Thursday, March 1, 2012

Money's Impact on Economic Output and Growth - Part 1

We take our use of money in society as a given.  It seems ridiculous to think of an economy as sophisticated as ours trying to operate on a barter system.  The benefits of using money are large.  However, the use of money creates obstacles as well.  Here I'd like to explore the effects of a monetary economy on the total output (GDP), and also fluctuation in that output.

There are many definitions of money.  The Federal Reserve has tracked money in the form of M1, M2, and M3; each of these terms, respectively, is a broader definition of the concept of money.  For example, M1 includes currency in circulation, plus demand deposits ((i.e. checkable deposits).  M2 includes all of M1, plus savings deposits, time deposits less than $100,000, and money market deposits.  Other measurements of money, such as the monetary base and money of zero maturity (MZM) are also referred to and discussed in the media.

The role that money plays in an economy are generally categorized into the following three groups.
  1. Medium of exchange
  2. Store of  value
  3. Unit of account
I'd like to examine these roles for money, and how each impacts the economy output and growth.  In my opinion:
  • the medium of exchange role results in large benefits at no costs for an economy.  
  • the store of value role results in harmful effects for an economy.  
  • the unit of account aspect of money results in benefits as well as costs for an economy, although the benefits exceed the costs.  
Overall, money increases total output in an economy, and facilitate economic growth as well.  It is no certainly no panacea, however, and a study of its harmful effects is important to understanding how our economy functions.  In Part 1, I'll discuss the medium of exchange and store of value aspects of money.  In Part 2, I'll address benefits and costs that result from the unit of account role of money.

Medium of exchange

By having an asset that is readily accepted to settle all transactions, costs associated with exchange are significantly reduced.  The costs of a barter economy include search costs, negotiation costs, divisibility costs (how could you buy a truck from someone who wanted payment in cars, when the truck was worth between 1 and 2 cars?)  As a result, in monetary economies individuals and institutions can specialize in producing a narrow range of goods or services, assured that they can trade for other goods and services they need.  The alternative to a specialization and exchange society is one in which individuals produce all goods and services they consume. Such a proposition is tremendously costly, and reduces the total output available.

I believe the medium of exchange characteristic of money is the easiest of the three to understand and observe in daily life.  Its impact on economic output is exclusively positive, unlike the other two characteristics of money.

Store of value

Individuals can store wealth in money or in other assets.  In our fiat monetary system (fiat simply refers to money has value because the government says it does, and not because it can be redeemed for real assets), money demonstrates two unusual characteristics:
  1. Money, unlike other assets, is not affected by certain market forces.
  2. The marginal value of money to the real economy is zero.
Lets look at these characteristics separately.

When demand for all other assets increases, the price of that asset increases.  Not so with money, which always keeps its nominal value.*  In addition, fiat money is controlled by the government and the banking institutions.  With fractional reserve banking, banks can alter the supply of money to a point.  However, banks are subject to governmental regulation, so ultimately money supply is a function of the government control.  Whereas for most real assets (e.g. oil, trucks, housing), market forces cause supply to increase when demand increases, this does not necessarily hold true under a fiat monetary system.

Once an economy has a well accepted monetary exchange system in place, additional money does not increase the wealth in the economy.  This is because, as widely accepted among economists, prices adjust to  reflect changes in the money supply.  The relationship between money and prices is referred to as the quantity theory of money.  Paradoxically, we can conclude that, for the economy as a whole, money is the only asset where an increase in quantity does not result in an increase in wealth.  Consider any other asset in an economy (e.g. oil, trucks, housing)--as more of these assets are held, the economy becomes richer.  For money, such a fundamental, logical relationship does not hold, as an increase in money only makes prices of real assets move higher.

Why does all this matter?  Well, when demand for money increases in our society, i.e. when people seek to hold more money for its store of value attributes, we face economic problems. Any supply response (whether from banks or from the government) does not add any value to our economy.  Any additional money supplied in an economy can be considered artificial assets, as it ultimately results in higher prices, not any value creation.  In essence, when demand for money increases in our society, we switch our demand from wealth creating assets (i.e. real assets) to wealth neutral assets (i.e. artificial assets).  Total real output suffers as a result.  

Macroeconomists that follow the concepts first articulated by John Maynard Keynes, generally termed Keynesian macroeconomists, refer to an increase in demand for money as "a fall in aggregate demand."  I believe a more precise term such an effect should be "a fall in demand for real goods and services."  After all, money is generally considered an asset, and demand for goods (including assets) and services has not actually changed in aggregate.  Instead, demand has been shifted, in part, from real goods and services to artificial assets. Our GDP and employment levels depend on the amount of  real goods and services produced.  When demand reallocates from real to artificial assets, we face declining real output and employment.

* Unlike other assets, whose price is generally expressed as an amount, the price of holding money can be expressed as the prevailing interest rate.

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