32 markets. Now let's ban trade in all but 5 of those markets. You can trade money today for: apples today; bananas today; and money tomorrow. And tomorrow, when the markets re-open, you can trade money tomorrow for apples tomorrow and bananas tomorrow. We have banned all markets which don't trade money; and we have also banned the futures markets where you can trade money today for apples and bananas tomorrow. If you want to swap apples today for bananas tomorrow, there is only one way to do it. You have to sell apples today for money today, sell money today for money tomorrow, wait till tomorrow, collect your money, and buy bananas tomorrow.

The markets that exist in the model economy I have described above are exactly the same as in the standard New Keynesian model. The only difference is that the New Keynesian model has many different varieties of fruit, while I have only two.

What's the difference between the original barter model, with 6 markets open today, and the monetary exchange model, with 5 markets, but only 3 of which are open today?

If people know the future with certainty, and if all prices are at equilibrium, it makes absolutely no difference whatsoever. Any trade you want to do in the original barter economy you can still do in the monetary exchange economy, just in a more roundabout fashion. Exactly the same equations that define the equilibrium in the original barter economy will still define the equilibrium conditions in the monetary exchange economy.

Anyone looking at the equations describing the equilibrium conditions for the New Keynesian model could very easily be fooled into thinking that the New Keynesian macroeconomic model is just a Real Business Cycle model in disguise. Because the equations are identical.

Introducing uncertainty will make a bit of a difference, but only because I have banned the futures markets where money today can be traded for apples or bananas tomorrow. People might want to use those markets, to buy and sell insurance against future bad harvests. But let's ignore uncertainty.

It's when prices are not at market-clearing equilibrium levels that banning those barter markets will make a big difference. Let me explain why.

Suppose all prices are initially in equilibrium. There are 5 markets and 5 prices in this economy: money is the numeraire, so there's the money prices of apples and bananas today and tomorrow, and there's the nominal rate of interest which is the price of money today relative to money tomorrow. The price of a loan of money from the central bank, in other words.

Now suppose we hold 4 of those prices fixed, but assume the central bank makes a mistake and raises the rate of interest above the equilibrium level. What happens?

In a barter economy, where all markets were open, very little would happen. And if all agents had the same rate of time preference, and if tomorrow's preferences and productivity for apples and bananas were the same as today's, so there wouldn't be any loans in equilibrium anyway, absolutely nothing would happen.

Just to keep it simple, assume apples and bananas perish at the end of the day. With the real rate of interest set too high, everyone will want to save. There will be an excess supply of apples for money, and an excess supply of bananas for money. Apple producers will be unable to sell apples for money, and banana producers will be unable to sell bananas for money. So what. The only reason the apple producers wanted to sell apples for money was so they could use that money to buy bananas. And the only reason the banana producers wanted to sell bananas for money was so they could use that money to buy apples. Why don't they just swap apples for bananas? If it's not prohibited by very high transactions costs, or theorist's fiat, they will. And because the relative price of apples for bananas is at the right level, by assumption, we will get the right level of production and consumption of apples and bananas.

If producers can directly barter apples for bananas, bad monetary policy (or anything else) that sets the rate of interest above the equilibrium natural rate cannot prevent the efficient production and trade of apples and bananas. Bad monetary policy cannot cause a recession.

But if producers cannot directly barter apples for bananas, because the theorist has banned direct barter, bad monetary policy that sets the rate of interest above the equilibrium natural rate will prevent the efficient production and trade of apples and bananas. Bad monetary policy will cause a recession. If everybody wants to save, and forego current consumption for future consumption, producers will be unable to sell apples and bananas for money. So they will stop producing apples and bananas, because there's only so many apples that apple producers will want to eat themselves, and likewise with bananas.

Paul Krugman is right, unfortunately. It is too easy to be blinded by the maths. You can stare at the equations defining the equilibrium conditions all you want, but you won't see what's not there. You will see the consumption-Euler equation, which defines the equilibrium condition for present vs future consumption. But you won't see the equation which defines the equilibrium condition in the barter market for apples and bananas. Because that equation doesn't exist; because that market doesn't exist, in a monetary exchange economy. And that equation doesn't exist, because it is redundant, because that market is redundant, in a real business cycle model where all prices are at equilibrium. And because you don't see what's not there, you won't be able to see the difference between a real business cycle equilibrium model of a barter economy and a New Keynesian disequilibrium model of a monetary exchange economy.

