Monetary Economics

The Functions and Forms of Money

Money Opens in new window exists in all modern economies and it clearly plays a major role in the exchange of goods and services. One way, then, to explain why it exists is to analyze the process of exchange.

The conventional approach to this is through an explanation of individual behavior asking why individual people (‘economic agents’) engage in exchange.

The first problem we face is that we face a complex world with a past which has determined endowments and institutions and with interactions and reactions which are difficult to decipher and which may occur with very long time lags.

People have unclear and conflicting motivations and many variables that influence decisions change at the same time. The degree of complexity is such that analysis of economic behavior (behaviour) requires us to make many simplifying assumptions.

Economists, typically, have approached this by excluding from consideration history, taking existing capital and labor (labour) endowments and wealth as given, and assuming that the distribution of these endowments does not change.

Since the utility-maximizing individual is assumed to be central to economic analysis, the simplest beginning of all is with a single person (Robinson Crusoe) on a desert island.

He is self-sufficient and no exchange is possible. There is clearly no need for money. The Robinson Crusoe of economic models has no history. When he has any human characteristics at all, these are allocated to him on an ad hoc basis which suits the particular story being told.

For example, one story begins with two Robinson Crusoes on the same island. Both are old and with poor memories. They meet occasionally but only to have dinner with each other. However, their memories are so bad that they both forget who provided the most recent dinner. From here develops an account of money as a device for keeping records.

If we extend the model to many individuals, each agent remains, in effect, a Robinson Crusoe, acting as if no one else existed. Even in such a world, however, agents soon realize that utility can be much increased through the division of labor, specialization and participation in exchange.

Within a family in a traditional society, a certain degree of specialization is possible — one member of the family catches fish, a second tends the family’s animals, a third weaves cloth and so on — but a more thorough exploitation of specialization requires exchange and this implies the establishment of markets.

All exchange proceeds through markets, which are treated as a logical construct without institutional and social detail. The only available basis for judging welfare in this abstract world is through consumption and the dominant economic aim becomes the maximization of individual utility through the most efficient in ‘real terms’.

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This is still true in modern economic analysis. We know that, in practice, people often make judgments in money terms. For example, the rich occasionally gain utility by engaging in extravagant consumption with the purpose being to demonstrate to others how much they can afford to spend.

Such ideas form a part of specific areas of economic analysis but do not influence the general presumption that the aim of all economic agents is to maximize utility with utility being judged in terms of real consumption.

Indeed, in orthodox economics, any decision based on money rather than real values must be an example of money illusion – a confusion of money and real values and can occur only in the short-run when the system is in disequilibrium. Thus, it is inadvertent and temporary.

To what extent do you make economic judgments in real terms? Can you think of occasions when you have been subject to ‘money illusion’?

We can attempt to explain such things as the determination of prices of different goods and services through the use of demand and supply analysis. To do this we need a starting point at which everyone is currently maximizing his or her utility and the economy is, thus, in equilibrium Opens in new window.

We can then assume an exogenous change that disturbs equilibrium positions and causes behavior to change as agents seek to maximize utility under the changed circumstances.

We do not know how long this will take but can define the new equilibrium position (whenever it is reached) as the long-run and the period during which agents are changing their behavior (when the system is in disequilibrium) as the short-run.

Since, in our simplified model, a new equilibrium is always reached, the short-run is just an inconvenient period of adjustment. Equilibrium models may be either partial (with only one variable allowed to change at a time) or general, acknowledging the existence of a much more intricate set of interactions among variables. However, to make general equilibrium models amenable to analysis and mathematical logic, they too need to be hedged around with assumptions.

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The best-known general equilibrium model is that developed by the Belgian mathematician/economist, Léon Walras. This was a formidable intellectual exercise which described the world as if it consisted of a large number of markets in which agents acted to bring about the set of prices that caused demand to be equal to supply in all markets simultaneously.

As a mathematical exercise this was unexceptionable but it was difficult to understand how anything like Walras’ result could come about in practice.

To help with this, Walras created a god/auctioneer who collected all information regarding demand and supply at existing prices from all agents, calculated excess demands and supplies and formulated a new set of prices. He (naturally) then repeated the exercise over and over again until the equilibrium set of prices was achieved.

To make things work, however, two other assumptions had to be made.

When we talk of prices here, we are talking of relative prices and these can be expressed entirely in terms of goods. Exchange can take place through barter and there is no immediately apparent need for money. How then is the universal presence of money explained?

The standard approach concentrates on efficiency with the advantages of a monetary economy being considered in terms of the costs involved in the process of exchange and the extent to which a movement from barter to the use of money in exchange reduces those costs.

Pause for thought

One clear assumption here is that exchange through markets preceded money and took place entirely through barter.

Barter is, however, inefficient because of the need for the double coincidence of wants for exchange to occur — that a person who catches fish and wishes to exchange them for pots needs to find a maker of pots who happens to want fish at precisely the same time.

