(This blog is called ‘thinking out aloud”. So here is some points about what I understand about the economics of money, and related matters, from my reading over the years. UPDATE This post was written before I started reading Scott Sumner's excellent monetary economics blog which has improved my understanding considerably.)
Money is a medium of exchange. Which is a fancy phrase meaning we use it to buy things. Barter is exchange without money, and is a clumsy and awkward way of trading, since both parties have to have some specific thing the other wants. Money can be swapped for any good or service offered for sale, so provides a generic trade item. Thereby making trade a lot easier. Money is surely the greatest single way to reduce transaction costs. (Making transactions easier by moving to a common, reliable currency has regularly produced economic booms.)
As a medium of exchange (i.e. a generic trade item), money flows from person to person. Economists talk of the velocity of money, which is an odd concept. Wikipedia™ defines it as:
the average frequency with which a unit of money is spent in a specific period of time.Like many terms in economics, it has been taken from the physical sciences, specifically physics. Wikipedia™ defines velocity in physics as:
the rate of change of position.In the case of physics, there is a thing that moves. There are also things moving in the monetary economics use of ‘velocity’, but with some striking differences. To talk of the velocity of money is much more like talking about the velocity of water rather than of a solid object, such as a bullet. Money flows, and flows in varying amounts, from transaction to transaction. To talk of a “unit” of money makes it seem more like a solid object but at the expense of distracting attention away from the way money flows in a series of joinings and partings rather than ricochets or bounces.
But even water is a distracting metaphor, because those transactions are wilful acts. People are choosing to buy or not. The size and number of transactions in a given time are the result of what people choose to do. If people choose to make more and/or bigger transactions, the velocity of money increases. If they choose to make fewer and/or smaller transactions, the velocity of money decreases. The transacting drives the moving: that is, the demand for money as the generic trade item is driving the moving.
Since it is the transacting which drives the demand for money, the issue is the scale of transactions (the number and size): or at least the scale of monetary transactions. Self-sufficiency does not count.
Aside: self-sufficiency also does not count for measuring GDP. Which, in terms of human productive activity to satisfy wants is a bit odd, but self-sufficiency is notoriously hard to measure. (Though how easy measuring human productive activity to satisfy wants which does involve money really is, is a controversy in itself.) Besides, the point of self-sufficiency is that it involves minimal productive interaction with others, and it is interaction with others we are generally interested in.
Back to money and scale of transactions. It might appear that increasing the supply of money would increase the velocity of money. More units mean more activity. Or does it? Surely it would just mean more money per transaction. Any given unit of money would circulate just as often.
Unless, of course, the increased supply made people more likely to engage in transactions. Which makes sense, up to a point. If people think the value of money as the generic trade item is falling, it is better spent than hung on to. Conversely, decreasing supply of money would make people less likely to engage in transactions, since they can get more for a given amount of money the longer they wait. Hence the expansionary effects (encouraging more transactions) of inflation and the contractionary effects (discouraging transactions) of deflation.
But neither effect is the whole story. In the deflationary circumstance, there are some things we just have to buy. Or want sufficiently that we cannot be bothered waiting. That is, the supply of money is not the only issue. There remains the matter of the demand for it. Money is a supply and demand phenomenon. As for limits in the inflationary case, money is just a medium of exchange: an extremely useful medium of exchange, but still a medium of exchange. We cannot buy what has not been offered for exchange. Money represents claims on goods and services: but we cannot spend what we do not have.
It may be possible to (temporarily) fool people about how much income they have. Any change in the value of money may have some time lag before people realise what is happening. But—once they have adjusted to such change—the spurious income effect will dissipate.
Playing games with money supply to “fool” people is not a long-term winning game. Uncertainty about the future value pf money discourages longer-term transactions. “Bazaar” transactions (immediate swaps) are encouraged, deferred transactions (do or buy now, be paid or get later: creating capital is a deferred transaction) are discouraged. Since deferred transactions (specifically those which create capital or buy assets) are the basis of future income, driving people to the economy of the bazaar is not a good long-term policy. (Though general uncertainty in property rights is likely much more of a problem for poor countries.)
It is easy to run a bazaar economy. Any poor country can, and does, do that (except complete disaster areas such as North Korea, which does not even have a proper bazaar economy). It is deferred income transactions (most important, the ones that produce capital) that are the tricky ones: it is how easy, effective and on what scale such deferred income transactions occur that divides rich countries from poor ones. Citizens in rich countries have lots of capital (physical, human, social) backing their income, that is what makes them rich. People in poor countries do not, that is what makes them poor. But such capital is not “manna from heaven”, it is all about patterns of transactions. As the perennial failures of foreign aid have so amply, and expensively, demonstrated.
Unfortunately, it is very tempting to officials to “pump prime” the economy by expanding the money supply in excess of demand for it to thereby gain kudos for the expansionary effects. It is even easier to pay for activity by and through officials by printing money in excess of the demand for it. Such overproduction of money is a form of tax—a tax on the holding of money. But one that does not require an intrusive bureaucracy, or much of a bureaucracy at all. Nor does it register with those paying it as a tax: a very tempting combination of “virtues” to some power-holders. Zimbabwe has been giving us a prime example of hyperinflation from such use of the “inflation tax”. (Even at Zimbabwe’s stratospheric rate of inflation, people still use the local currency as a medium of exchange, indicating just how preferable even a profoundly degraded currency is to barter.) One solution for a political class that cannot be trusted with the national currency is to “dollarize”, to use a currency they do not control: as Ecuador has done, for example.