Stop looking at the damned equations, because you can't see the equation that's not there. Think about the model. In particular, think about what markets exist and what markets are implicitly assumed not to exist.

And Paul Krugman is also right that there's a Dark Age. There's nothing original in this post that is not somewhere in Clower, Barro-Grossman, or Malinvaud. I've just applied some old 60's and 70's stuff to talk about New Keynesian macro, and New Monetarists' misunderstanding of it. But then I don't think New Keynesians are blameless either. How many New Keynesians make explicit that they are introducing monetary exchange into their models by the quick and dirty method -- by banning all except monetary markets? And how many of them really understand what it is they are doing when they introduce monetary exchange, and why it matters? (Update: and as Andy says, in the first comment, some of those "Dark Age" economists have indeed been introducing money the "proper way", which is good).

Comments

[Andy]

I thought we already went through how consumption Euler equations are not equilibrium conditions, but just optimization conditions.

More on topic, the "right way" is exactly what Kiyotaki-Wright and other search theoretic models of money do. You can trade anything you want but there's some transaction costs or finding fees or storage constraint or whatever. Dark Age Macro has been adding this stuff to their models since the 80s. We have some equivalence relations between that stuff and the cash-in-advance or money-in-utility function stuff that I believe you're calling the "quick way". There's work to be done, sure, but dark age guys have been working hard on this problem. I'm not sure exactly why you think they haven't been.

[Nick Rowe]

Andy. Fair point. They have been. I didn't mean to imply that they weren't. Let me see if I can find some way of editing my post to make that explicit.

[Nick Rowe]

Andy: there's the quick and dirty way to get a monetary exchange economy; and there's quick and dirty ways to get people to hold a stock of money. Those are different. Money-in-the-utility-function gets people to hold a stock of money. But it doesn't (by itself) create monetary exchange or prevent barter. Take a RBC model, then throw in money in the utility function, M/P, and I could just as easily interpret "M" as "jewelry". The real value of jewelry that I wear gives me pleasure. (It's the real not the nominal stock of jewelry, because I want to flaunt my wealth.) It doesn't make M a medium of exchange.

[anon]

You seem to be interpreting "sticky prices" in a quite peculia way. By your assumption, sticky prices cannot exist except in a monetary economy.

Imagine a barter model with n commodities and complete markets. We can write a square matrix with n^2 relative market prices. In a perfect frictionless market, this matrix is quite degenerate since there are only (n - 1) "degrees of freedom". But then it seems strange to argue that "sticky prices" for a commodity should only affect a few barter markets, rather than affecting price relative to all other commodities.

[Andy]

Nick, Yes cash-in-advance is the quick way, but you missed the point of my post, which is that Kiyotaki-Wright type models do in fact model why M is a medium of exchange. There is a lot of work on incorporating that into RBC or NK models. My understanding is that it is generally straightforward to generate cash-in-advance models that ALSO have the choice of money as a medium of exchange. (The difficulties tend to be about multiple equilibria and specifying expectations.) Williamson has some really nice notes on these sorts of models on his webpage.

[Nick Rowe]

anon: I'm not following your reasoning here. To my mind, you can get sticky prices in both barter and monetary economies. But in a barter economy, with n(n-1)/2 markets and the same number of relative prices (why do you say n^2?), I see no reason in principle why we can't have n(n-1)/2 prices stuck at wrong levels. Assume there's a law that says that apples must be traded at par for bananas, and bananas at par for carrots, but you can only swap 2 carrots for one apple. Sure, there will be no trade in some of those markets. But we can imagine that circumstance. It's logically possible.

[Nick Rowe]

Andy: "...but you missed the point of my post, which is that Kiyotaki-Wright type models do in fact model why M is a medium of exchange."

No, I understood your point there. That's (an example of) what I call the "proper way".

[Andy]

If we agree that Dark Age Macro has spent a lot of effort incorporating money into their macro models then I'm afraid I don't understand the point of your original post. Yes some models don't include a money-search framework. But not all models can have all elements. What exactly is the problem with taking the quick way, especially if we know there is a mapping between the quick way and the proper way?