This implies very large search and information costs. In other words, people spend a lot of time in the process of exchange that could be used in a more efficient system for producing additional goods and services.

The model suggests that the first development was for economies to pass through stages of increasingly efficient systems of barter, notably fairground barter and trading post barter.

  • Fairground barter occurs when a fair is held for the sale of a particular good in the same place at regular intervals. A common example around Europe was the horse fair.
  • Trading post barter occurs when someone sets up a trading post at which a specified set of goods are bought and sold and advertises the location and opening hours.

People know that if they were to go to the trading post during its opening hours, they would have a good chance of meeting other people who wished to buy the good they wished to sell or vice versa.

Thus, both fairs and trading posts considerably reduced search costs involved in the process of exchange.

Nonetheless, a major problem remains because, however it is organized, a barter system requires knowledge of a large number of price ratios: how many fish exchange for one pot; how much maize or fish for one cow, and so on. If there are only two goods to be exchanged (fish and pots), there is only one price ratio.

With three goods (fish, pots, and maize), however, there are three price ratios (fish/pots; fish/maize; pots/maize). As Visser (1974, pp. 2 and 3) shows, the number of price ratios can be calculated as the number of combinations of two elements from a set of n elements. The formula for this calculation is:

1 n (n – 1)

Where n is the number of goods and services. Thus, in an economy with 4 goods, there will be 6 price ratios; with 100 goods there will be 4,950; and with 1,000 goods 499,500.

Clearly, barter is a very inefficient system for this reason. It takes a good deal of time to collect information about such a large number of price ratios and so barter involves high transactions costs.

Money, then, enters the story as a way of dramatically reducing the number of price ratios with which people had to cope. This could be done by the adoption of the goods as a unit of account in which the price of all other goods could be expressed.

The great reduction in information costs resulting from the use of a unit of account (money) allows people to spend a greater proportion of their time producing goods and services, thus improving their standard of living.

In analyzing this role, Goodhart (1989a) describes money as one of the social artifacts (along with the distribution network and organized markets) that have evolved to economies on the use of time, which is seen as the ultimate scarce resource.

This idea can be extended in a number of ways. For instance, the high information costs in a barter economy would mean that many decisions would be made on the basis of incomplete information, creating uncertainty for market participants and allows a more efficient use of resources (see, for example, Brunner and Meltzer, 1989).

We may have an explanation of money as a unit of account but this is not sufficient to explain why money actually needs to change hands. That is, why did money develop as a means of payment?

Goodhart (1989a) accounts for this by stressing another informational problem associated with market exchange – the lack of information about the trustworthiness and/or creditworthiness of the counter-party to the exchange.

This, he says, truly makes money essential. If everyone in a market could be fully trusted, all exchange could be based on credit and with multilateral credit and a complete set of markets, money would not be needed.

An unwillingness of traders to extend credit or to accept other goods as a means of payment means that money is required if some goods are to be purchased. This has become known as a liquidity or cash in advance constraint.

There are two major criticisms of this examination of a movement from a barter to a monetary economy.

Firstly, the barter/money distinction proposes a static view of economies — all are classed as one of two simple possibilities even though exchange is a social process and money a social invention.

The role of money in exchange differs from one economy to another and changes over time. In any modern economy, monetary exchange and barter both occur, sometimes in a single transaction.

The tendency to think in terms of simplified models can lead to a failure to consider the way in which economic change and the nature of exchange interact.

We are more likely to interpret the complex real world in terms of our model — as static societies confronted by occasional exogenous shocks.

For example, problems with the testing of demand for money functions in the 1970s and 1980s led to the apparent discovery by monetary economists of financial innovation as if this had not always been a part of the development of the process of exchange.

Pause for thought

What forms of uncertainty can you identify in an act of exchange of goods and services involving delivery at a future date? How does the existence of money help to overcome these?

Secondly, the barter/monetary exchange distinction is ahistorical and implies that money came into existence solely to facilitate exchange. However, there is no evidence that barter preceded money anywhere other than in pre-economic societies in which exchange was only ceremonial.

Indeed, Wray (1990) argues that money evolved before markets developed and that its use grew more quickly than the growth of markets.

This is not a matter of pedantry since the ahistorical approach leads to the view that it is possible to analyze a barter economy in which money does not exist and then simply add money. This remains a powerful idea in modern economics and is at the heart of views that ‘money is a veil’ over the real economy (Pigou, 1949, p. 24) and that money has no impact on the functioning of the real economy.

We can summarize the argument to this point by saying that money exists in modern economies because:

  • exchange encourages the division of labor and specialization and the more efficient use of time;
  • money reduces the cost of exchange by acting as a unit of account;
  • money is needed as a means of payment because of the existence of inadequate information and uncertainty in markets.
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