Non-economists often think that "economists study money." The
reality, though, is that most academic economists hardly think about money at
all. Whether we're talking about tariffs, wages, Social Security taxes, or
pollution, the analysis (though often couched in dollar terms for the benefit
of the general public) really is grounded in microeconomics and would work just
as well if we were talking about a barter economy. In fact, in a typical Ph.D.
program, students study models with money in them only when explicitly trying
to answer questions about central-bank policy. Even in these cases—in which the
very purpose is to draw conclusions about appropriate monetary
policy—the underlying logic of the model doesn't really have a role for money.
Instead, economists insert money into the model somewhat awkwardly, through
various ad hoc assumptions.
This awkward situation underlines the chasm between "micro" and "macro" economics and shows that economists do not agree on the actual role that money plays in the real-world economy. There are two main approaches to dealing with money in economic analysis, each having strengths and weaknesses.
The Macro Approach: The Equation of Exchange
Probably all economists, and even many
non-economists, are familiar with the time-honored "equation of
exchange" approach to money, which takes a macro perspective by
essentially overlaying the entire stockpile of money on top of the underlying
"real" micro economy. (1)
The original and more intuitive version of the equation is MV = PT, where M stands for the total quantity of money in the economy, V is the "velocity of circulation" (meaning how many times, on average, a dollar bill changes hands for the time period in question), P is the average price of a transaction ("price level"), and T is the total number of transactions. In this form, one can see that the equation is not a statement of economic theory. Instead, it is an accounting identity. That is, the statement must be true. The left side, MV, measures how much is spent in the aggregate during the period in question. The right side, PT, is the exact same thing, from a different perspective. Since both sides measure how much total money is spent in the economy, the two expressions necessarily equal each other.
The problem with stating the equation of
exchange in this form is that the term T includes all transactions,
including the sale of previously-produced goods and even of assets. For
example, if Bill buys 100 shares of stock from Sally at $5 per share, then this
transaction is included in T, the price of the shares influences
the "average price" P, and the turnover of the $500 from
Bill to Sally is included in the "velocity of circulation" V.
However, economists typically don't welcome this result because they want to
exclude financial transactions from the analysis in order to focus on
production.
Consequently, it is more common nowadays to see
the equation expressed in the form MV = PQ, where Q stands
for newly-produced goods and services ("real
output") during the period in question, and where both V and P are
restricted to transactions involving newly-produced goods and services. In this
updated form, the equation of exchange can be very useful to illustrate certain
relationships.
For example, the equation shows that if the
quantity of money in circulation doubles while velocity and real output remain
constant, then the price level doubles, too. It can also show that if the
economy's production of "stuff" grows faster than the stock of money, and if
people don't change how quickly they spend the average dollar bill in their
possession, then prices will have to fall over time.
As with the transactions version of the
equation, this version is necessarily true, and economists of all stripes can
use it to illustrate their rival theories. On the one hand, a Keynesian might
use it to show that during a liquidity trap, monetary expansions by the central
bank will not lead to rising prices because they will be perfectly offset by
drops in velocity ("increased hoarding"). On the other hand, a Chicago
School proponent of efficient markets might argue that monetary policies
(especially in the long run) can't affect the "real economy" Q and,
instead, merely change the growth rate of P, that is, the inflation
rate.
The great virtue of the equation of exchange is
that it provides a simple and intuitive framework with which to keep track of
the various constraints in the economy. Whatever story an economist wants to
tell, the equation of exchange forces him to "stay honest" with the
listener. For example, if an economist wants to warn that a growing money stock
will cause prices to rise too rapidly, the equation reminds him that a full
explanation requires him to show that velocity and real output will not react
in ways that contradict his prediction.
The great weakness of the equation of exchange
it that it is artificial, providing no real insight into the function of money
in the first place. With this approach, economists typically will
"solve" for an economy in terms of barter, and then, as an afterthought,
overlay the total stock of money on these relative price
ratios to come up with absolute prices (quoted in money). Thus, the
economist might use the fundamental logic of utility maximization and resource
supplies to conclude that, in equilibrium, one apple will trade for two
oranges. Then, he might say that with a certain stock of money M,
an apple will have a price of $1 while an orange will have a price of 50 cents.
Now, if we double the stock of money to 2M, other things equal, apples
will be priced at $2 and oranges at $1.
To reiterate, the problem with this (standard)
exercise is that there is no explanation for why people in the real world use
money. After all, if the economist is able to "solve" for the
relative price of apples and oranges without the use of money, it's not clear
why people in the real world use intrinsically useless pieces of paper in their
dealings. Why not consult their preferences and swap fruits directly against
each other, as the economist assumes they can do?
Note that the criticism here is not the familiar
one that a given model is "unrealistic"; just about every economic
analysis assumes away real-world complications to isolate particular
relationships. Rather, the objection here is that if we are going to
use a model to talk about money, then there should be a good reason in
the model for people to use money. The standard equation of exchange approach
does not obey this simple principle.
The Micro Approach: Individual Cash Balances
Rather than taking a bird's eye view of the
entire stock of money in the economy, an alternative tradition focuses on the
typical individual and his holdings of cash balances.(2) The central insight
here is that, strictly speaking, money is never "in
circulation"; at any given moment, every single dollar is in someone's
possession. Rather than focusing on dollar bills as they flow around the
economy, the cash-balance approach focuses on individuals and
their optimizing decisions.
In the cash-balance approach, the economist
recognizes that in equilibrium—though it may be a fleeting condition—it has to
be true that every individual is satisfied with the amount of money he holds.