[Nick Rowe]

Andy: Oh dear. My post can't have been clear enough. What exactly is the problem with the quick and dirty way? I'm OK with the quick and dirty way. The problem is when it's not explicit. You have to recognise you are doing it, so it's clear both to the modeller and anyone reading the model what you are assuming. You are assuming some markets exist and are frictionless, and other markets are banned (are assumed to have prohibitively high trading frictions). Because if you don't make these assumptions explicit, people may think you have a model of a barter economy. And people (including the theorist) may not realise that this assumption makes a very big difference to what happens when prices are sticky. People (especially people who introduce money the proper way) may think that a New Keynesian model is really an RBC model in disguise. They won't understand that recessions in these New Keynesian models are caused by a deficiency of monetary demand for goods due to bad monetary policy.

[Nick Rowe]

Andy: I have re-read my post. I think my second and third paragraphs make it clear that I don't disapprove of the quick and dirty way. That the danger is not being clear about doing it.

[anon]

"But in a barter economy, with n(n-1)/2 markets and the same number of relative prices (why do you say n^2?),"

A simplification for elegance's sake. Obviously exchanging a commodity for itself is a no-op, and the "apples for bananas" exchange rate is the same thing as the "bananas for apples" rate. You could use a triangular array to visualize the n(n-1)/2 prices of a barter economy.

"I see no reason in principle why we can't have n(n-1)/2 prices stuck at wrong levels."

The reason may depend on the underlying causes of price stickiness. If information or bargaining costs are the main factor, then making the price of a commodity "sticky" (relative to an arbitrary numeraire or benchmark) could be consistent with a barter economy and arbitrage-free prices, especially if quantity-based adjustment is possible.

[Nick Rowe]

anon: OK. I think I see your point. I suppose I was thinking that if we have a barter economy, a lot of trading conditions could be peculiar to each individual market, so almost anything is possible in principle for sticky relative prices. But a common numeraire might change things. I just find it hard to think of barter with a numeraire, though there's nothing logically wrong with the idea.

[Andy]

I think I'm complaining about the last few paragraphs (which I do see you've updated). Mainstream macroeconomists have been dealing with these issues for the past 30 years! The "Dark Age" narrative is not helpful and not true.

And perhaps it's easy to get blinded by the math, but without the math, it is also easy to fall into logical errors or confuse the story/mechanism. The math is just language we use so that everyone agrees what every sentence means.

[Nick Rowe]

Andy: I expect I've been arguing with too many people, both Keynesians and non-Keynesians, who don't see that monetary exchange is essential to Keynesian models. Who don't see that these Keynesian models don't make any sense at all unless we interpret them as models of a monetary exchange economy. On the one hand, Paul Krugman objects when "quasi monetarists" say that the paradox of thrift is really a paradox of hoarding the medium of exchange, and on the other hand Steve Williamson says that Woodford's model is really an RBC model dressed up to look Keynesian.

I think I mostly agree with you on math.

[Alan Rai]

Nick
If I were to re-title your post, it would be: "The quick and dirty way of introducing market incompleteness and market failure" in which a lack of market completeness (all those missing barter markets) leads to a market failure induced by bad policy.

[Nick Rowe]

Alan: it is rather peculiar though. It's market incompleteness plus sticky prices in the remaining markets, plus a policy failure.

[JP Koning]

Andy: "My understanding is that it is generally straightforward to generate cash-in-advance models that ALSO have the choice of money as a medium of exchange."

Do you know any examples of this in the literature? A cash-in-advance model that lets you choose an MOE is still a quick and dirty method because it forces *some* sort of cash upon its agents. At least, that's my initial thought.

Great post Nick, still cogitating.

BTW, I have no problems condemning quick and dirty methods of incorporating money. I can't see how anyone who takes money seriously can't avoid gagging when they see one. They're cheap hacks to model around the fact that economics still doesn't really understand money.

[JP Koning]

Nick: "That's (an example of) what I call the "proper way"."

And the other examples would be... a Misesian regression theorem? Any others?

[Nick Rowe]

JP: No, the Misean regression model was trying to explain something different -- why a money could have value without having any intrinsic value. Menger would be the original version of "the proper way", because he was trying to explain (succeeded in explaining, in an informal way) why people use money rather than barter. And, like later examples, he talked about what would be called "trading frictions". There's also a clear statement of positive feedback in Menger (and with enough positive feedback you get multiple equilibria). Menger is the grandfather of "the proper way", as far as I know.

