Thirteenth Installment
The Generation and Disappearance of Money
Economic fluctuations and money
A certain asset can serve as money when all parties believe that other parties are willing at any time to exchange other goods for this asset. This was Katsuhito Iwai's circular reasoning as a theory of money (No. 12, November 2).
The situation described by this circular reasoning as a theory of money, slightly reworded, is one in which everyone believes that the asset in question can be easily cashed in the market, i.e., in which the asset has increased its liquidity in the market. Thus the transformation of a certain asset into money can also be considered the result of that asset having gained in liquidity.
Gains and losses in the liquidity of assets are a well-known phenomena, frequently occurring not only in financial crises such as the present one but also during ordinary economic cycles. The essence of the matter here is that an asset that has gained liquidity alters the allocation of economic resources by serving as a medium of exchange for other goods (as "de facto" money). The assumption of this medium function by a given asset should be considered one type of outside economy effect, an aspect that has not been addressed successfully in standard economic analysis. The circular reasoning as a theory of money, which claims that certain items serve as money because everyone accepts them as money, can indeed only be viewed as an outside economy effect (as was the case with the Kiyotaki-Wright model). To my knowledge, no adequate theoretical model has yet been developed that dynamically addresses the process of the generation and disappearance of outside economy effects (i.e., the generation and disappearance of money).
Understanding the generation and disappearance of money is of more than just academic interest and could potentially have a significant impact on practical economic policy, as the causes for the economic fluctuations necessitating the policy response may be connected therewith. The outside economy effect of a certain asset (financial institution debt, real estate, etc.) assuming intermediary functions as a medium of exchange (as a result of having gained liquidity in the marketplace) may be one factor in economic fluctuations. This hypothesis merits serious examination in future economic research.
What are the causes of business cycles?
Changes in productivity and changes in wages and other markups are held to be the principal causes generating business cycles in the standard framework at present. This phenomena regarded as changes in productivity and changes in wages and other markups is also thought to arise from the generation and disappearance of money.
Changes in productivity are regarded as the primary cause of economic fluctuations in neoclassical real business cycle theory. Neoclassical analysis using macroeconomic data from Japan, the U.S. and other countries has shown that a considerable share of economic fluctuations can be explained by changes in productivity. It has also shown that flagging productivity played a major role in causing the Great Depression in the U.S. in the 1930s and the prolonged recession in Japan in the 1990s. The factor emphasized by the New Keynesians, on the other hand, is changes in wages and other markups, that is, the gap between labor's marginal productivity and marginal rate of substitution, which is indicative of the degree to which the labor market has diverged from perfect competition and become exclusive. The inverse of markup is the labor wedge, and even neoclassical researchers are beginning to pay closer attention to changes in the labor wedge as an important factor in the business cycle.
Changes in productivity are supply shocks, while changes in markup are typical demand shocks. Both have come to be seen in business cycle theory research as shocks striking the economic system from outside. Although various theoretical hypotheses have been advanced, no decisive conclusion has been reached on the causes of productivity shocks and markup shocks.
An integrated understanding of business cycles from the generation and disappearance of "de facto" inside money (scrip money) would not only offer a new theoretical hypothesis, but would also have powerful policy implications. Examining productivity shocks and markups (the labor wedge) from this perspective reveals the possibility that the generation/ disappearance of money is causing these changes. As was argued in the fifith article (August 31) in this series, if companies seeking to procure funds to purchase intermediate goods were to face greater financial constraints macroeconomically (e.g., the price of collateral real estate falls), the amount of intermediate goods purchased and the production volume of final goods would drop. This phenomena would then be measured as a decline in productivity in the macroeconomic data. In other words, productivity shocks can be caused by financial constraints. Should the intensity of these financial constraints vary in accordance with the generation and disappearance of inside money, greater credence would be lent to the hypothesis that productivity shocks, too, arise due to monetary factors.
Financial constraints can similarly cause changes in the labor wedge. For example, consumers face liquidity constraints such as having a limited amount of cash on hand to purchase consumer goods, and tighter constraints would cause the labor wedge to expand (worsen) in the macroeconomic data. The labor wedge would also worsen if companies were to face tighter financial constraints in procuring funds to pay wages. The former case is quite interesting in particular in that financial constraints in the consumer goods market, unrelated to the labor market, would worsen the labor wedge. In either case, though, if the generation and disappearance of money are seen as affecting liquidity constraints, there will be the possibility of the labor wedge changing.
If changes in productivity and the labor wedge - looked upon as the principal factors in the business cycle - are thought to be caused by the generation and disappearance of inside money, then it may hold true that changes in money (any item that serves as a "de facto" medium of exchange) is the principal cause for macroeconomic fluctuations in ordinary business cycles as well as in the current financial crisis.
* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the November 9, 2009 issue of Kinzai Financial Weekly
