Money (the medium of exchange) is an asset. But the demand for money is different from the demand for any other asset. Here is an (inadequate) parable that tries to explain why it is different.
A dozen kids are sitting in a circle around a campfire. They have cold hands. The parent has a bucket of hot yams. (They are magic yams that stay hot forever). Each kid has 2 hands and wants to hold exactly 2 yams. Trying to hold more than 2 hot yams would burn the kid. So a kid holding 3 yams would immediately pass one on to his neighbour, who will only accept it if he has an empty hand, or sees there's another kid with an empty hand.
With 12 kids times 2 hands each there is a demand to hold 24 hot yams. The parent hands out 24 yams and the kids pass them along until each kid is holding 2 yams. If the parent tried to hand out a 25th yam, no kid would accept it. Because any kid who accepted it would be unable to pass it on to another kid who wanted it. The stock of hot yams held by the kids is determined by whichever is less — the kids' demand or the parental supply.
Now let's change the story from yams to potatoes. Unlike yams, a hot potato will only burn you if you hold it longer than one minute. You can hold as many hot potatoes as you like, providing you don't hold any potato for longer than one minute. So the kids hold each potato for exactly one minute, then pass it on to the next kid in the circle.
What is the demand for hot potatoes? How many potatoes should the parent hand out? 12? 24? 36? 48? This question doesn't (yet) have an answer. The parent can hand out as many hot potatoes as she likes, and the kids will accept them, hold each potato for one minute, then pass it on to the next kid. The stock of potatoes held by the kids is determined by the parent's supply, and not by the kids' demand.
How would we need to change the story to make the demand for potatoes determinate?
Suppose the kids also supply and demand backscratches. You can only give a backscratch with your right hand, to the kid on the right. So you can only get a backscratch from the kid on your left. Suppose the rule is that the price of a one-minute backscratch is one potato (I'm assuming sticky prices). Potatoes circulate clockwise, and backscratches circulate counter-clockwise.
Let's start with a recession. There are only 6 potatoes in circulation, so 6 kids are producing backscratches, and 6 kids are consuming backscratches, at any point in time. You might say that the demand for potatoes is also 6, because that is the number of potatoes needed to pay for the backscratches that are being produced and consumed. But if the parent hands out a seventh potato, it will be willingly accepted, and be passed on once a minute, so now 7 kids are producing, and 7 kids consuming, a backscratch, at any point in time. If the parent hands out 12 potatoes, the recession ends, because each kid is now fully employed giving backscratches.
The stock of potatoes demanded equals the number of backscratches produced per minute. Because velocity of circulation is 1 per minute. But if the parent increases the supply of potatoes, the number of backscratches increases, and the demand for potatoes increases in proportion. The supply of potatoes creates its own demand.
What happens if the parent tries to hand out more than 12 hot potatoes? The kids will still accept them, because they can always pass them on to the next kid. But they won't get a backscratch in return. Because all the kids are already fully employed. If it weren't for the campfire taboo on changing prices, we would see the price of backscratches begin to rise.
Should we say that the kids demand a stock of potatoes equal to one minute's worth of nominal income from selling backscratches? Wouldn't it be better to say that the kids have a desired velocity of circulation of one per minute?
Money, as the medium of exchange, is like the hot potatoes in this parable. All other assets are like the hot yams.
Perhaps we should abolish "the demand for money", and speak about "desired velocity" instead. Or, better still, talk about the desired degree of synchronisation between payments and receipts.
Worthwhile Canadian Initiative 
note that this post is not about monetary policy at all but fiscal transfers. you never state that any kid owes a potato to the parent. handing out potatoes (or yams) is fiscal policy.
Nathan: there’s a difference between handing out free bonds, so the stock of bonds increases, and handing out free money, so the stock of money increases. Both are fiscal. But only the second is monetary too.
I was wondering what do you think of the Swiss Central Bank’s experience.
I was checking out the balance sheet of the central bank and foreign reserves have reached 70% GDP. The peg is certainly holding and EUR/CHF has actually gone the other way recently. I just wonder if velocity can really collapse quite so much. They should have been credible. A large part of the increase was in 4Q 2012 almost a year after the peg was started.