Nor is playing games with prices and wages to “maintain” income in the face of a serious slump a winning game. Any price (or wage) is so much money for some quantity of something. If the economy is contracting, but wages and prices are held constant, then each individual transaction involves the same amount of money, but there will be fewer of them, since the blocking of price adjustments forces all change (in this case contraction) to be quantity adjustments (so the fall in production and employment will be, in quantity terms, greater). President Hoover’s notion of convincing employers not to cut wages or prices after the 1929 asset-price-crash was precisely the wrong policy. Conversely, in an expansion, if money wages are held constant then all adjustment (in this case expansion) will be quantity adjustments, so employment growth will be faster for a given level of demand of goods and services. (Whether overall demand would rise faster if wages also rose is another question.)
Hoover’s wage-and-price rigidity policy, plus the Smoot-Hawley tariffs—which raised the price of foreign goods in the American market, leading other countries to do the same to American goods in their markets, thereby massively contracting international trade as prices rose and quantities plummeted—and the US Federal Reserve pulling money out of a financial system in collapse, turned an asset-price crash recession into The Great Depression.
As former colleague with a PhD in monetary economics emailed to me:
money is probably the most poorly understood aspect of economics, not least because most modern texts fail to discuss its most important property: it has no market of its own, so excess demand/supply needs to be cleared through other markets (goods, services, assets). This is what makes money potentially so potent in destabilising an economy.Money can be earned from current efforts or assets or it can come from a loan—money gained now on the basis of paying it back with interest later. Interest being the payment for the foregoing other use of the money, plus a component for expectations about how the value of money as the generic trade item will change plus a component for the assessed risk of not being repaid.
Lots of businesses rely on lines of credit to operate. If credit dries up, then those businesses may reduce activity or fold. Which will in turn further reduce the number of transactions people engage in (also known as reducing economic activity: the US Federal Reserve reducing the money available to the financial system after the 1929 asset-price-crash was spectacularly bad policy). Governments spending money to stimulate the economy (if they do not just print money) is borrowing money against future income to spend now: a form of credit against future taxpaying. The intended effect in encouraging economic activity in part presumes that the government spending will produce more economic activity (transactions) than what the buyers of government bonds would have otherwise done with their money. If the bond-selling brings in money that would have been otherwise spent in another economy, this is a fairly safe bet. As for domestic buyers of bonds, that is why there are controversies about crowding out effects.
As the manifold failures of public policy in the 1929-32 period indicated, one of the greater foolishnesses is to see markets as naturally chaotic and government policy as naturally productive of order. While markets obviously can display sudden, dramatic shifts, to see them as naturally or inherently chaotic is to miss the phenomenon of spontaneous order. Conversely, while certain sorts of laws can help make markets more orderly (it seems Australian prudential financial regulation works rather better than the US variety, perhaps because we were more pragmatic and less ideological about it)—particularly if the regulations have the effect of reducing transaction costs—official discretions are great sources of social chaos. There are few systems more chaotic in their patterns than command economies, with their perennial shortages and sudden gluts. The housing price bubbles of the “Zoned Zone” occurred because official control over land use suppressed the ability to build houses in response to increased demand, driving prices up (or, to put it another way, restricting the quantity response increases the price response), thereby creating a “one-way” bet in those housing markets and turning houses into apparently sure-fire inflation-beating assets. Adding the demand for inflation-beating assets to the demand for houses further inflated demand for such housing, creating asset-bubbles. Since people can (and have) move from the “Zoned Zone” to “Flatland” (where house construction could respond directly to supply)—reducing demand for housing-as-such—the value of such houses as inflation-beating-assets collapsed, leading to collapses in prices known as the “bursting” of the housing bubble.
Official discretions are sources of chaos because officials lack sufficient information, have poor feedbacks, wield coercive power which itself suppresses information and creates particular demands (such as home-owning voters wanting their house values to increase) and can be subject to all sorts of strange fads and beliefs. (Of course, if you think that people like you “know” the truth, the whole truth and nothing but the truth, the possibility of serious error may not even strike you: that is only what happens to other folk who do not know The Truth.) President Hoover’s policy of wage and price rigidity was based on “new economic thinking” that had a fetish about the magic of demand and deprecated the information role of prices (and wages): indeed, it actively sabotaged their information role. It turned out to be very bad economic thinking.
So, to conclude, money is something we use in interactions with others. Being a generic trade item, it is subject to demand and supply. There can be economic interactions without money: production, barter, tribute paying, gift giving, theft. What money does is make exchanges (two-sided or one-sided) much, much easier. If we want something we do not have to find a specific thing the seller wants in order to purchase, we just offer them money, which they can then use themselves. It is thus a medium of exchange and a store of value: the latter being a consequence of the former since the store of value effect is just future expectations about its value as a generic trade item. (Similarly for its role as a unit of account.) Indeed, current value and expected future value are intimately connected. If money’s future value is expected to decline, then that creates an incentive to spend now. If its future value is expected to rise, that creates an incentive not to spend now. (In both cases, the more so, the more so.) But its uses are always wilful acts by the holders of money. They are purposive acts of exchange that both respond to the supply of money and create the demand for it.
So, the notion of the velocity of money is an odd one: and has a certain naturally misleading quality to it.
ADDENDA: This post makes it clear that more than one form of money can be circulating, so there may be several "generic trade items" circulating but one is preferred as a unit of account. Indeed, the agreed unit of account may not match any actually circulating currency, but be an agreed derivation from one or more of them.