What makes our chequable demand deposits at banks media of exchange? The answer is: the clearing house, where circles of offsetting IOUs are cancelled out.
It is clearing houses that create money. Unless there is only one bank, where everybody banks, because it doesn't need a clearing house.
Nothing revolutionary here (except maybe a little bit right at the end). This is just me trying to get my head straight on something, following a discussion with JKH in the comments.
1. Amanda cuts Betty's hair for $20. Betty manicures Cathy's nails for $20. Cathy massages Amanda's back for $20. They pay for each other's services with currency. That currency is their medium of exchange. It flows around the Wicksellian triangle in the opposite direction to the flow of services. $60 in total transactions with currency.
2. Suppose Betty is temporarily short of currency, and gives Amanda an IOU for $20 in exchange for the haircut. And then pays off (buys back) her IOU a couple of days later for $20 in currency (maybe plus interest). I say that Betty's IOU is not a medium of exchange. Betty has merely postponed payment. Betty still needed to pay Amanda $20 in currency. Being able to buy on credit may reduce Betty's demand for medium of exchange, but it is not itself a medium of exchange. $60 in total transactions with currency.
3. Suppose Betty is temporarily short of currency, and gives Amanda an IOU for $20 in exchange for the haircut. Suppose Amanda gives Betty's IOU to Cathy in exchange for a manicure. And suppose Cathy gives Betty's IOU to Betty in exchange for a manicure. Betty then tears up her IOU to herself. They didn't need any currency at all. Betty's IOU was used as a medium of exchange. Betty is like a central bank, because everyone accepts her IOUs. $0 transactions in currency.
4. Suppose all three women are temporarily short of currency, and all three give their IOUs in exchange for services. And all three repay those IOUs with currency a couple of days later. There were still three transactions of $20 for currency. Again, I say that those IOUs are not media of exchange. $60 in total transactions with currency.
5. Suppose all three women are temporarily short of currency, and all three give their IOUs in exchange for services. After a couple of days, all three women meet together, in a place called a "clearing house". They add up each woman's debits and credits. Each has a credit of $20 and a debit of $20. They agree to cancel out the circle of offsetting debits and credits. They tear up the IOUs. They didn't need any currency at all. I say their IOUs are now media of exchange. $0 transactions in currency.
In that 5th case, what makes their IOUs media of exchange is the clearing house.
Now suppose that each of the three women starts a financial intermediary. She both borrows and lends. She sells her own IOU for $20 (she borrows $20), and uses that $20 to buy someone else's IOU (she lends $20).
Are their IOUs media of exchange? Are their financial intermediaries banks, that create money? That depends.
6. (same as 3). Suppose Bill uses Betty's IOU to buy carrots from Chris, who uses it to buy apples from Andy, who uses it to buy bananas from Bill. Then Betty's IOU is a medium of exchange. Nobody needed to use any currency at all. Betty runs a bank. All three men bank with Betty. $0 transactions in currency.
7. Suppose Bill uses Betty's IOU to buy carrots from Chris. Chris uses Cathy's IOU to buy apples from Adam. And Adam uses Amanda's IOU to buy bananas from Bill. But the boys don't like holding IOUs from girls with the wrong first letter in their names. Each boy banks with his own girl. Adam goes to Amanda and swaps Cathy's IOU for another one of Amanda's IOUs. Bill goes to Betty and swaps Amanda's IOU for another one of Betty's IOUs. Chris goes to Cathy and swaps Betty's IOU for another one of Cathy's IOUs. What happens next?
7a. (same as 2.) If the three women don't have a clearing house, Amanda gives Betty $20 to repay her IOU, Betty gives Cathy $20 to repay her IOU, and Cathy gives Amanda $20 to repay her IOU. You get as many currency transactions as if the three guys had used currency in the first place. The women's IOUs are not media of exchange. $60 in total transactions with currency.
7b. (same as 5.) The three women meet after a couple of days and cancel their IOUs in the clearing house. Nobody needed any currency at all. Their IOUs are media of exchange. The three women's financial intermediaries are banks. They create money. $0 transactions in currency.