[JP Koning]

I guess I see the explanation for money's value (fiat or not) and the explanation for it's use as being pretty much the same issue. They should be coincident.

I realize you are trying to say that modelers must be explicit about banning barter markets. But I can't help reading into your post that models *should not* ban barter markets, because including such markets may lead to significantly different conclusions. ie. that bad monetary policy cannot cause a recession.

[Nick Rowe]

JP: Well, von Mises saw it as a puzzle, and I think he's right. If it's used as money, and people want to hold a positive stock, then it will have value. But it can't be used as money unless it does have value. So there are two equilibria: one where it has value, and is used as money, and a second where it does not have value, and is not used as money. Von Mises gave one answer (I think a good one) of how to break that circle.

Ideally, we should explain why people do not use barter, not just assume they can't. But I think it's OK, as a simplifying assumption, for some purposes, just to assume they can't use barter. But it will lead to some (we hope small) errors. Because unless the costs of barter really are infinite, in a recession we will in fact see some people resort to barter.

[JP Koning]

"But it will lead to some (we hope small) errors."

If the possibility that people turn to barter means that bad monetary policy cannot cause a recession, I'd say the errors caused by models that ignore barter are pretty big.

[edeast]

What was Von Mises answer?

[Nick Rowe]

JP: Well, the question is: how many people resort to barter, and how costly is it for them to resort to barter? My guesses are: few; very. So it doesn't make much difference to the costs of recessions. But the fact that barter is more common in recessions (if it is a fact, and I think it is) is further evidence in favour of the monetary nature of recessions.

edeast: In a nutshell. Start out with a money that is valuable because it is convertible on demand into some real commodity (like gold), so people get used to using it as money, and valuing it, then slowly withdraw convertibility, and it keep flying under its own power.

[Lee Kelly]

Goods have degrees of moneyness.

When there is an excess supply or demand for a good, its degree of moneyness decreases until equilibrium is restored.

The reason things like T-bills become close substitutes for money is not because T-bills' degree of moneyness increases, but rather because money's degree of money decreases. Or something like that.

In this case, decreases in money supply are logically equivalent to increases in money demand -- it just depends on how the world is carved up by words.

[Gizzard]

Ive read the post twice and I'm still having trouble keeping it all straight (I think thats part of the plan of you academic economists ;-) ) So I'll just ask you a question Nick.

Are you a believer in the idea that money is simply a neutral veil? I'm assuming that you are but I want to be sure.

If you are then I have a hard time reconciling that position with much of what you argued in this post and your post on the "Paradox of Thrift".
Doesnt the neutral veil argument rest on the notion that if there were no money in the economy, the distribution of real wealth would be exactly the same as the distribution of monetary wealth we see now? If thats true it doesnt matter when monetary exchange gets added to the model because it changes nothing.

[JP Koning]

"Well, the question is: how many people resort to barter, and how costly is it for them to resort to barter?"

The proportion of people resorting to barter is an empirical question. This shouldn't prevent models from incorporating some possibility of barter along with monetary exchange. Especially if this has important repercussions. Both your proper and quick & dirty methods seem to rule out barter combined with monetary exchange.

Speaking of quick & dirty, the regression theorem is a great example. It's a pseudo-psychological rule applied in an ad hoc way by Mises that conveniently applies to only one of the many items in an economy (money) and not the rest. It forces upon all individuals naive backwards expectations (just like cash-in-advance forces money on them). But Mises only forces backward expectations on people's interaction with money. The value of every other item in the economy is governed by good old forward looking expectations. It's a very arbitrary theory, I don't like it one bit.

[vjk]

JP:

Von Mise's answer was gold, as opposed to paper fiat, at least for base money due to the former almost undilutable nature:

"it does not lay the prices of commodities open to violent and sudden changes from the monetary side. The biggest variations in the [inner objective exchange] value of money that we have experienced during the last century have originated not in the circumstances of gold production,but in the policies of governments and banks-of-issue"

Von Mises was also opposed to bank maturity transformation, the core activity of the modern banking system:

"The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, "The date on which the bank's obligations fall due must not precede the date on which its corresponding claims can be realized." Only thus can the danger of insolvency be avoided.
"

Probably, he had a point or two ;)

[Nick Rowe]

Lee: maybe. Depends what we mean by "moneyness". In this post, "money" means medium of exchange, and there's a fairly clear distinction. Your comment pertains more to my previous posts.

