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Any policy that depends on using the 'demand for money' as a driving input is even more inherently flawed than one that uses the supply of money. In neither case can one produce an unambiguously useful value, even ignoring the question of definitions. If I routinely hold an average of $10,000 of money (the medium of exchange), I can be said to have a demand for money of that amount, but it is useless since the total is composed of at least three distinct components with both disparate purposes and economic effects. First is money held for unpredictable purchases in an uncertain future, where an actual medium of exchange is required for an immediate payment. Think of a sandwich from a vending truck. Even if a credit card payment were sometimes accepted, you couldn't depend on it in advance. Second is money held for predictable purchases. In this case, think of a rent payment. Even if real money is needed, there is no need to hold it for weeks in advance when some other liquid asset can be converted to money in time to make the payment. Note that a monthly rent payment interacts with the supply of money not only due to the amount, but at least as importantly, the time of possession of actual money in advance of payment. A dollar that I possess cannot be possessed by anyone else at the same time. Third is a remnant of money for which no preferred alternative is perceived, after any potential transaction costs. Goods and services are always ultimately exchanged for other goods and services. Money serves as a buffering and time shifting mechanism and is not consumed in exchanges. It is the time of possession of money which is used up. Regards, Don Lloyd
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Like every other economic good, money is scarce. However, it is not necessarily obvious how the actions of individuals interact with the limited supply of money. First of all, when someone makes a purchase of a good with money, this does not stress the supply of money because all that happens is that the money involved in the purchase is instantaneously transferred from the buyer to the seller, with no net effect in the total supply of money. Rather the stress on the supply of money associated with money purchases comes from the pre-purchase holding period for the money accumulated for the purchase. In particular,the stress depends on the multiplicative product of the purchase price and the time duration of the pre-purchase money holding period. This has all kinds of consequences, but the most significant may be that the demand for holding money is highly variable, if not arbitrary. For example, let's say you have a monthly salary that serves in part to pay a monthly rent of $1000. It should be clear that the holding period of the $1000, and thus the resultant stress on the supply of money, can easily vary by more than an order of magnitude as the relative timings of the salary payment and the rent payment vary. This, of course, is only one of the many ways that large changes in the demand for holding money can result from what are otherwise innocuous differences in context. Proposed lesson : Even if the demand for money could be accurately measured, using it as an input to an economic policy would seem to be sheerest folly. This is not even taking into account that the demand for holding money by an individual is not homogeneous, but consists of at least three distinct components, each of which has distinct economic effects. Regards, Don
Steve, It strikes me that although your lecture claims that the effects of an increase in the money supply are microeconomic in character, free banking is just as macroeconomic as central banking. I would expect that the ability of individuals to respond to their own individual demand for money to hold results in a system that will remain near an overall stable equilibrium. While this can result in shifts in the objective exchange value of money if most people are lining up on the same side temporarily, the relative price distortions of a tide of new money washing through the economy will be largely absent. One problem with both free and central banking is that it is an inherent characteristic of any linear feedback control system that delay can eaaily turn a stable equilibrium into an unstable one, with either ringing or actual oscillation being the result. Regards, Don Lloyd
Steve, I have made a first pass through the audio mp3 of your lecture on 'Money and Inflation' and I was pleasantly surprised to find that your understanding of the most important adverse effects of moderate increases in the money supply (independent of the definition of inflation)largely agrees with my mine, i.e. microeconomic distortion of relative prices as new money disperses from its source in a step by step manner over time until it has spread throughout the entire economy. In trying to reconcile this understanding with your policy, I need two additional points cleared up about your concept of monetary equilibrium. 1. If all we say is that monetary equilibrium is the equality of money demand and money supply, we have omitted the most important characteristic of equilibrium, i.e. whether the equilibrium is stable or unstable. A ball subject to the force of gravity can be said to be in equilibrium either at the rounded peak of a hill or at the bottom of a valley. In the first case the equilibrium is unstable and the smallest of disturbances or displacements will cause the ball to roll off the peak of the hill completely. In the second case, the equilibrium is stable and small distrubances or displacements will produce a self-restoring force that will tend to return the ball to the bottom of the valley. Even if there is no bank to create new money, both the demand for and the supply of money will always be in a state of fluctation, and only instantaneously in a state of equilibrium. We still have the question of whether the equilibrium is stable or unstable. I would certainly suspect that the equilibrium for small displacements is a stable one, but I have no proof for that. Do you have a belief that answers this question? 2. It seems to me that the negative distorting effects on relative prices of an increase in the money supply that works its way through the economy will be largely independent of whether the demand for money is larger, smaller or the same as the supply of money at a given time. Given both 1. and 2. above, any attempt to artificially change the money supply would seems to have undesireable consequences. Thanks, Don Lloyd