But notice something that I fudged. The three women meet every "couple of days" and cancel out circles of offsetting IOUs in the clearing house. It matters a lot how frequently the clearing house meets.
Assume a stationary economy, but where the timing of discrete transactions is random. In one limit, as the clearing house meets less and less frequently, the percentage of gross transactions that need to be settled with currency approaches 0%, because they all net out. (It wouldn't be stationary if it didn't). But in the other limit, as the clearing house meets continuously, the percentage of gross transactions that need to be settled with currency approaches 100%, because none of them net out.
The extent to which chequable demand deposits are media of exchange depends on the percentage of transactions that net out in the clearing house, which is a negative function of how frequently the clearing house meets. In the limit, with continuous clearing, only one transaction is settled at a time, and none net out. All have to be settled with currency (i.e. reserves). So chequable demand deposits are not media of exchange, in the limit. But the velocity of circulation of reserves increases towards some very large number, as you approach that limit.
I think that's right.
Worthwhile Canadian Initiative 
Late as usual here…
@JKH: “I’m a bit lost as to how others think about this in general or if there is any standard view on it.”
Likewise. And that, I think, speaks volumes about the central terminology here, “Medium of Exchange,” and the failure of economics to work with a coherent or standard definition of “money.”
That lack of an accepted and coherent definition, hence understanding, explains to me why Nick had to write this post, and why JKH is at a loss (as am I) to understand if there is a “standard view,” and what it is. Rather like discussing physics without a coherent and standard, accepted definition/understanding of energy.
I much prefer “units of exchange,” which for me is synonymous with “financial assets.” (“Medium” here is conceptually intractable, at least for me.) Dollar bills (which are just physical tokens representing account-book tallies), reserve balances, bonds, CDOs, whatever.
All financial assets embody money, which for me is exchange value that cannot be consumed by humans. (Apples have both consumption/”use” value and exchange value. But nobody would call apples “money.”)
Money is (unconsumable) exchange value embodied in financial assets. It doesn’t exist absent that embodiment.
If we start talking about reserves and dollar bills as units of exchange (financial assets embodying exchange value aka money), with the value designated in the unit of account — The Dollar (not “dollars”) — does it get easier to think coherently about these questions?
A dollar bill or a dollar bank deposit (credit balance) or a dollar Fed deposit: each is a unit of exchange whose value happens to equal one as measured in the unit of account. (Well, until–in the terms used for money market accounts–the “buck gets broken”…)
I think the problem is conceptual — failing to distinguish, conceptually, between what’s always been called “money” (coins, currency, etc.) and what money actually is: exchange value embodied in financial assets.
I have no idea if this helps. But I hope it doesn’t seem crazy to suggest that the widespread (if far from standardized or conceptually coherent) terminology, usage, and understanding re: “money” is at the root of all our confusion here.
This is why I complained about Mankiw’s intro textbook not starting out with a discussion of money and value. (Sorry, I think price theory is just a decades-long evasion.) Without that crux-ial understanding, economics is like physics before Newton.
Steve: “All financial assets embody money, which for me is exchange value that cannot be consumed by humans. (Apples have both consumption/”use” value and exchange value. But nobody would call apples “money.”)”
I would call apples “money”, if people used apples as a medium of exchange and unit of account. People have used cigarettes as money. And cows, and pretty shells, and gold.
Saying that all financial assets are money, and that no good with use-value is money, is a non-starter.
Did Einstein and Newton think of energy the same way?
And see the macro half of Mankiw’s intro text.
Nick Im not sure you got my point (maybe expressed it very poorly….likely). Im assuming there is nothing else other than the 20$ in currency, which I thought was part of your story as well. So eveyones income is simply the other persons spending and everyone spends their income necessarily to obtain the other service.
“And even if the total stock of currency is fixed, nothing prevents all of them spending it more quickly, or more slowly.”
Sure there is something that prevents spending it slower, the price of the good. Its 20$, so they can’t spend ten and buy anything.
I do think you are on to something about clearing houses and IOUs. IOUs necessarily must have a hierarchy, some must be less likely to default than others in order for them to become more money like…. more valuable.
gizzard: Ah! OK. I missed that. I wasn’t assuming there was just one $20 note in the economy. If I did assume that, it would be hard to price a haircut at $40, unless you got half your hair cut at once, or paid in two installments.