Gizzard: Roughly: money is certainly not a veil in the short run (when prices are sticky); it is approximately neutral in the long run (when prices have time to adjust fully). That means that if we change the money supply, nothing real changes, whether it's the quantity of goods produced and consumed, or the distribution of wealth. But if money disappeared altogether, and we returned to barter, that would be a very big real change, with big consequences. Maybe a return to the Stone Age!

[Nick Rowe]

It's only when we add money to a purely hypothetical barter model economy, where there are no costs to trading, that adding money changes nothing real.

[Nick Rowe]

JP: "The proportion of people resorting to barter is an empirical question. This shouldn't prevent models from incorporating some possibility of barter along with monetary exchange. Especially if this has important repercussions."

Agreed. But it makes the model more complicated, and that's a penalty.

"Both your proper and quick & dirty methods seem to rule out barter combined with monetary exchange."

No. The proper method could incorporate some barter, and if the proper method were done .... properly, the amount of barter would vary with the business cycle.

Yes, von Mises is in a sense assuming backward-looking expectations. And I like it (in this context). It's called "custom". Without custom, language could never work, because we assume that words will mean roughly what they meant in the recent past. We would never know what side of the road to drive on. Laws wouldn't exist. We would be in the Hobbesian State of Nature.

vjk: interesting. So von Mises was a narrow banker!

[Nick Rowe]

JP: just to expand. The quick and dirty method effectively assumes monetary exchange has zero transactions costs, and barter has infinite transactions costs. The proper method could allow that monetary exchange usually has lower transactions costs than barter, but in a recession, the foregone gains from trade due to an excess demand for money could make barter profitable enough to overcome those higher transactions costs.

[edeast]

I wrote a long comment but I was a little tipsy from an afternoon dinner.

So in restraint; basically, the mises thing doesn't make sense.

I compare it to religion you've compared to language; once the leader node is withdrawn an institutional structure or custom could emerge (meaning new nodes) however in the case of the market: When the strongest node(either Gov redeemability, or mises Gold), is withdrawn, the money could be used for a while, but it will lead to a slow death, as nodes begin to withdraw from the network starting with the people who actually needed gold.

[edeast]

ok, but then if gold is no longer necessary, then that node will die off and the network evolves. i get it.

[edeast]

^ Goddamn language counterfeiters

This node nonsense I'm talking about is similar to your airport hubs. Figure 1, of M Shubik's Monetization of Credit. The title is more ambitious then the paper. But I enjoyed it, he tries to reconcile between chartalists, and 'Mengerians'.

[JP Koning]

"No. The proper method could incorporate some barter, and if the proper method were done .... properly, the amount of barter would vary with the business cycle."

I thought you were always and everywhere a Clower guy... money buys goods and goods buy money but goods don't buy goods. Perhaps adopting a Clower constraint is more pragmatic given the complicated nature of an economy in which "money buys goods and goods buy money AND goods buy goods"? Are you moving away from Clower?

Anyways, I completely agree that a proper method would incorporate some amount of barter that varies given economic events and changes in other variables.

Wondering if there is a modern formal model that does incorporate barter in addition to monetary exchange. Do Kiyotaki & Wright and followers explore this idea (and explore the macroeconomic implications)?

[JP Koning]

"It's called "custom". Without custom, language could never work, because we assume that words will mean roughly what they meant in the recent past."

We'll probably never agree here. I've poked around a bit in old economics books... our argument goes back centuries. Locke said money earns a value through the "universal consent of mankind" (ie. custom). Turgot countered and said: "A money of convention is ... a thing impossible." I happen to agree with Turgot.

Customs and conventions must be based on something intrinsic, otherwise they'll quickly disappear. Same with money... it must have some intrinsic value.

vkj: Although I tend not to agree with Mises on monetary matters, he's always a great read.

[Nick Rowe]

JP: "Customs and conventions must be based on something intrinsic, otherwise they'll quickly disappear. Same with money... it must have some intrinsic value."

