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The Theory of Money

Fiat money(1) is a creation of both the state and society. Its value is supported by expectations which are conditioned by the dynamics of trust in government, the socio-economic structure and by outside events such as wars, plagues or political unrest. The micro-management of a dynamic economy is not far removed in difficulty from the micro-management of the weather. However, money and the financial institutions and instruments of a modern economy provide the means to influence expectations and bound behavior.(2) Paper money emerges as a virtual commodity. The dynamics of the economy permits it to serve as an imaginary gold.Although it is an abstraction, it is meaningful to talk about its quantity. Closely related to but basically different from fiat money is credit.(3) Credit, unlike fiat money is not a virtual commodity but a two party contract. The fact that it is a two party contract set in a dynamic context implies that there are chances that the economy may reach a state where a debtor is unable to meet his or her obligations. When this happens the laws and customs of the society must provide default, bankruptcy and reorganization rules. These rules are usually denominated in terms of fiat and socio-economic penalties such as the confiscation of assets, garnishing of salary or time in debtors' prison. Thus the value of paper gold is determined in two ways by the dynamics of the system. First by acceptance in trade, based on the expectation that it will remain valuable and second by its role in the discharge of debts where failure to repay has unpleasant consequences. When taxes are present a third valuation appears in the penalties for failure to pay taxes. The control of the fiat money supply together with rules on the granting of credit and the bankruptcy, default and reorganization rules,in essence, provide lower and upper bounds for the price level in the economy. They also determine the innovation rate of the economy. An innovation may be regarded as an economic mutation; the less costly failure is, the more likely an innovation will be risked. The rates of interest for loans combined with the harshness of the bankruptcy and reorganization laws help to determine the rate of innovation in a society. Government controls only one among many interest rates. A host of institutional details involving risk and transactions cost determine the others. The velocity of both money and credit may vary. Even though velocity may vary, human decision-making takes a finite amount of time. This implies that velocity will remain bounded. Beyond some speed of circulation expectations will degenerate and the economy will break down. In order to appreciate the intrinsic dynamics of a high information and communication mass economy at least three agents must be distinguished. They are the highly visible government; other largely visible legal persons, such as banks and corporations and real persons. Their differences are characterized by their relative power and the size of their communication networks. The contrast between a market economy and a state economy is not a clean contrast. The distinctions are on a continuum. Among modern democratic market economies the size of the government sector is roughly anywhere from 15% to 50% of the economy. Thus the control description of virtually any modern economy is of one extremely large and visible player; at most a few hundred large corporate entities of reasonably high visibility and a mass of small agents known by and in direct communication with only a few others. The reconciliation of a dynamics oriented macro-economics with an equilibrium oriented micro-economics lies in the understanding that the economy is embedded in the polity and society. The institutions, customs and laws are the carriers of process and provide bounds to process. They limit the dynamics.The role of macroeconomic policy is to bound the dynamics of an evolving society. Individual behavior is local and necessarily myopic. Myopic local optimization is consistent with global evolution. An elementary understanding of history and the decision and game theory proliferation of strategies is enough to indicate that the search for a unique or even stationary economic dynamics is an essay in futility.In contrast the search for the correct carriers and bounds on process is feasible.The monetary structure provides the sufficient loose coupling to permit mass independent behavior to take place even somewhat chaotically within institutional bounds.(4) 1. I use the term fiat or abstract paper money interchangeably to stand for a government supplied means of payment of no intrinsic worth. 2. Phrasing this somewhat more technically they provide the bounds on the state space. A state space is the set of all feasible states which can be achieved by the system. 3. Credit such as bank credit from a well known bank may be referred to as "inside money" in the sense that it is a contract between two legal persons in the economy other than the government. Yet the bank credit, because of the visibility and reputation of the bank, may serve as a substitute in transactions for fiat money. 4. Technically the institutions and the monetary and financial structure fully define the state space, but do not describe the dynamics. There is a robust collection of local individual rules of behavior which are all sufficient to provide the dynamic support of expectations that money will be accepted as having value. The control system may be sufficient to guide or at least limit the overall macroeconomic behavior without necessarily providing for a precise or unique dynamics. Money is the only financial instrument without an offsetting instrument. This nonsymmetry appears to be critical in the introduction of time into the model of the economy.

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Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1253.

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Length: 21 pages
Date of creation: Apr 2000
Publication status: Published in World Economics (2001), 2(1): 95-120
Handle: RePEc:cwl:cwldpp:1253
Note: CFP 1024.
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