This week we will explore one of the most poorly understood concepts in economics: the price of money. More specifically, what does supply and demand for money determine?
The traditional textbook view, as originally developed by John Maynard Keynes, is that supply and demand for money determines the interest rate. This simple notion lies at the heart of all modern macroeconomics. While some economists have disputed this notion, particularly those in the Austrian tradition, few have offered a sensible alternative.
The reason that Keynes’ liquidity preference theory has stood for so long is that offering a sensible alternative this theory requires an overhaul of the current microeconomic theory of price determination. In particular, if supply and demand for a good determines the price of that good, then how can supply and demand for money be incorporated in microeconomic price determination?
The key intellectual leap that needs to be made is recognizing that every price is a function of two sets of supply of demand. The price of one good (the primary good) in terms of another good (the measurement good) is a function of both supply and demand for the primary good and supply and demand for the measurement good.
The view of The Money Enigma is that supply and demand for money determines the market value of money, the denominator of every “money price” in the economy.
Economists struggle with supply and demand for money because economics has not developed a sensible paradigm for the measurement of “market value”. As a result, current models of price determination present a very “one-sided” of the price determination process.
Every price is a relative expression of two market values. If the market value of one banana is three times the market value of one dollar, then the price of bananas, in dollar terms, is “three dollars”.
Supply and demand for a good determines that good’s market value. However, in order for us to calculate the price of a good, in terms of another good (such as money), we need to know the market value of that second “measurement good”. The market value of this measurement good is determined by supply and demand for that measurement good.
The “money price” of a good is determined by two sets of supply and demand: supply and demand for the good itself, and supply and demand for money.
The trick to understanding this concept is recognizing that the property of “market value” can be measured in both absolute and relative terms. All properties can be measured in absolute or relative terms. For example, the speed of a car can be measured in absolute terms (in terms of some invariable measure of speed such as “miles/hour”), or in relative terms (in terms of some other object that possesses the property of speed, for example, the car is doing twice the speed of the bus).
Market value can also be thought of in absolute or relative terms. The way we experience market value in every day life is in “price” terms. Price is a relative measure of market value. For example, “the price of the banana is three dollars” is a way of measuring the market value of bananas in terms of another good that possesses the property market value, namely “the dollar”.
However, both the banana and the dollar must possess the property of market value and we can measure the market value of each good individually in terms of an invariable measure of market value (just as the speed of the car and the bus can both be measured in terms of “miles/hour”, an invariable measure of speed).
In the diagram below, the price of Good A, in money terms, is determined by two sets of supply and demand. On the y-axis, market value is measured in absolute terms, that is to say, in terms of a theoretical and invariable measure of market value, or what one might call a “standard unit” of market value.
The price of good A, in money terms, can rise for one of two basic reasons. Either, the market value of good A can rise, or the market value of money can fall. For example, if demand for money falls, then the demand curve on the right side of our diagram shifts downward and the market value of money falls. What happens to the price of good A? The price of good A, in money terms, rises. Why? Because price is a relative expression of two market values.
Let’s circle back around to our original question. What is the price of money?
This is not a straightforward question because price is a relative expression of two market values. Therefore, the first follow up question that needs to be asked is the price of money in terms of what? What is the measurement good?
We can measure the price of money in banana terms. For example, if the price of bananas in money terms is three dollars, then the price of money in banana terms is one-third banana.
Alternatively, we might measure the price of money in terms of a basket of goods. The price of the basket of goods, in money terms, is the price level. The price of money, in terms of the basket of goods, is the inverse of the price level, also commonly referred to as “the purchasing power of money”.
Therefore, we can’t say that the price of money is the price level, but we can say that the price of money is the inverse of the price level.
What we can’t say is that “the price of money is the interest rate”.
If you step back and look at the history of economics, it becomes clear why Keynes posited that supply and demand for money determines the interest rate.
Keynes was a pupil of the great Alfred Marshall, author of “Principles of Economics” (1890), a book that did more than any other to popularize the notion that the price of a good is determined by supply and demand for that good.
But Marshall’s work left one question unanswered. If supply and demand for a good determines the price of a good, then what does the supply and demand for money determine?
If you don’t recognize, as Keynes did not, that every price is, in fact, a function of two sets of supply and demand, then this leaves you looking for candidates. The only plausible candidate that Keynes could find was “the interest rate”.
Despite the fact that it should have been clear to Keynes (and all modern day economists) that the interest rate is determined by supply and demand for bonds, Keynes came up with his awkward justification of the notion that supply and demand for money determines the interest rate.
Just to be clear, it is perfectly correct to say that central bank operations can influence the interest rate. If a central bank creates money and uses it to buy bonds, then the demand curve for bonds shifts to the right and the price of bonds rises (the interest rate falls).
What is not correct is to say that since these central banking operations influence the interest rate, that supply and demand for money determines the interest rate.