There is no intrinsic reason to drive on the right rather than the left side of the road, though there is an intrinsic reason why we each choose to do what we think everyone else around us will do. There is no intrinsic reason why "cat" should mean cat, though there is an intrinsic reason why each of us should use "cat" to mean what we expect everyone else around us will use the word to mean.

Every morning I wake up, confidently expecting the future will be like the past, and that Canadians will continue to drive on the right and use "cat" to mean cat. And accept paper Loonies as valuable. Those backward-looking expectations serve as a coordination device. They pick one of several possible equilibria. It takes a lot of real force to change an established custom like that. It took massive hyperinflation to destroy the Zimbabwe dollar's use as a medium of exchange.

Clower's "goods do not buy goods" was always a pragmatic simplification. I'm really not familiar enough with the literature to know or remember if there are models with both money and barter in equilibrium. There must be. Sometimes, in the simplest case, double coincidences of wants do happen.

[Scott Sumner]

Nick, Suppose the medium of exchange and the medium of account differ. Say Canada abolishes its monetary system, and for some odd reason Canadians adopt the US$ as their medium of account and the euro as their medium of exchange. So stores price goods in dollars, and at the checkout a computer tells the customer how many euros he must pay for each item based on the current US$/euro exchange rate.) Which is the "right" money in a monetary model? I'd say dollars, as wages and prices will be sticky in dollar terms. If the US has a deflationary monetary policy, cutting dollar supply by 20%, and Europe does a hyperinflationary policy, then prices in Canada will fall sharply, and Canada will go into depression (assuming dollar wages are sticky.) So why is the medium of exchange important?

In the US most base money (prior to 2008) was held for purposes of tax evasion, not transactions. Were I to introduce "money" into a model, I'd call the medium of account "tax evasion facilitators" and I wouldn't assume it had any major role to play in transactions. It would be a sort of real good, and the inverse of its value would be the price level.

In 1928 I'd call money "gold," another real good that served as a medium of account, but (by 1928) rarely was used for transactions.

[vjk]

JP:

One would speculate that money, be it gold or paper, has zero intrinsic value (ignoring gold use for industrial or adornment purposes).

Arguably, money is nothing more but a more or less reliable way to record your labor in the broadest sense. So, the bank account record represented by ones and zeroes on a computer, a bank note or a piece of gold are a legal title to your past labor just as your property title is a reliable record of your ownership. In this sense, regardless of a specific embodiment, one can talk about money as "store of value" and derive the function of "medium of exchange" due to the actual value associated with but not being intrinsic to a specific medium.

[JP Koning]

"One would speculate that money, be it gold or paper, has zero intrinsic value (ignoring gold use for industrial or adornment purposes)."

You can't ignore those purposes. They comprise gold's intrinsic value.

[JP Koning]

"There is no intrinsic reason to drive on the right rather than the left side of the road... There is no intrinsic reason why "cat" should mean cat."

You're trying to draw an analogy from money to language, and since your point about language is hard to deny, and money is (according to you) like language, then money is purely customary.

But the words in a language aren't economic good. Money is. Words don't have a marginal utility... they are not traded on markets and have no price. You can say any word you like without having to buy it first. While the net effect of monetary exchange may resemble something like the net effect of language (order out of chaos), actual individuals don't hold money because of its net effect. The buy and sell money for the same microeconomic reasons they buy and sell other goods. Show me an economic good earning its value purely from habit and I'd be convinced that the same could apply to money. But you can't point to language or driving rules for your analogy since they aren't economic goods.

[JP Koning]

"Arguably, money is nothing more but a more or less reliable way to record your labor in the broadest sense."

Locke and Berkeley's counter theory of money. Another oldie.

Say I pay someone for their labor with a blue rock which I tell them will "record their labor", and then they try to spend it at a store. No matter how much the owner of the blue rock points out to the storekeeper... "But sir, you owe me, it's a legal title to my past labor!" the storekeeper won't take it. Something additional is required to convince the storekeeper to take the counter.

That being said, I'd agree that one of the emergent properties of the use of money is record-keeping, i.e. who owes who what. But people don't initially purchase money because of this emergent property.

