Crisis section

Crisis section
Gödel's Money : The future of freedom and civilization
- Macroeconomic Policy and Measures for the Financial System -

Senior Fellow, RIETI

The Ideal Exchange Market Assumed by Macroeconomics

In the previous installment, we saw that the financial system in the standard macroeconomic model is viewed as a passive entity, like pipes connecting household savings to business investment. The following outlines how money is treated in contemporary economics. We will consider macroeconomics that deals with economic fluctuations and banking theories that address the financial crisis, among other issues.

The existence of money whose value changes in inflationary and deflationary times is not included as a basic element in the macroeconomic model. Those who are not economists might wonder why economic theory could make sense if it ignores the existence of money. My answer to that question is that this is because standard macroeconomics assumes an ideal exchange market that does not require any medium of exchange (means of payment).

In macroeconomics, which deals with business cycles, markets for assets and goods are considered to be perfectly competitive, in the sense that no asymmetry in information or incompleteness in contracts is assumed. If there is any asymmetry in information between sellers and buyers (for example, buyers do not have sufficient information on the quality of goods) or any incompleteness in contracts (parties are not free to set penalties that will apply to debtors who default because of social and legal constraints), market transactions will be distorted. However, there seem to be tacit assumptions that distortions in markets are basically problems in microeconomics and that the distortions will not have a great influence on economic trends in the entire macro economy. A research approach established based on these assumptions is to study economic fluctuations in a model where perfectly competitive markets are assumed at the start of the study and factors that would generate distortions in markets are added. The approach is intended to find factors that produce actual economic fluctuations. A similar approach in physics first studies the movements of particles in an ideal situation where there is no friction (comparable to a perfectly competitive market) and then observes the movements of actual objects, adding different types of friction (comparable to distortions in markets).

A major characteristic of the perfect competitive market is that the market does not need a special medium of exchange (means of payment), or money. In a perfectly competitive market, it is assumed that every exchange between goods and between goods and assets is possible. If you offer to exchange an apple for an orange of the same value in a perfectly competitive market, the other party will not reject the offer on the grounds that payment is not being made in cash. All economic transactions are assumed to be possible, even if they are not mediated by money.

New Keynesian model is a tool for analyzing monetary policy in ordinary times

Since sellers and buyers have complete information about each other in the ideal market, all economic transactions will be carried out by margin trading and barter transactions, without either of them being cheated, and money is not needed. Of course, there have been many excellent pieces of research that have introduced money as a medium of exchange in macroeconomic models. I will introduce and consider them in detail in later installments. In this article, I will describe how money is introduced to the New Keynesian model, which is a standard framework for analyzing business cycles and central banks' monetary policies.

The New Keynesian model has introduced money. (Without it, central banks' monetary policies cannot be analyzed.)

However, money is not assumed to function as a medium of exchange. I believe this is a major problem with the New Keynesian business cycle model (a problem shared by the real business cycle model in the neoclassical theory).

Money has been introduced to the New Keynesian model merely as a scale to measure nominal prices. The model introduces accounting units (such as the dollar, the euro, and the yen) that indicate the values of goods and assets and the nominal prices of goods and assets indicated in the accounting units. In this way, the existence of money as an entity indicating nominal prices is introduced tacitly. In the framework of New Keynesian economics, money equals an accounting unit. Money does not have any meaning beyond that of an accounting unit. In this setting, price stickiness (in short, prices not indicated correctly), a market distortion well-known in Keynesian economics, is introduced, and the question of how price stickiness affects business cycles and monetary policies is studied. This is the structure of New Keynesian macroeconomics.

In the New Keynesian model, price stickiness is assumed to be a situation where businesses and other economic entities are not free to change at any time nominal prices (prices of goods indicated in accounting units such as the dollar) for products that they have produced and seldom have the opportunity to change set prices.

The theoretical structure has been developed for the very reason that New Keynesian economics has considered the relationship between changes in nominal prices (inflation and deflation) and changes in the reak economy to be a major target of analysis. In other words, the relationship between money as a medium of exchange and changes in the real economy has not been considered a target to be analyzed from the start. New Keynesian economists have not seen the role of money as a medium of exchange as a big issue with macroeconomic implications. The issue of a medium of exchange (or a means of payment) was eliminated in their assumptions before the establishment of their theory.

The New Keynesian economic model, considered to be a standard tool for analyzing macroeconomic policy, was not able to make effective policy recommendations about the recent financial crisis. If the new Keynesian policy analysis were effective, the effectiveness would be limited to an analysis of monetary policy in ordinary times. I could say that this point has been reconfirmed in the recent crisis.

* Translated by RIETI from the original Japanese article in the series, "Gödel's money" published in the September 7, 2009 issue of Kinzai Financial Weekly

December 3, 2009

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