Money Matters

Note: I originally designed this post as a separate post, but it changed as I continued to write. At one point, I realized that I needed to write the background for the first post of the “Back to Basics” post series, as even in this form there were points left behind that needed to be clarified. Therefore, this post can be read as “Back to Basics, pt. 0”. If you are going to read the series, it’s best to start from this point.

From the beginning, I have been thinking about how to learn the money economy, how to shed light on the confusing concepts that are confused. Later, I realized that when people learn about monetary economics, they must forget what they believed before.

Market monetarist economists believe that monetary shocks are the main cause of business cycles and that they are the only cause of unemployment fluctuations. People don’t believe it; This is not clear even to most economists. The ordinary person thinks the recession is due to big real shocks or financial shocks: explosion of asset bubbles, 9/11, stock crashes, disasters…

It will probably seem difficult to get rid of these “real” theories at first, but the more you think about it, the more likely it is that the foundations are rotten and can be easily broken down. It is easy to see that 9/11 did not cause the 2001 recession, because the recovery started after 2 months. One of the biggest stock market crises in the last 50 years occurred in 1987, almost identical to 1929, including a recovery in stock prices. The biggest natural disaster to hit a wealthy country in the last 20-30 years was the 2011 Japanese earthquake that killed tens of thousands of people, devastating a large area of Japan and its entire nuclear industry (25% of total electrical energy).

The next two graphs show the unemployment rate 2 years before and after the October 1987 crash and Japan’s unemployment from January 2009 to 2015(the tsunami was in March 2011):

What do we see here? Absolutely nothing. These real shocks do not matter much to business cycles. The tsunami, of course, caused a temporary drop in industrial production, but nothing severe enough to create a recession. You can really see how little real shocks matter if you turn your attention to the labor market. Because real shocks do not cause big jumps in unemployment. Recessions are due to unstable NGDP, which is due to unstable monetary policy(by definition, stable NGDP growth is my definition of stable monetary policy). However, it’s not a tautology that the recessions themselves are caused by monetary policy. It is surprisingly difficult to explain why NGDP instability has caused unemployment to fluctuate so much. Especially when NGDP shocks are caused by quite obvious changes in monetary policy rather than “errors of omission.”

Let’s look at another example. In the US, residential construction fell 50% between January 2006 and April 2008. So what happened to unemployment? It rose from 4.7% to only 4.9%.

Many people, and even some economists, grossly overestimate the importance of real shocks in the business cycle. On the other hand, again, most people and some economists vastly underestimate the importance of monetary shocks. If we’ve got rid of the idea that non-monetary shocks cause recessions, it’s time to talk about monetary policy as the real cause of business cycles.

First, it is necessary to explain why money is important for nominal variables such as inflation and NGDP. After that, we can go back to the business cycle.

The key concept we will use from now on is the value of money, and it is defined as:

Value of money = 1/(Price Level)

This definition actually comes from basic microeconomics. We move away from simple supply and demand curves in upper-level micro-lectures and start talking about “relative prices” or “real prices.” Therefore, if the CPI rises by 10% per year, then the prices of goods that increased by 8% declined relatively, and those who experienced a 12% price increase relative to their price increase. Relative price is the actual price relative to the price of all other goods in the economy. Now let’s do the same with money. What is the nominal price of money? One. So what is the real price? We call this the purchasing power of money; it shows how many goods you can buy for each dollar. This is only 1/price level. Thus, if the price level doubles, the money’s purchasing power, i.e., the value, falls by half.

The field of monetary economics exists for a reason – money is the medium of account, the commodity we use to measure all other values. Most textbooks oversimplify this concept by combining the two ideas into “units of account.” Currency banknotes are the medium of account, which is used to measure value. Abstract accounting units such as the US dollar and Euro are examples of units of account.

Because money is good for pricing all other goods, almost every change in the value of money affects changes in price level and other nominal variables. I have to remind you that this is not a “theory” but a definition. The theory will come later, asking whether government policymakers can control the price level through “monetary policy.”

While studying the monetary economy, the most efficient example on this subject was the metaphors that Irving Fisher used money as a measuring stick. I’ll first give an example with price level; then we’ll see the same example with measuring sticks:

In 1996:
Income $20,000
Price level 1.0
Real income $20,000.

In 2021:
Income = $120,000,
Price level = 3.0
Real income = $ 40,000.

This means that prices have tripled in 35 years, and a person’s income has increased 6 times. He can now buy twice as many goods and services. This is derived as follows:

Real income = $ 120,000 × (1.0) ÷ (3.0).

Let’s see the same example on the measuring sticks, our example would be the height of a child:

In 1996:
Height = 1 yard
Real height = 1 yard

In 2021:
Height = 6 feet
Real height = 2 yards

The child is 6 times bigger in nominal terms, but only twice as tall in real terms. No one would believe it if his father claimed that his son was 6 times taller. This is usually not possible. However, it is claimed that we made 6 times more money in 2021 than in 1996, and they make the same mistake that the father did: 1996 dollars are thought to be the same as the 2013 dollar. But that’s not true, the value of each dollar today is only 2/3 of 1996 dollars. We can say that those who made this mistake suffer from the “money illusion.”

Let’s imagine that we are using something other than cash as money. If oranges were money, a large harvest of oranges that degraded the orange would cause too much “inflation.” In fact, we are experiencing a lot of “orange inflation” when the relative price of oranges falls anyway. And, for example, when the relative value of silver rises, we experience a lot of “silver deflation”. Why do we only care about money inflation and not other types of inflation and deflation? This is a difficult question to answer. Textbooks have two sections devoted to this:

  1. Welfare costs of inflation.
  2. Welfare costs of business cycles.

In theory, measuring sticks don’t matter. No matter what you measure objects with, their actual dimensions do not change. But imagine a country where for some reason people make contracts to supply 100 “units of wheat” within 12 months in the future and units are left unspecified. Or let’s say people agreed to work at 2 units of wheat per hour next year. Suppose, moreover, that the government can change units from pounds to pounds and ounces at any time. In this case, a change in units will definitely affect the public. This is the main reason why monetary inflation is important and orange inflation is much less important. Our measuring stick always changes in value and this causes a lot of problems.

Now that these points are clear, we need to explain why the value of money has changed. In a post series.

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