Steve Roth, what do you think are the unit of account (UOA), medium of account (MOA), and medium of exchange (MOE) in the USA?
I think the theory is missing something important, but I’m not totally sure what that is. You’re implying that the velocity of money depends only on the frequency with which the clearing house meets. Yet in reality we do observe variations in the velocity of money that are positively correlated with the interest rate. A plausible extension of this model that would fit the stylized facts would be that they base their decision on how often the clearing house should meet on the interest rate–at higher interest rates they would want to meet more frequently to minimize the interest costs. This all reminds me of the old Baumol-Tobin model.
Too Much: based on my previous understanding of JP Koning’s evaluation of the blog literature on this, and supposing for a moment we are back on a gold standard with direct convertibility at say $30 / oz I would say:
UOA = The dollar. Literally the word “dollar” or the symbol “$”. Defined as being equal in value to 1/30 oz of gold.
MOA = gold
MOE = $ denominated reserve notes, bank deposits, coins, etc.
Then at one point in time JP tried to extend this to fiat money with a CB targeting inflation. I think at one time his definitions would thus have been like this (MOE doesn’t change):
U0A = “$” defined as being equal in value to a certain sized slice of the CPI “basket of goods”
MOA = the CPI basket of goods (?)
I think that was the case (if I recall correctly) at one time. However, I think he’s changed his mind since then. He almost had Nick convinced I think too.
Now Scott Sumner would say that
MOA = base money = cash & reserves = a kind of “paper gold”
I’m not sure what he says about the UOA, but probably:
UOA = the word “dollar” or the symbol “$”
and leave it at that. I’ve forgotten Nick’s take. Bill Woolsey was somewhere close to JP previously I think.
So perhaps “Scott’s” definition has the advantage of not being tied to a CB targeting the CPI (or tied to the CB’s success in that targeting). Scott’s definition is divorced from any concrete commodity or good though, and Scott does not agree with Mike Sproul’s backing theory.
Since Scott isn’t here to defend himself from my sloppy reckless slander, Let’s just call that “Tom’s” definition:
UOA = $
MOA = base money
MOE = broad money = base money + banks deposits, etc.
How does that work for you?
Tom Brown, use a gold standard, but gold is not MOE.
MOA = gold, UOA = certain amount of gold like 1/30 of an ounce of gold. Now define convertibility with currency and keep it fixed (with emphasis on the fixed part). Now currency is both MOA and MOE. Now fix demand deposits and currency as convertible 1 to 1.
MOA = gold, currency, and demand deposits
UOA = 1/30 of an ounce of gold, $1 of currency, and $1 of demand deposits
MOE = currency and demand deposits
Now use a “no commodity” standard.
MOA = currency, UOA = $1 of currency. Now fix demand deposits and currency as convertible 1 to 1.
MOA = currency and demand deposits
UOA = $1 of currency and $1 of demand deposits
MOE = currency and demand deposits
zyxzyxooxwo
The Canadian Payment Association, a separate and distinct organization from the Bank of Canada could probably be considered a modern day Canadian clearinghouse. Prior to the 1980s and 1990s much of the function of the CPA resided in the Canadian Bankers Association which going back to the pre Bank of Canada era played the historical role of a clearinghouse described previously. However, in the 1980s and into the 90s there was a desire on the part of the Bank of Canada and the Department of Finance to split payment system functions into a separate organization that would representing “non banks” like ATB Financial and Desjardins in addition to chartered banks.
The CPA runs two different parallel settlement system one ACSS created in the 1980s to replace a previous CBA ran system handles non critical retail payments on an overnight basis(Additionally ACSS handles check clearing however out of region checks can take more than one day to clear). The second LVTS was created in the 1990s to replace another previous CBA ran system handles critical payments instantaneously.
The Bank of Canada is both a member of ACSS and LVTS in addition to being a member of the Canadian Payments Association.
There are also additional Canadian specific clearing organizations such as Interac(which uses ACSS) and the CDCC.