After all, if the individual thought he'd be happier by trading away 50 cents
to receive just one more gumball, then it would not be equilibrium. Having
thought through the necessary and sufficient conditions for a typical individual to
be in equilibrium with respect to his cash holdings, the economist finishes the
analysis by saying that the sum of all desired cash balances must
equal the total quantity of money. In equilibrium, it must be the case that the
community collectively desires to hold the exact amount of money in existence
at that moment—no more, no less.
The great virtue of the cash-balance approach is
that it focuses on the interesting fact that people want to hold money—even
though qua money it's intrinsically useless—but not too
much money.(3) Going down this path forces the analyst to think about
the different things one might buy with money, including not just consumable
goods and services, but also assets. Thus, we see that cash can "burn a
hole in one's pocket" not simply because of a desire to buy pizza, but
also because of a desire to diversify wealth out of currency and into corporate
stock, bonds, precious metals, etc.
As with the equation of exchange, the
cash-balance approach, too, is very flexible, allowing economists to implement
their preferred theories explaining monetary activity. A Keynesian can argue
that at very low nominal interest rates, there is little reason to prefer
relatively illiquid bonds over money; thus, the demand to hold money can rise
substantially, perhaps frustrating the central bank's efforts to boost
aggregate demand. In contrast, an inflation hawk might use the approach to
argue that an expected burst of money printing in the future would
lead people to reduce their desire to hold money in the present. Since the
nominal quantity of money is fixed (for the moment), the only way to restore
equilibrium is if prices generally rise, so that the "real" amount of
purchasing power everyone holds can decline.
The downside of the cash-balance approach is
intimately connected to its strength. It's all well and good to praise the
method for focusing on the optimizing behavior of the individual, thus treating
the commodity "money" with the same conceptual tools that economists
use on every other good and service. The problem is that it's very difficult to
explain the demand to hold money. (In contrast, explaining the demand for apples,
or even the demand for unskilled labor, is relatively trivial.) In explaining
why people choose to hold money, economists are ultimately forced to take
positions on the role of institutions, how individuals deal with uncertainty,
and even the mechanics of commercial transactions. Because the cash-balance
approach carries with it so much baggage, economists cannot use it to quickly
settle an argument over, say, whether the Fed should drop the dual mandate to
care about both unemployment and inflation and, instead, adopt an explicit
inflation target.
Evaluating a Given Scenario With Both Approaches
As we have seen, both of the approaches to money
can be flexible, allowing the economist of a particular school of thought to
tell a more specific story involving behavioral assumptions he favors. It is
also true that economists can ultimately handle a given scenario with either
approach, and the decision about which approach to use boils down to which is
more convenient or intuitive for the scenario at hand. In practice, the two
approaches may often blend into one unified analysis, drawing on elements from
both perspectives.
For example, suppose that an economist wants to
discuss David Hume's thought experiment of a magical doubling
of the quantity of money during the night. Using the equation of exchange, the
economist might say:
"Assume that we had full employment originally, so there is little scope for increasing real output. In this case, if velocity is constant, doubling M will cause P to double. However, if the overnight magic causes people to worry that their money is not a good store of value, then velocity will rise, meaning that P ends up more than doubling."
In contrast, the economist could handle the
stipulated scenario with the cash-balance approach, perhaps saying:
"The typical individual was originally in equilibrium with a certain nominal quantity of dollars, and with respect to a certain level of prices. The next morning, everyone wakes up to discover that he is holding twice as much money as he thinks is optimal. Each person will try to get rid of the excess cash holdings. However, collectively, the community can't get rid of money; one person's spending is another person's income. If we assume that what people really care about is the amount of goods and services that can be purchased at a moment's notice with cash balances, then equilibrium can be restored once prices rise. If the magical doubling wouldn't change this desired amount of "real" cash balances, then prices must double. However, if the episode has soured the typical person on storing wealth in the form of currency, then he will re-optimize and reduce his desired level of real cash balances. This means that prices must more than double in order to induce the community to hold the doubled quantity of nominal dollars."
This example shows that, in practice, the
distinct approaches may merge into a unified explanation. Even when an
economist uses the equation of exchange, he will probably motivate discussions
of "what happens to V" by reference to individuals'
preferences and expectations about future purchasing power. On the other hand,
even the economist who writes strictly in terms of the cash-balance approach
may often reach the qualitative answer in his mind by first thinking
in a macro framework and then giving the reasoning a
"micro foundation" by incorporating it into the perspective of a
typical individual's demand for money.
Conclusion
Although money is essential to modern
civilization, it occupies an awkward position in economic theory. The equation
of exchange provides an intuitive framework for quickly analyzing various
scenarios, but it can lead to faulty policy conclusions because it doesn't
really explain why individuals hold money in the first place. In contrast, the
cash-balance approach seems like a natural extension of standard microeconomic
analysis, applied to the special case of money. But this special case is
qualitatively more complicated and controversial than standard applications.
In practice, when assessing the impact of a
policy or preference change, economists often draw on elements of both
approaches. Despite the typical non-economist's belief to the contrary, economists
do not "study money," and, in fact, most economists are
very uncomfortable doing so.
Footnotes
1. The classic reference on the equation of exchange
approach is Irving
Fisher (1911) The
Purchasing Power of Money, though the approach is tied to the quantity theory of money, which goes
back centuries in various forms.
2. An early yet systematic work in this tradition is Ludwig von Mises' (1912) The Theory of Money
and Credit , while a more modern yet still "classic" exposition is Don
Patinkin's (1956) Money, Interest, and Prices.
3. My preferred explanation for the function of money as an
institution, and consequently why individuals desire to hold cash balances, is
tied up with Carl
Menger's theory of the origin of money.
See my article, "The
Origin of Money and Its Value," Mises Institute, September 23, 2003.
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