Given how much they had to do, the world seems a lot more complicated than a simple parable…
acarraro: the world is always more complicated than our models, let alone a simple parable which is designed to elucidate only one aspect of the world, ignoring all the rest. In a more complicated version of my parable, the desired velocity of the potatoes would depend on the difference between the temperature of the potatoes and the temperature of the kids’ hands (the interest rate differential between the medium of exchange and other assets), as well as on the marginal utility of getting a backscratch now and marginal disutility of giving a backscratch now.
Right, helicopter drops work.
Question is, is all money helicopter money?
“But only the second is monetary too”
Bank deposits are for all practical purposes bonds. Equivalently all bonds are for most practical purposes deposits.
But unwanted potatoes would reflux to the parent. And don’t forget that private banks are issuing claims to potatoes, and those claims work just as well as genuine potatoes. Now, if 5% of the genuine potatoes try to reflux to the parent and the parent refuses to take them back, then that 5% reflux will instead take the form of claims to potatoes refluxing to the private banks that issued the claims.
On the other hand, if the parent has issued too few potatoes, private banks will fill the gap by issuing more claims—unless, of course, those private banks are hobbled by banking laws that restrict their ability to issue claims to potatoes.
Ritwik: would it make any difference in my parable if the parent increased the supply of hot potatoes by buying a backscratch, or buying a yam?
Sergei: yes, bank deposits are an asset, and also a liability, just like bonds. But bank deposits, like some assets and liabilities, are used as media of exchange. Other assets and liabilities are not used as media of exchange.
Mike: but to define what you mean by the stock of “unwanted” potatoes, or “too few” potatoes, you would first have to define the “demand” for potatoes.
“Let’s start with a recession. There are only 6 potatoes in circulation, so 6 kids are producing backscratches, and 6 kids are consuming backscratches, at any point in time. You might say that the demand for potatoes is also 6, because that is the number of potatoes needed to pay for the backscratches that are being produced and consumed. But if the parent hands out a seventh potato, it will be willingly accepted, and be passed on once a minute, so now 7 kids are producing, and 7 kids consuming, a backscratch, at any point in time. If the parent hands out 12 potatoes, the recession ends, because each kid is now fully employed giving backscratches.”
Still mulling your parable over. That some component of potato demand comes from the warming properties of potatoes is a bit tricky. Kids have a demand to hold potatoes not only for the backscratches that potatoes can buy but also the ability of potatoes to dispel cold. So if there are only 6 potatoes in circulation and 6 kids producing backscratches, the demand for potatoes is 12 since the kids would all like to be holding at least one warm potato. What about kids who would rather hold two warm potatoes than get backscratches?
JP: Good point. My parable has bugs. My potatoes are indivisible. Suppose I cut them in half. Or assumed there are 12 potatoes in circulation, but the price of a backscratch is 2 potatoes, so each kid gives a 30 second backscratch every minute?
Seems more like a feature to me than a bug. It captures the returns to holding money. A warm potato alleviates cold, a wad of bills alleviates unease about the future. Maybe it provides some bling services too.
“Money (the medium of exchange) is an asset.”
It’s also a liability?
In the USA and Canada, does money = medium of account = medium of exchange = currency plus demand deposits?
“If the parent hands out 12 potatoes, the recession ends, because each kid is now fully employed giving backscratches.”
That sounds like create more medium of account (MOA) and medium of exchange (MOE). If so, does it matter how it is created, how it is distributed in time, and how it is distributed between the major economic entities?
TMF: Money is always an asset. It may or may not be a liability. Shells are not a liability. Bank deposits are a liability.
Nick,
Rookie question.
In this “model” of yours what economic phenomena would you define as being “fiscal”? I though that the word “fiscal” refers to one of these or more…
1) Anytime the government does anything.
2) Anything to do with with government bonds.
3) Anything to do with government taxes and transfers.
But then in response to Nathan, you said that handing out free money is both fiscal and monetary. Now, I’m confused. What is fiscal? What criteria would have to be fulfilled for an economic interaction in order for it to be defined as fiscal?
