This is the first part of a planned introduction to monetary economics. I imagine it will develop slowly, but hopefully I will stick with it. I plan to first post sections here and then revise them and place them into a single document. Please leave a comment if you have a comment or criticism.
The approach of this series is to understand the economics of money using the same fundamental economic concepts used to understand other phenomena. These concepts are economic goods, decision theory, agents with utility functions, informations sets and as set of possible actions.
The first step is to understand monies as economic goods, so that we may understand them using standard economic concepts. Monies have two major uses which distinguish them from all other goods:
- Unit of Account – Prices are quoted in terms of money rather than other goods. For example, the price of a gallon of milk will be quoted as $1.59/gallon rather than .1 music lessons/gallon.
- Medium of exchange – When people trade, they trade goods for money and then trade money for other goods. I usually cannot trade music lessons for groceries at the grocery store, but I can trade money for groceries at the grocery store.
These two uses are distinct and separable, but come together so often that we have a name for goods that have both uses. A good that is both a Unit of Account and a Medium of Exchange is called a Money.
A good can be a Medium of Exchange but not a Unit of Account. Postage stamps (not forever stamps) are a good example; you need stamps to give stamps to the post office to mail a letter, but the price is given in terms of money (you need 43 cents worth of stamps).
For another example, consider an economy where wool is very common and used as the Medium of Exchange. However wool is difficult to quantify, it has a mass which is nontrivial to weigh in large quantities but can be eyeballed effectively by experienced wool traders and a quality which is difficult to quantity but can also be discerned by wool traders. Since wool is difficult to quantify prices are not generally quoted but negotiated on the spot, so wool does not serve as a Unit of Account (there is none).
A good can also be a Unit of Account but not a Medium of Exchange. If prices in some market are quoted in terms of a good M (for example .1 music lessons/gallon) but with the understanding that the exchange will be conducted with gold (you will exchange .1 music lessons worth of gold (looking at other prices) for a gallon of milk) then M is a Unit of Account in that market but not a Medium of Exchange.
Properties of Units of Account
Units of Account require some properties to be workable as Units of Account. These properties can play an important role in the economics of money, but not necessarily unique to Units of Account. These are some but there are probably others as well:
- Quantifiable – Units of Account must be quantifiable in some way in order to communicate prices. Many goods besides goods used as Units of Account are quantifiable.
- Translatable – Units of Account must be able to be translated into meaningful terms of trade for an actual transaction. The preserved body of chairman Mao does not work well as a Unit of Account because it is difficult to translate “.1 bodies of Mao” into a meaningful quantity of any other goods.
Properties of Mediums of Exchange
Mediums of Exchange require some properties to be workable as Mediums of Exchange. These properties can play an important role in the economics of money, but not necessarily unique to Mediums of Exchange. These are some but there are probably others as well:
- Store of Value – Since people hold a Medium of Exchange in order use them for future purchases, they must be worth something in the future so they must be able to effectively move resources through time. If you make $20 babysitting today, you can either spend it and consume today, or you can spend it next week and consume then. No one will use a good as a medium of exchange if it does not store value to some degree. Mediums of Exchange are not special as a store of value; many other goods are also stores of value over time. Anything you would call an ‘asset’ is a store of value. All financial assets are stores of value, stocks, bonds options etc.. Assets vary in how they store value, some assets rise in value, some assets decline in value. Mediums of Exchange are also not necessarily special in how well it stores value over time; it can rise in value (deflation) or drop in value (inflation), it may even pay interest, like financial assets.
- Transferable – If a good is not transferable to other agents, it cannot be used in exchange, so it cannot be a Medium of Exchange. Education is a Store of Value, but not transferable, so it can’t be used as a Medium of Exchange. Since there is a lower limit on transfer costs (zero) and many goods are near this limit, differences along this dimension are not usually important.
- Measurable – The important qualities of a good (including quantity) must be measurable (not necessarily quantifiable) to be used as a Medium of Exchange. Since there is a lower limit on measurement errors and costs (zero) and many goods are near this limit, differences along this dimension are not usually important. Lots of other goods are measurable; water is measurable (gallons); cupcakes are measurable (mass, deliciousness (which may not be quantifiable, but is measurable)).
In the sections above, the only highlighted property is Store of Value because this is the one that can be significantly different across different monies and across time. It plays an important role in practical monetary economics, but the other properties do not.
In monetary economics we frequently talk about “money” as if there were only one kind of money because we are usually focusing on one particular money. In reality there are many kinds of money; there are different currencies, and goods like bus tokens. Bus tokens are goods that are used in the same way as money is: bus ride prices are often quoted in terms of bus tokens (though not exclusively) and the bus will trade you bus tokens for a bus ride. Monetary economists would regard bus tokens as money. The difference between these different kinds of monies is the set of markets where where they are used as a unit of account and a medium of exchange. The set of markets that accept US dollars is much larger than the set of markets that use the bus tokens of a given bus system. Most US stores do not accept bus tokens, but they do accept US dollars. Likewise, most US stores do not quote prices in terms of bus tokens, but they do quote them in terms of US dollars. One can think of bus tokens as “bus money” and US dollars as “US money” and Euros as “Europe money”. The economics of money still applies to goods like bus tokens in the set of markets where they are used as money.
There are several properties people often falsely think makes money unique. It’s usually true that money has these properties, but false that they are unique to money.
Many people believe that money is different from other goods in that people hold it only as an intermediate. People hold stocks and bonds only as intermediate goods, it is impossible to consume a stock or bond, they are only held as ways of transporting potential consumption from now into the future, much the same as money. The inventory that retail stores hold is another close example: retailers buy and hold their merchandise only because they will later trade them for goods they value more.
Many also think money is unique in that it is only a means to an end, rather than an end in itself. The fact is that most, if not all, other goods are used merely as means to other ends: refrigerators are used merely to keep food cold (no one eats a refrigerator); food is only used as a means to get nutrition and for experiencing pleasant tastes and feelings. Human wants are quite abstract, and there is usually no way to directly satisfy them, only means to that end.