The view of The Enigma Series is that every price is a function of two sets of supply and demand. Supply and demand for money determines the market value of money, the denominator of every “money price” in the economy. We can measure the market value of money in absolute terms (in terms of our invariable measure of market value, “units of economic value”). Alternatively, we can measure the market value of money in relative terms: this is “the price of money” in terms of some other good, basket of goods or even other currency. The point is that there are multiple ways to measure the price of money, but none of them are “the interest rate”.
I would encourage all those who are interested in a critique of liquidity preference theory and an alternative view on price determination to read The Enigma Series.
Why do you not distinguish between bank notes, hpm, bank deposits and the other forms of “money”?
I feel we will never get anywhere unless we stop lumping these things together.
Yes, bank notes are a liability of society. However bank deposits are a liability of a bank and credit card spending involves a new liability of a consumer.
Any chance of reframing your work to properly separate these very different forms of “money”?
I really feel you are on the right track.
I think the key point is: USD (for example) is a unit of measure held (reasonably) constant relative to goods and services by the inertia of massive amounts of credit contracts that reference it. These contracts include bank notes, hpm deposits, government bonds, interbank loans, bank deposits, private loans, etc. The quantity of these contracts, and their distribution across consumers is what influences their “price” expressed as a quantity of a particular good… and indirectly therefore the ratio of the USD unit of measure to units of that good.
Paul,
Thanks for your very constructive comments.
I agree that economics must distinguish between “money” (a liability on the output of society) and “credit instruments” that are often misclassified as money (for example, liability of banks, including, but not limited to, bank deposits).
The view of The Money Enigma is that the monetary base is money. Society authorises the government, on its behalf, to issue proportional claims on the future output of society.
Conversely, society does not authorise banks to issue claims on the future output of society. Rather, banks can only create credit instruments such as banking deposits. These are merely future claims against the bank.
Money (base money) is a special form equity instrument (it is a proportional claim on the future output of society, just as a share of common stock is a proportional claim on the future cash flows of a company).
In contrast, most of the things economists classify as “money” are really just credit instruments.
Supply and demand for money (the monetary base) determines the market value of money, the denominator of every money price in the economy.
Supply and demand for a credit instrument determines the interest rate on that credit instrument (eg. bank loans).
As you note, the importance of distinguishing between the two is paramount.
You say that in your view money is the monetary base.
This really means that when you say money you mean the monetary base.
It doesn’t follow that people will receive that meaning.
Readers would understand you better if you used a different term. Then your work stands more chance of achieving what you want it to achieve.
Paul,
That is a good point. In the first paper in The Enigma Series, The Money Enigma, I explain that I believe that money is the monetary base, while everything else is merely a claim to money (a claim to a claim on the output of society).
But I agree that it is not clear in this post and I will be more explicit in the future. From my perspective, money = monetary base.
I like the concept of hpm being a claim on the future output of society.
I think though that government bonds are also a claim on the future output of society. Have you addressed this anywhere?
Also I’m not convinced that only claims on the future output of society, as opposed to other claims, affect the value of the referenced denominator.
I think that private claims also affect the value of the denominator.
For example, imagine a small society which has banned private credit, and has 1000 dollars worth of bank notes in circulation. The market price of bananas is $1. The restriction on private credit is lifted and the banana supplier can now sell bananas on credit. It seems clear that the price of bananas would rise, all else being equal. Would you agree?
Both of your points are valid.
Re government bond as a claim on future output, you might have a look at the long form version of The Money Enigma. (You can download it at http://www.themoneyenigma.com/money/).
Society has three choices when it wants to finance public expenditures:
1). raise taxes
2). issue bonds
3). issue money
Taxes are a claim on current output.
Bonds are, at least in one sense, a fixed claim on the future output of society.
Money is a proportional (variable) claim on the future output of society.
The reason US government debt is AAA rated is because it represents a fixed claim on the future output of the world’s largest and most diversified economy.
Clearly, it is a little more complicated than that because government bondholders can’t demand future output as payment per se. But I think the general principle is valid.
Money, on the other hand, is the equity of society – it represents a variable claim to the future output of society.
Your second point raises a host of issues that are discussed in The Inflation Enigma and The Velocity Enigma. There is no doubt that private debt matters. The framework that I use to think about it is called Ratio Theory. In simple terms, the price level is a function of two market values: (1) the market value of goods (the numerator) and (2) the market value of money (the denominator). As credit expands, this should generally increase the market value of goods which places upward pressure on the price level.
Where is gets complicated is the impact of private credit on the denominator (the market value of money). The market value of money is primarily determined by long-term expectations of the path of the “real output/base money” ratio. A large expansion of private credit can boost confidence, raising the value of money and suppressing the price level. (I think this is what has happened over the last 20 years). Alternatively, such a large credit expansion may, at some point, erode confidence in the future path of the economy at which point the value of the proportional claim (the value of money) begins to fall (the price level rises).
I think the risk today is that we are living on a bit of a confidence high, driven in part by massive credit expansion over the past 20 years. If this confidence falters, the value of money could collapse quickly, leading to a sudden surge in inflation.