[Nick Rowe]

Scott: I had to think about that question. New Keynesian models are monetary exchange models, so there must be a medium of exchange. But prices are sticky in terms of a medium of account. I think what matters is the real interest rate the central bank sets on loans of the medium of exchange. For example, suppose we start in equilibrium, and hold all present and future prices fixed in terms of the medium of account. Now suppose the central bank raises the nominal interest rate, measured in the medium of account, by 1%point. The economy goes into a recession. But if it raises the nominal interest rate, measured in the medium of exchange, by the same 1%point, but at the same time, the medium of exchange is expected to depreciate against the medium of account by the same 1%point, there's no change in the real interest rate, and no recession.

I think I've got that right.

[Nick Rowe]

JP: we use language for economic reasons (inter alia), but which language we use is arbitrary (more or less, because some are more convenient than others). Same with money.

"Show me an economic good earning its value purely from habit and I'd be convinced that the same could apply to money."

As I sit in front of this computer, most of Microsoft's goods come to mind. (OK, the analogy isn't perfect, but then money really is peculiar).

[vjk]

JP:

You can't ignore those purposes. They comprise gold's intrinsic value.

Those properties are irrelevant for value accounting. Should the stock of fiat money be constant (perhaps an impossibility), its accounting property would be indistinguishable from gold's.

the storekeeper won't take it
It is easy to imagine a friendly group of people recording, and accepting, their mutual obligations they would wish to exchange on a piece of paper.

In the real world, where such trust is regrettably lacking, people have to resort to a more reliable way of recording the socially agreed upon value of their labor. Whether such record is made with a piece of gold, silver, a piece of paper or a computer record whose reliability is trusted is irrelevant. The trust itself is paramount for a medium of exchange to be recognized as such. The choice of the medium is utilitarian and coincidental.

[anon]

x

[Edit: Aha! I now see what you were doing anon. Turning off italics. Thanks! I've just gone into the previous comment, and corrected the "end italics" thingy. Nick]

[Gizzard]

Nick

The whole problem I have with the whole long term/short term neutrality of money is that we are ALWAYS in both the long term and the short term. Today is the long term relative to events and changes in the 1930s, its the short term relative to yesterday. We are never "in" one term or the other. To me its a completely meaningless concept.

If I was able to print up some "impossible to determine as counterfeit" money today,say 1 trillion$ worth, I could bring forth some real production. I could place orders to thousands of suppliers and they likely would have to hire more people to meet my orders (and prices likely wouldnt rise at all). There would be real short term production and generation of real wealth. As long as I could keep my press running, for as long term as I wished, I could maintain production at that level.

And if that money is then removed, a lot of real production would stop.

Trading and selling are two completely different things. Selling is what modern economies depend on barter economies are simply trades. Not until money is introduced are we selling something.

[JP Koning]

"It is easy to imagine a friendly group of people recording, and accepting, their mutual obligations they would wish to exchange on a piece of paper."

There's a big difference between a piece of paper given to you by person A that supposedly "records" the value of labor you provided to A, and one that contractually obligates A to render an amount of labor in return. The second piece of paper has an intrinsic value and can be passed on to C because it is a debt claim on A's valuable labor, but the first piece of paper will never be accepted by C. A mere record of your labor would be laughed at, but if the paper is a contractually agreed debt claim on A's labor, on your labor, or on the labor of anyone else in that society who has signed on to your scheme, it might be accepted. Not because it is a recording device, but because it is a debt.

[Scott Sumner]

Nick, I must not have followed your answer, because it seemed to me you were agreeing with me. If US$ are the medium of account, then all loans are denominated in US dollars. If euros are used for transactions purposes in lending, but all the book-keeping is done in dollars, then the euro interest rate doesn't matter. Did I misunderstand your argument somehow?

[Nick Rowe]

Scott: I think I am agreeing with you. But since it's the real interest rate that matters (in this NK model), it wouldn't matter what units we measured the nominal interest rate and prices in. What actually gets lent by the central bank is the medium of exchange. But it's the real interest rate measured in apples and bananas that matters.

Gizzard: " As long as I could keep my press running, for as long term as I wished, I could maintain production at that level."

No. The 1970's told us we can't. Theory tells us we can't. Zimbabwe tells us we can't. You can only do it as long as actual inflation exceeds expected. If you keep on trying, you destroy the currency altogether.

"Trading and selling are two completely different things. Selling is what modern economies depend on barter economies are simply trades. Not until money is introduced are we selling something."

No. That's just semantics. When I sell apples for money, I am buying money with apples, and trading money and apples.

