Tuesday, February 21, 2017

The Emergence and Functions of Money 2.0





1. durable
2. easily divisible
3. relatively scarce
4. highly saleable
5. portable.

1. a medium of exchange
2. a store of value
3. a unit of account
4. a standard of deferred payment.

The development of money represents an innovation in accounting. A common standard or standards of measure allow for an approximation of the socially determined value of a good. Since prices are denominated in a common unit of account, the value of different goods, as determined in light of the demand of consumers and cost of supply, can be compared objectively. These prices represent the quantity of money a good can fetch if it is sold on the market. This allows producers to compare costs and revenues so that they can be certain of the magnitudes of their gain or loss.

These prices fluctuate according to changes in the quantity demanded at a given price (shifts in the demand curve) or as quantities available at given prices fluctuate (shift in the supply curve). They also change if either of these factors are expected to change. Thus, prices reflect not only present conditions but also expected changes in these factors. Since prices reflect information about agent valuations, they increase the accuracy with which agents can account for the value of their goods. This promotes an allocation of goods that reflect needs of all agents the preferences and budget constraints of those agents. With the addition of money, our model contains the building blocks requisite for economic calculation and widespread patterns of exchange.

Market regulation of the quantity of money

Just as money emerges from within a market dependent upon barter exchange, the quantity of money is also determined by market forces. Imagine that in some market, oats become the commonly accepted medium of exchange overnight. This change means that any person who buys or sells goods is willing to let money represent the other half of the exchange. A farmer who sells an apple use negotiates a price in terms of some weight of oats. He buys other goods using these same oats. 

Suppose that a community recognizes, overnight, that oats can now be used as money. Instantly demand for oats will increase as agents understand that oats can be exchanged for other goods. That is, oast not only have a use value – they can be eaten – but they also have an exchange value – they can be used to acquire other goods. The new price of oats, p1 (Figure 1) represent the combined use and exchange values. The original price, p0, represent the use value of oats. The difference between these two (p0 – p1), represent value derived from exchange. Note that if the supply curve was perfectly inelastic at q0, that the exchange value would be reflected by price implied at the intersection of Q0 and D1. For this example, the exchange value of oats in the short-run will be higher than the price reached in the long-run equilibrium.

The higher price sustained by the use of oats as medium of exchange incentivize greater production of oats. If the price is pushed high enough, it can also incentivize the development of technology that reduces the cost of oat production. Something similar occurred at the end of the 19th century when a relatively high price of gold incentivized the development of cyanide extraction process. For oats, this may include the development of new irrigation techniques or systematic use and breeding of the most productive strains of oats, among other possibilities. If the technology successfully reduces the cost of producing a unit of oats, the cost of supply falls. We represent this by shifting the supply curve to the right (Figure 2). Suppose that oat farmers suffer a drought one year. What will happen to the price of oats? In the case of a drought, the cost of supply increases. The supply curve for oats will shift left and the value of oats will increase.

Figure 1

Figure 2

The price of money
You may ask yourself, if oats are money, how do we determine their price. For any money, its price is what it exchanges for. If a quart of oats trades for 2 apples in equilibrium, then the price of a quart of oats is two apples. Likewise, if the same quart trades for 3 oranges, then the price of a quart of oats is also 3 oranges. Likewise, the price of an apple is 1/2 quart of oats and the price of an orange is 1/3 quart of oats. Money has an array of prices. Thus, the price of money is whatever it can exchange for. What we usually mean by the price of money, however, is the average price of money. This is often referred to as its purchasing power. Typically, we refer to the price level, which is the inverse of the purchasing power of money. A price index considers all exchanges for each type of good. Ideally, the price of each category of good sold is weighted according to the total number of goods exchanged. In reality, the basket of goods and weights of these goods change overtime, so there exists no perfect estimation of the price level and, by implication, the purchasing power of money.

[1] Another term commonly used is the purchasing power of money.

*Expanded from The Emergence and Functions of Money

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