Possible Insight

Explaining Money: Part II

with 5 comments

In our last episode, we examined how Money might emerge in a toy economy. The key turning point was when we achieved common knowledge that most people would accept miniature silver figurines in trade for most goods and services. In this episode, we’ll look at what happens when events occur that erode this foundation.Because Money fundamentally relies on people’s expectations, it seems only logical to focus on a seller’s and a buyer’s expectations at the moment of a monetary transaction. Obviously, there are the necessary conditions that the seller must be willing to provide the good or service and the buyer must want to acquire the good or service. But let’s look at the expectations about Money itself that the seller and buyer must hold for a transaction to occur:

(1) The seller must believe that, if she accepts the Money, her husband will be able to use it in future trades where he is the buyer. The extent to which she believes Money will be useful in future transactions affects the price at which she will be willing to sell.

(2) The buyer must believe that he will be able to acquire more Money from his wife’s selling activities to support future trades where he is the buyer. The extent to which he believes Money will be scarce affects the price at which he will be willing to buy.

Most people focus on expectation (1). They examine reasons why the seller might not like the buyer’s Money. Potential debasement (reducing the amount of a precious commodity represented by the Money) and inflation expectations are the chief worries.

But they forget all about expectation (2). Remember that Money enables transactions that would otherwise not be possible. If a buyer has only a limited amount of Money, he will make the most important of these trades first. When he runs out of Money, all the other potential trades will not happen. So if there isn’t enough Money in circulation, it will have a real effect on the economy.

Consider the following scenario, using the setup from the previous episode. Sally becomes so ill that she can’t produce figurines anymore. The economic success enabled by Money had caused a steady increase in demand for it. The geographic area where people use Money has grown, people have moved into the area to take advantage of the better life enabled by Money, and people are constantly discovering new products and services whose trade was profitable with Money. Now the Money supply can’t expand to meet this growing demand. What do you think will happen?

Obviously, there are a bunch of lower-value transactions that simply can’t occur because there isn’t enough Money in circulation to execute them once the higher-value transactions are completed. However, the situation is actually worse. Because people will feel uncertain about whether they will have enough Money to meet future critical and surprise needs, they won’t even spend all the Money they have! They’ll want a reserve. The worse the shortage, the higher the reserve they’ll want and the worse the decrease in Money-mediated transactions. It’s just common sense to increase your inventory when future resupply is uncertain. Whether it’s money or food.

Hopefully, you can now see the outlines of my argument for why commodity Money isn’t necessarily better than fiat Money. Sellers like commodity Money such as silver figurines because it has some intrinsic value: the value determined by its demand for use in products and services. If they accept silver figurines, at the very least their husbands will be able to use the silver as barter.

But when you take into account the buyer perspective, this intrinsic value is a double-edged sword.  Inherently, the demand for the commodity as Money will always compete with the demand for the commodity as a good. So in our toy economy, if someone discovers a new use for silver or a new use for Sally’s metalsmithing skills, the supply of Money will come under pressure and potentially cause a Money shortage like the one discussed above.

I tend to think that human ingenuity will always come up with more uses for things over the long term, so I believe commodity Money tends to directly harm buyers more than sellers. However, sellers can get hurt directly too. If someone figures out a really good substitute for the commodity as good, its intrinsic value can drop dramatically. Consider the invention of white gold as a substitute for silver or machine stamping as a substitute for Sally’s smithing. Because the commodity Money would be worth fundamentally less as barter, every seller that accepted it would take a hit. What you really want is Money that has the common knowledge properties of silver figurines but whose supply can be directly managed, without competition from direct use in goods and services. That’s what fiat money is.  Of course, someone has to properly manage the Money supply. But that’s a topic for Part III.

So in summary, shocks to the Money supply can affect real economic activity and commodity money is no panacea.


Written by Kevin

October 12, 2010 at 8:16 pm

5 Responses

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  1. Kevin, excellent progression. I'm looking forward to reading your views on the management of the Money supply. Our political system isn't perfect, but at least there's an illusion of a democratic process that links the decision makers to the public, so that we can feel partly accountable and passionate. Monetary decisionmaking powers are much more removed in a real and illusory/nominal sense from the public.”…communism forgets that life is individual. Capitalism forgets that life is social” -MLKi think he's saying that SHARING is the problem and should be weighed against a continuous increase in lower-value transactions for some. Don't get me wrong, i'll take the Fed, but at least give me an illusion of a democracy.

    Alex Golubev

    October 13, 2010 at 6:13 am

  2. Thanks Alex. I mostly agree with you. The Fed is rather opaque for my democratic tastes. I'd like them to be given a mandate for level targeting of some combination of price- and output-related metrics. Then they explain the actions they're taking to hit the target. Sumner's NGDP futures is one such mechanism, but I'm open to others.


    October 13, 2010 at 6:58 pm

  3. Good stuff Kevin,I would add one more commodity money supply shock, new resource discoveries. If gold is your standard of value and someone finds a massive new gold deposit then all money is suddenly debased on the spot. One other consideration is that money is not the only store of value. In fact most of our savings are directed into investments. Investments may be valued in terms of dollars but that is very different from saying that you are holding value in dollars. Where in/deflation really present problems is in their affect on contracting…how do I structure a contract if I don't know what a dollar is worth in the future?


    October 15, 2010 at 7:49 pm

  4. Thanks Gregory. You're absolutely right about resource discoveries. In fact, the more successful a commodity Money, the more effort people will put into discovering new sources of it, magnifying the potential for future supply shocks.Of course, you're also right about there being other stores of value. However, I've omitted them from my toy economy. Things become very complicated very fast when you start trying to analyze substitutions among different stores of value (aka portfolio theory). In fact, I think a lot of economists get distracted by this topic. For now, I just want to demonstrate some basic facts about Money itself, not all the useful financial technologies we can build once we have Money.


    October 18, 2010 at 9:00 pm

  5. […] Part I, we saw how Money is an emergent phenomenon.  In Part II, we analyzed how changes to the supply of  Money affect trade.  Now, we’re going to examine […]

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