“Shells are not a liability.”
I’ll think about this one some more, but at first glance, I’m going to say shells are a liability to some entity.
“Bank deposits are a liability.”
of the banks and if redeemable for currency 1 to 1, they are also MOA and MOE?
Currency and central bank reserves are liabilities of the central bank. Currency is MOA and MOE, while central bank reserves are not?
JoeMac: If you change G and/or T, it’s fiscal. If you change M it’s monetary. So if you change (say) T and M at the same time, it’s both. That’s how I think of it, anyway.
Oh, I get it. By “giving away free money” you meant transfers.
JoeMac: yep. And a transfer is a negative tax.
“Oh, I get it. By “giving away free money” you meant transfers.”
And, “JoeMac: yep. And a transfer is a negative tax.”
If the gov’t is already in deficit, doesn’t that mean just more currency denominated gov’t debt?
Would it work with rational expectations and flexible prices? I presume so since I’m trying to build such a model. If the price of the backscratch is low enough the kid will prefer to store it for next period() so we could have a recesion due to insufficient money supply.
Anyway that is what I’m hopping for…
Backscratches? Really stretching it now, aren’t we? That was even more convoluted than my comments on Scott’s blog! But great post.
Roger: I don’t think that would work. If there’s a recession caused by too few potatoes, a sufficient fall in the price level should cause the real value of the stock of potatoes to increase until it’s big enough to prevent a recession.
I apologize if I sounded overly critical of the parable. It wasn’t my intention.
I am genuinely curious if the experience of CHF has somewhat changed your views of the power of the central bank. I have always bought the argument that the BOJ never really tried and that it wasn’t conclusive proof that monetary policy loses traction. But the experience of the SNB is starting to corrode my conviction. Does it trouble you or am I just giving up to early?
Nick
Unbeknownst to the parent, there is this invisible multi-handed monster that promises to take the children’s hot potatoes and give them cold yams in return, and promises to reverse the trade whenever the children need to do so.
So yes, it does matter whether the potatoes were exchanged for yams or for backscratches.
acarraro: no worries. I haven’t been following Switzerland very closely. My guess is that it may depend on what inflation rate Switzerland is targeting (or believed to be targeting). You can’t target both the exchange rate and the inflation rate.
Ritiwk: the expected future supply of potatoes will matter, if it affects the future price of potatoes, which affects the expected rate of inflation, which affects desired velocity. But I assumed desired V = 1 per minute.
Nick,
I did some math it seems to work(although is a very rough model for the moment), of course there is a price that would clear the market so all your stock is sold, but if you can keep part of your stock to sell it for the next year you will only lower your price up to the point that it matches the expected value of the stock.
Basically let P(t)low be the price needed to clear the market if P(t)low < E(P(t+1))*DISCOUNT, there would be inventory hoarding since the price would not fall enough. Even if there is stock depreciation and such there is a plausible shock low enough to get the economy in a recession due to lack of aggregate demand.
(I don’t know what happened to the end of my comment.) [fixed. You need a space before and after the < sign. NR]
If P(t)low is smaller than E P(t+1)*Discount , a flexible price setter would not lower the price enough to sell all the stock, so it will carry extra inventory to the next period. Creating potentially in t and in t+1 an aggregate demand driven recession.
As a non-economist I have no comment on the substance of
your post. I usually have to re-read them over a number of
days in order to begin to grasp the message.
But I’ll keep coming back .. if only to see what incredible
edible you come up with next to analogize economic concepts.
Roger: this is what I think is happening in your model: there is some natural real rate of interest r. If the real rate of return on holding money (i.e. the expected rate of deflation, if holding money pays no interest) exceeds r, then you hit an absolute liquidity trap. Suppose for example that nothing else changes but the central bank commits to have the stock of money decline at a rate faster than r.
Bill: must think up more food parables!
Roger Gomis said: “Would it work with rational expectations and flexible prices?”
Are you going to assume the demand for backscratches is unlimited?