When I first came to Canada I walked into a bank, put some pounds Sterling on the counter, and said I wanted to buy some Canadian dollars. The teller gave me a strange look, but it made perfect sense to me!

[Lee Kelly]

Money is really weird.

Consider: suppose that tomorrow everyone woke up and forgot about money. People discover pieces of paper and metal discs in their wallets, and notice numbers on something called a "bank account", but just see pieces of paper, metal discs, and numbers on a screen with only non-monetary uses. It occurs to nobody to accept these things as a medium of exchange, and all trade is reduced to barter.

How does an economist describe this transition? Did M fall to zero, or did V fall to zero? While the pieces of paper, metal discs, and bank account records all remain the same as the day before, is there any sense in claiming that M was constant? If something isn't used as a medium of exchange, then in what sense should it still be counted as part of the money supply?

This is an extreme example, but what if the change was gradual, occurring over a year or more. How can one tell the difference between a fall in V and a fall in M? Aren't they kind of the same thing? I don't know ... this is getting confusing.

[vjk]

JP:

but the first piece of paper will never be accepted by C

This line of reasoning reflects regrettable decline in morals running so deep that it is not even possible to *imagine* a group of people who would recognize mutual obligations without outside coercion. The operative word in the imaginary scenario with pieces of paper was "trust".

Gold scarcity is an imperfect substitute for lack of trust in accounting for labour (broadly understood), as is partial trust of the populace in the modern banking system, in combination with the legal system coercive power to make up for deficit of such trust. Either make possible use of the respective medium as a store of value, without need to appeal to some intrinsic value.

None of what was said above is of course original or not well known.

[Gizzard]

Nick

Youre telling me that if I went to every business in my area and purchased $1000 gift certificates(which I then gave away to people) with my printed cash, and I did this regularly and I paid someone to do that all around the country until I had spent my hundreds of billions of undetectable counterfeit currency, that this would only cause price rises and not bring forth new and untapped production.? Why would they simply raise prices because some guy comes in regularly and pays a thousand dollars cash for gift certificate every week or so.?

Your reference to Zimbabwe is specious. That was not simple printing money. It was an extreme fall in productive capacity that severely caused real prices to rise.

When you sell apples for money its the presence of money that allows that to happen. It introduces something new and NON NEUTRAL to the transaction. Prior to the introduction of money If you wanted my lemons there was not a fixed "market" price of the number of apples needed for a lemon. The banana guy might want three of my lemons for his banana and you might want two for your apple. In addition you guys might trade your apple and banana one for one. The economy changes completely once someone introduces a money price into the equation. I dont think its simply semantics at all. They are different beasts all together.

[Nick Rowe]

Gizzard: Have a read of my old post: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/05/units.html

Lee: "Consider: suppose that tomorrow everyone woke up and forgot about money. People discover pieces of paper and metal discs in their wallets, and notice numbers on something called a "bank account", but just see pieces of paper, metal discs, and numbers on a screen with only non-monetary uses. It occurs to nobody to accept these things as a medium of exchange, and all trade is reduced to barter."

That's a lovely thought-experiment. It's one I have used myself. It shows that history matters. Here's a similar one: suppose everyone woke up and forgot who owned what.

Economists have a saying "Bygones are bygones". In cases like these, that saying is totally false.

I would describe your case as M fell to zero. The physical stuff remains, in the same quantity as before, but it's no longer seen as a medium of exchange, and so is not used as such, and so is not money.

[Lee Kelly]

But Nick, instead of everyone waking up tomorrow and forgetting about money, suppose it occurred gradually over a decade.

After a month economists begin noticing falling NGDP and deflation. The same quantity of money exists as before, so they conclude money demand has increased. The central bank increases the supply of money to offset the decrease in money velocity and NGDP is stimulated. But people just keep holding more and more money and spending less and less, for whatever reason, and the increasing money supply can't keep up. It seems like velocity is falling while the money supply is growing. Eventually, after ten years we are in the same situation as before, and all trade is reduced to barter.

Why is this a fall in the money supply and not a fall in velocity? Did the falling velocity cause the fall in the money supply? But then how are we to separate the concepts of supply and demand for money? Is a fall in velocity in some sense equivalent to a fall in supply? But it would be nonsense to say something like this for any other goods.