Monetary Theory & Policy – Introductory Notes

The study of monetary economics has both microeconomic and macroeconomic components.

The microeconomic elements arise in addressing:

1)      why does money exist? (what microeconomic behaviors/decisions lead to the adoption and creation of money),

2)      the existence and nature of the money demand function (what economic variables determine or affect the quantity of money demanded), and

3)      the existence and nature of the money supply function (what economic variables determine or affect the behavior of the public, banking system, and monetary authorities in creating a supply of money).

The macroeconomic elements arise in addressing:

1)      how do the level and changes in the level of the quantity of money affect economic activity (as measured by GDP, prices, inflation, unemployment and employment, interest rates, exchange rates, and other macro-variables) and

2)      how can those macroeconomic relationships be used to conduct monetary policy to achieve particular macroeconomic policy goals and objectives.

To then begin considering these elements leads to obvious questions of what is money and why does it exist.

There is a tautological (circular reasoning) problem in the logic of defining money as an asset which performs the functions of money.  Typically, those four functions are defined as serving as 1) a medium of exchange, 2) a store of value, 3) a unit of account, and 4) a standard of deferred payment.

A much better (correct logic) approach is to develop a theoretically-based definition.  The definition to be derived is:  Monies are assets commonly used to facilitate exchange.

How is that definition developed?  (The following “theory” was more formally developed and presented by Karl Brunner.)  Imagine a simple barter economy with “n” goods, resources, and services to be exchanged.  Recall that as long as the endowments across society are different than the preferred/desired allocation for consumption, there is an incentive for exchange/trade.  In conducting direct barter exchanges, transactions costs are incurred in searching, negotiating, and completing exchanges.

The critical axiom/assumption is that these transactions costs vary across the “n” items because of their physical characteristics (that is, some goods, resources, and services can be traded with lower transactions costs because of their physical properties).  Further, it is reasonable to assume that as the frequency of exchanges with a particular item increases, the transactions costs with that item are further reduced (lower search costs because of the greater frequency of trades).

Thus, what evolves is that as individuals conduct exchanges (pursuing their economic self-interest), they find that some sets of transactions can occur more cheaply (with lower transactions costs) than other transactions.  They find that indirect exchanges through a smaller set of items may be cheaper (have lower transactions costs) than attempting direct barter exchanges.  As these items become more frequently used for exchange, their transactions costs fall further, enhancing the cost advantage.  Ultimately, a small set of items appear to become the medium of exchange – that is, they become money.  So rather than incur high transaction costs through direct barter, indirect barter/exchanges occur through the money assets.

Money exists because as a medium of exchange it lowers transactions costs, improves the efficiency of exchange, and thus enhances individual (and social) welfare.

There are two critical things to note here.  First, money is a “social invention” arising from individual pursuit of economic gains from exchange – each individual is simply trying to do the best they can from trading and trying to trade more efficiently (saving time, effort, and other resources).  The unconsciously-collective effort of individual behavior engaging in social behavior of trade leads to the invention/creation/adoption of monies.  Second, note that there is no government or such authority in this theory/story – this reinforces the previous point (and also raises other questions for future consideration as to why governments have come to play a dominant role in controlling money).

Once this theoretically-based definition is established, it then becomes a simple matter to observe the other functions of money as economically reasonable actions.  If most trades are occurring through the money asset, it is “cheaper” to use it as a unit of account.  In anticipation of current and future transactions, holding some money as store of value and using it as a standard of deferred payment makes economic sense.  Thus, these functions of money are derivative (the result of) money’s use as a medium of exchange.

There are a few other points to be developed and extended – why have particularly items become monies and how/why have monies evolved to their modern forms?