For nearly a century the progress of macroeconomics has been stalled by a single error, the error of regarding money as cash balances and the demand for money as the demand for cash balances. It is an error that is common to the Keynesians, the monetarists and the Austrians. And it has been taught to every economics undergraduate for generations so that it is etched into the collective consciousness of all economists.
To view it in practice look at how Milton Friedman used it. For Friedman money is an asset, one of many alternative assets, such as stocks, bonds, durable consumer goods, or even human capital. To determine the demand for money one has to compare it with the demand for those alternative assets. If Paul wishes to hold more stocks and bonds it follows that his demand for money and therefore his cash balances will come down.
So where is the error? Consider that Paul decides to hold fewer bonds than he did, preferring instead to hold more money. In Friedman’s analysis his demand for money has gone up. But the only way that Paul can reduce his holding of bonds is to sell some to Peter. So Peter’s holding of bonds goes up and his demand for money goes down. Although Peter and Paul can change their individual stocks of bonds and money, their combined stock of bonds or combined stock of money cannot change. By trading in financial assets the stock of money in the economy cannot be changed one whit.
In Friedman’s model of the economy money exists only in the form of currency. There are no banks and the only way in which money can be increased or decreased is through the agency of the central bank. To see how such a model results in errors for Austrians, see http://www.philipji.com/stupidity-of-economists.html, and for how it lands Keynesians in errors see http://www.philipji.com/paul-krugman-and-the-liquidity-trap.html.
So what is money? To answer that question, we begin with the money multiplier. In its simplest form, this is how it works. The central bank buys $100 worth of, say, government bonds, from a bond dealer. The dealer deposits the $100 in a commercial bank. Assuming that the reserve ratio is 20%, the bank has to retain $20 as a reserve; so it lends out $80. Assuming this is deposited in another bank, the second bank now has to retain 20% of this $80 as a reserve i.e. $16 and can lend out $64, which in turn is deposited in a third bank. By adding up the entire chain of new deposits it can be shown that the $100 created by the central bank’s initial purchase of a bond for $100 will result in the creation of $500 of new money.
We show the process in a simple diagram as below, where M is the reserve, m is the multiplier, and mM is the money created.
So far, Keynesians, monetarists and Austrians will all be in agreement with us. Curiously none of them seems ever to have asked: What happens when this newly created money mM is spent? We now ask the question by drawing the figure below.
And having asked the question we are immediately confronted by a problem. At A the central bank injects M dollars into the system. The banking system, through a series of loans and deposits, converts it into mM dollars at B. When this money returns to A, it is then converted by means of the multiplier to a value of m2M at B. In the next cycle this becomes m3M at B, and on on in an ever-increasing spiral. Equilibrium, it would seem, is impossible.
There is only one way out. For equilibrium to be maintained the money created while moving from A to B must be destroyed in the movement from B to A. We answer one objection immediately. Why isn’t the entire mM dollars created at B spent? That is to say, why is M dollars retained unspent at A while moving from B to A? The answer is quite simple: in the money multiplication process described at the start of this section, when 500 dollars of new money is created, 100 dollars has to be retained by all the banks together as reserve.
The answer to the second question may be a little more difficult to appreciate. How is the amount of money mM at B destroyed so that it becomes M at A? The answer is that the destruction happens through the mechanism of saving. Each person who receives money spends some of it while saving a little and withdrawing it from the system. The total of this saving must be exactly equal to the net money created mM-M for equilibrium to be maintained. But people do not hide their savings under their mattresses. Because they are assured that the central bank will not allow the disorderly failure of banks they place their savings in the bank. We draw the result as in Fig 3 below.
Simple though it is, this is the model of the economy that has eluded economists so far. In it a) Money is created when banks lend money and is destroyed when loans are liquidated and b) Money is endogenous i.e. it can be created and destroyed without the intervention of the central bank.
Many conclusions can be derived from this model. For instance,
a) If the injection of money into the system by the central bank is multiplied by a process of bank lending, it can be sustained only if the system produces an equivalent amount of saving and this saving is loaned out again.
b) It is possible for the system to remain in equilibrium when the economy is operating at levels far below full employment.
c) It is possible to estimate the amount of money (an aggregate I call Corrected Money Supply) by estimating the amount of savings in demand deposits and by subtracting this amount from M1. See http://www.philipji.com/riddle-of-money/ For the period from 2001 to 2011 we get a graph accurately tracks the economy.