Nick
And I’m saying desired velocity of potatoes = 1 per minute. Actual velocity of potatoes = 1 per minute. But the observed(by the parent) velocity of potatoes < 1/minute. Potatoes are irrelevant. There are hot yams and cold yams and all kinds of yams in between.
As J P Konnig would say, there’s no such thing as potatoes and yams. Only potato-ness and yam-ness.
Too Much Fed;
No, I’m assuming regular demands in the monopolistic competition framework, so demand is a decreasing function of price in the usual P^1-sigma, model.
Nick,
I’ve been thinking about your comment unfortunately I don’t grasp how such a policy interacts with the endogenous downward rigidity that I’m considering.
Ritwik: one of these days I am going to write a post attacking the defining thesis of JP’s excellent blog! (Or did I already do that? The liquidity race is a winner-takes-all race?)
As Yeager said, a difference in degree becomes a difference in kind, where all other goods, even the second most liquid good, trade for the most liquid good.
Sometimes I use currency notes. Sometimes I use my debit card. Other times, a direct net-banking transaction. Sometimes McDonald’s coupons. At all times, I use a medium that someone generally accepted as trustworthy backs with their assets. People richer than me use money market deposits or treasury ETFs.
Perhaps Yeager lived in a different world than us. Or perhaps, like most theorists – even nuanced ones – he simply didn’t think much of lived experience.
A difference in degree is indeed a difference in kind. But markets and strategy spaces are hierarchical and there are multiple levels of hierarchy. Winner takes all, in one hierarchy. But macroeconomically, there are many winners.
Kids who have access to cold yams don’t care about potatoes. Those who don’t have access may.
And yes, you have written about it before. You have written about all this before. But keep writing more!
someday there may even be convergence. 🙂
Nick, I love your concluding para. I really think that demand for money notion — along with misunderstanding of “saving” — might take us farther from, not closer to, understanding. Supply/demand curves might not make the same kind sense for money.
“Demand for money” = reluctance to spend?
Saving = not spending.
Saturday night, on my way out the door, unfortunately no time to give this the attention it deserves…
If there’s demand for money, why doesn’t everyone lay down their credit card instead of their debit card? Seems like exactly the opposite happens.
Steve Roth,
Swiss francs are money and US dollars are money. There is a market that trades them. Markets work on supply and demand.
But there can be no demand for money? Clearly you’re using the word money in some special sense (and economists often do, though they don’t always agree on the definition).
Put me clearly in the moneyness camp.
Roger Gomis, ok. Here is the scenario I want. 18 backstratches could be produced, but only 12 are demanded.
Peter N said: “Swiss francs are money and US dollars are money.”
By money, do you mean currency only?
Too Much Fed,
“By money, do you mean currency only?”
No, I believe that money is whatever possesses moneyness, which is contextual. Us dollars are better money in the US than Swiss francs. The converse is true in Switzerland. It is impossible for anything to be simultaneously the best store of value, unit of account and medium of exchange for all markets, so clearly what serves best as money depends on the circumstances of the transaction. For instance once for a real estate closing I had to bring a certified check. Only that most inconvenient, expensive and dangerous form of money was acceptable. I would never use such a form given any alternative.
I don’t believe in a Platonic ideal of money or in any perfect instantiation of one.
Peter N said: “For instance once for a real estate closing I had to bring a certified check.”
So should “money” be currency plus demand deposits (including certain checks)?
The point is a certified check is one of the least convenient forms of money ever devised, yet it is sometimes the necessary form. Travelers checks are money. Casino chips are money. Bitcoins are money. Linden dollars are money… The list is endless.
From JP Koning’s moneyness blog:
Hayek on money
“although we usually assume there is a sharp line of distinction between what is money and what is not—and the law generally tries to makes such a distinction—so far as the causal effects of monetary events are concerned, there is no such clear difference. What we find is rather a continuum in which objects of various degrees of liquidity, or with values which can fluctuate independently of each other, shade into each other in the degree to which they function as money.
I have always found it useful to explain to student that it has been rather a misfortune that we describe money by a noun, and that it would be more helpful for the explanation of monetary phenomena if ‘money’ were an adjective describing a property which different things could possess to varying degrees.”
