March 14, 2018

The objective value of money

Comment on David Glasner on ‘Is “a Stable Cryptocurrency” an Oxymoron?’


David Glasner recalls: “One of my first posts after launching this blog was called ‘The Paradox of Fiat Money’ in which I posed this question: how do fiat moneys retain a positive value, when the future value of any fiat money will surely fall to zero? This question is based on the backward-induction argument that is widely used in game theory and dynamic programming.”

This train of thought is based on microfoundations, or as Krugman put it: “most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point.” This subjective-behavioral starting point is axiomatically false and has to be replaced by objective-systemic macrofoundations. Walrasian microfoundations and Keynesian macrofoundations have to be scrapped. This affects also the theory of money.

As the new analytical starting point, the elementary production-consumption economy is defined with this set of macroeconomic axioms: (A0) The objectively given and most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm. (A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

Under the conditions of market clearing X=O and budget balancing C=Yw in each period the price is given by P=W/R (1), i.e. the market clearing price is equal to unit wage costs. This is the most elementary form of the macroeconomic Law of Supply and Demand. For the graphical representation see Figure 1.#1

The price is determined by the wage rate, which takes the role of the nominal numéraire, and the productivity. The quantity of money is NOT among the price determinants. This puts the commonplace Quantity Theory to rest.

So, what is the ‘value of money’? What can one dollar of wage income buy in the elementary production-consumption economy? All we have to do is to divide the wage rate by the price. From (1) follows W/P=R, i.e. real wage = productivity.

Monetary profit for the economy as a whole is defined as Qm≡C−Yw and monetary saving as Sm≡Yw−C. It always holds Qm+Sm=0 or Qm=−Sm. Under the condition of budget balancing total monetary profit is zero.

What is needed for a start is two things (i) a central bank which creates money on its balance sheet in the form of deposits, and (ii), a legal system which declares the central bank’s deposits as legal tender. Without the central bank, money takes the form of an IOU of the business sector.

Deposit money is needed by the business sector to pay the workers who receive the wage income Yw per period. The need is only temporary because the business sector gets the money back if the workers fully spend their income, i.e. if C=Yw.

Overdrafts are needed by the household sector for consumption expenditures if the households want to spend before they get their income. This time sequence is no problem for the central bank because the temporary overdrafts vanish with wage payments.

For the case of a balanced budget C=Yw, the idealized transaction sequence of deposits/overdrafts of the household sector at the central bank over the course of one period is shown in Figure 2.#2

The household sector’s deposits/overdrafts are ZERO at the beginning and end of the period. The business sector’s transaction pattern is the exact mirror image. Money, that is, deposits at the central bank, is continually created and destroyed during the period under consideration. There is NO such thing as a fixed quantity of money. The central bank plays an ACCOMMODATIVE role and simply supports the AUTONOMOUS market transactions between the household and the business sector.

From this follows the average stock of transaction money as M=κYw, with κ determined by the transaction pattern. In other words, the average stock of money M is determined by the AUTONOMOUS transactions of the household and business sector and created out of nothing by the central bank. The economy NEVER runs out of money.

The transaction equation reads M=κYw=κPX=κPRL in the case of budget balancing and market clearing and this yields the commonplace correlation between average stock of money M and price P for a given employment level L, except for the fact that M is the DEPENDENT variable.

Money comes into existence on the balance sheet of the central bank as soon as the central bank enters an overdraft for the business sector on the asset side and a deposit of equal amount on the liability side (step 1). This deposit is then transferred to the household sector as wage payment (step 2) and returns in the form of consumption expenditures (step 3).

In the elementary production-consumption economy, money is a means of transaction and nothing else. The stock of money is zero at the beginning and the end of a period. Strictly speaking, money itself has no value.

The workers accept money from the business sector in the form of wage income because they can be reasonably sure that the business sector, in turn, accepts the money and hands over the consumption good output. This cycle has usually the length of one month. The real value of money is under the conditions of budget balancing and market clearing exactly equal to the productivity.

Over time, productivity changes and therefore the ‘value of money’ changes. The price is kept absolutely constant over time if the rate of change of the wage rate W in each period is exactly equal to the rate of change of the productivity R.

The ideas that the ‘value of fiat money’ depends on convertibility into gold or the taxing power of the state or that it will surely fall to zero are crackpot ideas of folks who never rose above the proto-scientific level.

Egmont Kakarot-Handtke

#1 Wikimedia, Elementary production-consumption economy
#2 Wikimedia, Idealized transaction pattern, household sector, balanced budget