Possible Insight

Explaining Money: Part III

with 5 comments

In 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 how expected changes to the supply of Money in the future affect trade today.

Earlier, we considered what would happen if Sally became ill and were unable to meet the ever-growing demand for new silver figurines created by population growth and innovation.  We concluded that families would increase their reserves of figurines and the frequency of trades would decrease.  A current event affected future activity.  Now consider whether a future event could affect current activity.

Suppose Sally announces that she will retire in one year.  Moreover, she declares that she has not seen any other metalsmith whose work matches her standards for beauty and quality (and most people trust Sally’s opinion).  She’ll continue to manufacture figurines for a year, so there’s no effect on the actual supply of Money today.  It will just stop growing a year from now.  But what do you think will happen?

If I lived in this country, my wife and I would put a plan into place to accumulate a greater reserve of figurines over the next year.  If there were a significant fraction of people like us, the frequency of trades would immediately begin decreasing , with the negative impact growing over time as those with less foresight began initiating reserve plans as well.  You can see the potential for a snowball effect here: a constricting supply of figurines in circulation due to accumulating household reserves causes everyone to update their plans and desire… even greater household reserves!

We should also expect a general price decrease.  Here’s why.  Bob and Brad would probably tell their wives, Sue and Sara, that they need to accumulate a larger reserve of figurines to ensure they’ll be able to trade for necessities in the future.  So Sue and Sara will thus want to increase their sales.  But when Bob goes to buy clothes from Sara, he’s going to be less willing to part with his figurines due to his accumulation plan.  How will Sara convince Bob to buy clothes so she can help Brad build their family’s reserves?  That’s right, by lowering prices.  Same for when Brad goes to buy milk and meat from Sue.  So as the frequency of trade decreases due to greater demand for reserves, prices would go down.

But the worst part would be the effect on innovation.  If I were an entrepreneur and I knew that the supply of Money would stop growing a year from now, how would I adjust my efforts at creating new products and services?  I would probably reduce them because any innovation might end up in no man’s land; people want it, but they need to use their Money for higher priority items.  Lower chance of a payoff means lower investment.  Heck, entrepreneurs with currently successful products might well stop making improvements or even stop maintaining their means of production due to the combination of an expected future decrease in demand and their own desires to accumulate reserves. Our country could actually go backwards technologically! Not surprising though if you think of Money itself as a technology. You’d expect a similar effect if metal or computers became relatively scarce.

Of course, the opposite sequence of events would occur if everyone expected a future increase in the supply of Money.  Suppose Sally announces that her daughter, Sunny, will finish her metalsmithing apprenticeship in a year and the capacity to product new silver figurines will increase (but not double, Sunny won’t be nearly as productive as Sally to start).  I would expect the frequency of trades, prices, and investments in innovation to all increase.

Now, if Sally had ten apprentices and everyone expected the rate of new figurines introduced into the economy to skyrocket, our little economy might have a problem with runaway inflation.  Similarly, if someone figured out a way to mass produce silver figurines equivalent in quality to Sally’s handcrafted ones, people’s trust in silver figurines as Money might erode.  So more is not always better.

What we really want is for Sally and Sunny to have a fairy godfather who tells them exactly how many figurines they should make to keep up with population growth, innovation, and any changes in demand for household reserves.  I like to think he’d be named Alan.  Everyone would love Alan.  Unfortunately, nobody lasts in the fairy godfather job forever. So people in our little country would eventually need to somehow harness their collective wisdom to determine how many figurines they need.

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Written by Kevin

November 17, 2010 at 10:37 am

5 Responses

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  1. In other words, expectation becomes reality, directionally speaking.

    Rafe Furst

    November 21, 2010 at 6:09 am

    • I’m not sure causality is that simple in this case. Obviously, reality can also become the expectation. That’s why you have to reason so carefully about Money. I don’t understand strange loops very well but it seems like Money has some of those properties. Expectation and reality reinforce each other.

      Anonymous

      November 28, 2010 at 11:44 pm

      • Yes I wasn’t suggesting asymmetry in the feedback, just highlighting the direction we are not used to talking about in reductionist science.

        Rafe Furst

        November 30, 2010 at 1:34 pm

      • Ahh, yes. We are in violent agreement. The lack of reductionist causality is one of the reasons I did the series. I think it’s fascinating that I can present a series of cause-effect steps that lead to Money but then be unable to express the direction of causality once we get there. As far as I can tell, the causality problem is currently bedeviling macro economists right now as they try to explain Fed behavior, stock moves, and interest rates.

        Anonymous

        December 4, 2010 at 8:50 am

      • Dynamic programming is an indispensable tool for working out the consequences of bidirectional causality.

        Let’s say you’re heads up at the end of a no limit hold’em poker tournament. Your opponent declares that he will move all in on every hand. Should you play any hand that has positive chip expectation against a random hand? Dynamic programming shows that you can do better than that by playing a bit tighter.

        Paul

        December 4, 2010 at 4:14 pm


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