-Denationalization of Money: The Argument Refined
Keynes on money:
“As a footnote to the above, it may be worth emphasising what has been already stated above, namely, that “liquidity” and “carrying-costs” are both a matter of degree; and that it is only in having the former high relatively to the latter that the peculiarity of “money” consists….There is, clearly, no absolute standard of “liquidity” but merely a scale of liquidity — a varying premium of which account has to be taken.”
-The General Theory of Employment, Interest, and Money – Chapter 17
http://jpkoning.blogspot.ca/
Peter N: I see it differently. Compared to the total variety of different goods, which really is almost endless, the set of goods that are used as media of exchange is very very short. And within a given country, nearly all those money goods are convertible on demand at par into one of those money goods. The distribution of liquidity is a nearly continuous distribution. The distribution of moneyness has a very sharp drop-off. Honda Civics are much more liquid than Mazda MX6’s, but do they have more moneyness?
Liquidity causes moneyness, and moneyness in turn causes liquidity, so we get a positive feedback loop with multiple equilibria and threshold effects. But moneyness (being used as a medium of exchange) is not the same as lquidity.
Nick
The fluid shift between goods and assets. Not done. 🙂
If you wish to collapse assets/goods into one whole ‘commodities’ framework, you’re arguing that moneyness = liquidity + low convenience yield. I (we all?) agree. Doesn’t subtract a whit from the JPKoning camp’s argument.
Nick:
1) “convertible on demand” isn’t very well defined in practice. You need something like convertible to all holders with minimal friction. There are, after all, differences in when, where, how and to whom you have to make a demand for conversion, and you have to say what an acceptable fee for conversion is. There may also be minimum conversion amounts.
2) Countries aren’t the only possible currency areas. Many on line games define their own currency areas. Possession of the currency is necessary for play, and it can be earned (in theory, at least) only inside the game. At this point gaming is a significant economic sector, equivalent to a central american country and growing more rapidly, so you can’t just ignore it.
Many forms of financial system transactions settle in dollar instruments rather than dollars. I think the trend may be toward the creation of specialized currency areas.
BTW here’s a truly frightening little money supply graph. I know aggregates are out of fashion, but this is scary:
Peter N,
Very much so. One gets a similar picture of tight money if one looks at a broad simple-sum aggregate or a sectoral analysis-
http://moneymovesmarkets.com/journal/2012/3/9/us-broad-money-growth-moderates-business-holdings-still-soar.html
Notice how the velocity of household money remained fairly stable, whereas non-financial business deposit growth indicated trouble in 2008.
I wish the Fed provided better modern monetary statistics, e.g. a sectoral analysis of Divisia M4 like the UK-
http://www.bankofengland.co.uk/statistics/Pages/bankstats/current/default.aspx
The breakdown of the interbank lending market greatly distorted the financial money holdings, but household and corporate money have continued to be very useful indicators, especially when calculated on a Divisia basis. Household Divisia M4 indicated trouble as early as Q2 2008 and the non-financial business sector Divisia M4 signalled trouble in Q1 2008-
http://www.bankofengland.co.uk/statistics/Pages/ms/2009/mar/default.aspx
That should have indicated that a financial sector crisis that emerged in August-September 2007 was filtering into a squeeze on the private sector’s money holdings and ergo into future trends in NGDP.
Nick – in the spirit of the post, what textbook do you think best expresses your view of macro? Or, what textbook do you use in your intro/intermediate classes?
Ritwik. “The fluid shift between goods and assets. Not done. :)”
All goods are assets. It’s just that some have high depreciation rates! But few as high as the Zimbabwe dollar, in its final moments. Which just goes to show how powerful the positive feedback loop is.
Peter N: 1 and 2. true, good points. But there’s not the smooth continuum in “moneyness” one would expect to observe, if it weren’t for the positive feedback process.
Ravi: good question. I don’t know. I don’t think there is one. I use Intro and intermediate versions of Mankiw (Canadian editions). Mostly because I like its clarity. My own ideas are a confused work-in-process. I wouldn’t expect to see a textbook reflect them.