Thursday, March 15, 2012

Money's Impact on Economic Output and Growth - Part 2

In Part 1 of  Money's Impact on Economic Output and Growth, the implication of money's role as a a medium of exchange and a store of value was discussed.  The third role of money in our economy--a unit of account--follows here.

Unit of account

Because money trades against all goods and services, it is easy to compare value across goods and services in a monetary economy.  Austrian economists discuss how prices send signals to market participants, and these signals result in resource allocation and innovations.  Prices (and interest rates) are the unit of account that occurs in monetary economy.  Barter economies don't have a common unit of account until one of the goods trades against all other goods. If a good started trading against all other goods (think of gold for example), the common good being traded has essentially evolved into a form of money.

The benefits from the information content in prices and interest rates is vast.  Business managers and entrepreneurs make decisions based on current and expected prices for the goods and services.  Allowing the value of goods and services to easily be measured against one another makes decision making more effective.  As prices change in our economy, businesses are able to respond and new companies form to seize profitable opportunities.

The nominal value of money can also cause our economy problems, most notably when there are unexpected changes in the overall price level (inflation or deflation).  Contracts are generally written in nominal terms, unadjusted for price changes.  For example, the standard bond (a very common business contract) promises to pay the holder a set amount of money over time, regardless of what happens to prices in the future.  A large price increase makes the bond issuer better off, but the bond holder worse off,  because the payments under the bond contract now purchase fewer goods.  Possibly even more destructive to our economy is a deflation, where prices drop across the board.  Because nominal contracts do not fall with prices, companies are faced with larger debt balances relative to their operating profits.  Widespread bankruptcies can occur during deflations, leading to large levels of unemployment.  This is one of the common observations of what occurred during the great depression.

Both parties of any contracts based on nominal dollars are subject to risks from changing price levels.  This is a main reason why central banks, including the Federal Reserve, generally have a mandate to keep overall price levels stable.*  Because governments control the money supply and inflation rates to a large extent, the credibility of the government to enforcing price stability is paramount to participants willingness to contract.  As contracts, including debt contracts, play such a large role in our economy, a loss of government credibility in fighting both inflation and deflation can lead to a loss of total output and employment.

* A mandate to keep the overall price level stable does not mean central banks prevent relative price changes. Price changes occur as preferences change between goods, leaving some goods more expensive and others less expensive.  Overall the price level in such a scenario remains the same.


  1. To some extent central governments do, in fact, prevent or enact relative price changes. The agricultural subsidies that the U.S. government pays out to farmers reaches into the billions annually and greatly affects the value proposition that farmers face between different crops. My understanding is that the market for corn in the United States is the most affected by this behavior. I would be interested to hear your take on how this flows through to the greater economy as a whole.


    1. Chris, your point is certainly true and well taken. I would point out that a a governement's mandate to keep prices stable is separate and apart from the any subsidy decision it makes. Therefore, any decision to artificially keep certain product/commodity prices high does not invalidate the proposition that price stability allows relative price changes to occur.

      As it relates to the discussion above, lending contracts between corn farmers and banks likely face a different set of risks. Given government subsidies, that parties face less risk that corn prices will fall and the farmer will be unable to pay its debt, assuming the subsidy is guaranteed for the life of the contract. Such a contract is still exposed to the risk that the government changes its subsidy program, and the price of corn immediately plummets. The market risk is replaced with a political risk. Its no wonder various subsidized industries spend so much on lobbyists in Washington...