Finance people are good people. Economics needs finance people. Some of my best friends are finance people. But (you heard that "but" coming), finance people (though there are of course honourable exceptions) just don't seem to get money.
I can hear the reply now: "Yeah, and money people don't get finance either!". And I think you are right, but only half right, about that. I think that money people do get simple basic finance; it's the more complicated stuff we don't get. But finance people, it seems to me, often don't get the simple basic stuff about money.
And that's not because money people are smarter than finance people (though we are better-looking). It's because money is weird. Money is not like other assets. So when you take simple basic finance theory, that works OK for other assets, and apply it to money, you can get in a mess.
I watched a finance person on Twitter ask the question: what determines the market value of a zero-coupon perpetuity, like currency? That's a very good question to ask, but you won't get a sensible answer if you do a standard Present Value calculation of a perpetual stream of zeros. Why isn't it zero??
Let's do this Present Value calculation very slowly. (And please excuse my cruddy math, which I always get wrong.) Start with a perpetuity that has a fixed annual coupon C, a market price P(t) at time t, where people are willing to own it at a discount rate r(t). We know that:
P(0) = C + P(1)/(1+r(0))
and since P(1) = C + P(2)/(1+r(1), we get
P(0) = C + C/(1+r(0) + P(2)/[(1+r(0))(1+r(1)]
Wash, rinse, and repeat, for a horizon of T periods, and we get:
P(0) = PV[C] + PV[P(T)] where "PV[.]" stands for Present Value of, and you know the formula better than I do.
Now we want to take the limit of that equation as T approaches infinity. And it is very tempting to say that the second term PV[P(T)] approaches zero in the limit as T goes to infinity, unless there's some sort of bubble, so we can re-write that equation as
P(0) = PV[C]
Or, in the simple case where r(t) is a constant over time:
P(0) = C/r + lim[P(T)/(1+r)T] as T goes to infinity
and the denominator in the second term goes to infinity if r > 0, so the second term must go to zero if the price is always finite.
So if currency is a zero-coupon perpetuity, it is very tempting to say it must have a fundamental value of zero. But since (obviously) currency does not have zero value, there's gotta be something funny going on.
Here's a different way to think about it, that you might find useful:
You know that liquidity matters. Other things equal, people prefer holding a more liquid asset than a less liquid asset. They will own a more liquid asset even when it has a lower rate of return than competing less liquid assets. The discount rate we should be using in the Present Value calculation should reflect the liquidity of that particular asset, and should be the rate at which people will just be willing to own that particular asset.
Now suppose there were some very liquid asset that people would just be willing to own at a zero rate of return?
If we stick r(t) = 0% for all t in the Present Value calculation above, we can't get rid of the second term PV[P(T)]=P(T)/(1+r)T. Because the denominator stays at one, and does not approach infinity in the limit as T goes to infinity.
That really messes up the Present Value calculation. We can no longer say that the fundamental value of a zero-coupon perpetuity is zero, if it's very liquid so people are just willing to own it at a 0% rate of return. But what the hell is it? What is 0 divided by 0?
Here's the standard way that money people have answered that question:
Suppose the demand curve for liquidity slopes down, but is also an increasing function of Nominal GDP. So the rate of return at which people would be just willing to own a particular very liquid asset, at the margin, for a given set of rates of return on other less liquid assets, is an increasing function of the Market Capitalisation of that particular asset as a ratio of NGDP. So the r(t) we use in our Present Value calculation for this particular asset is an increasing function of M(t).P(t)/NGDP(t), where M(t) is the number of "shares". And the r(t) will go negative if the market capitalisation is small enough.
So, in the simple case where everything is constant over time, it's easy to reconcile the formula P(0) = C/r with a zero-coupon perpetuity like currency. Just use the liquidity demand function (we call it a "money demand function") to figure out the P(0) at which the ratio of market capitalisation to NGDP gives us an r=0%. Done.
Come to think of it though, shouldn't all finance be done a bit like this? Is it really plausible that the rate of return at which people are just willing to hold a particular asset, at the margin, is always strictly exogenous with respect to the price and hence market capitalisation of that asset? Sure, that might be an OK simplification for some partial equilibrium work in very competitive markets, but it won't be generally true.
Oh, and money is special because it's the unit of account, so its price is normally written as 1/P(t), where P(t) is the price of everything else in terms of money, and so its market capitalisation is M(t)/P(t). And the ratio of market cap to NGDP becomes M(t)/P(t).RGDP(t) where RGDP is real GDP.
And the reason money is so very liquid (in fact the most liquid) asset is because everything else is bought and sold for money (it's the medium of exchange), but getting properly into that issue is beyond the scope of this post.
Worthwhile Canadian Initiative 
Brian: well, my FTPL question was aimed partly at you, but also at anyone else who happened to be reading and who thought FTPL a useful approach 😉
David B.
For theory of inflation in MMT and PK check section “income distribution and inflation” in this: http://neweconomicperspectives.org/2016/04/money-banking-part-11-inflation.html
@ Nick R.
Suppose commercial banks refuse to allow anyone to have an overdraft in their chequing account. Then there’s no inside red money.
OK, so I’ve had that wrong all the time. But then for there to be green money in an inside money only world, banks must be able to issue by fiat, too (I thought the idea was that they couldn’t). And my observation about interest income and debt service cancelling out remains, independent of the bank setup.
Oliver: suppose banks issue green money (positive balances in chequing accounts) as liabilities, and hold bonds (that are not used as money) as assets. This is the simplest textbook model of banks.
Nick:
For interest rate R and convenience yield Y, the price of a security paying 1 oz of silver in 1 year is
PV=1/(1+R-Y)
So if R=5% and Y=2%, then the security will be worth about .97 oz at the start of the year, and will grow to 1.00 oz at the end of the year.
Throw in printing and handling costs of C=3%, and the formula becomes
PV=1/(1+R-Y-C)
So if R=5%, Y=2%, and C=3%, then the security will start the year worth 1 oz and end the year at 1 oz.
Call the security a dollar, and call the convenience yield “liquidity” and the value of a dollar is always 1 oz. The rules of finance explain money.
Mike: Let’s change your example slightly.
Suppose the Bank of Canada keeps a lot of CPI baskets of goods in its basement. (Yep, the haircuts and fresh food are a bit tricky to store, but allow me some literary licence). Then targeting 2% CPI inflation would be very easy. The Bank stands ready to buy and sell currency for CPI baskets at a crawling peg exchange rate that depreciates at 2% per year against the CPI basket.
That determines the price level path. And we talk about the liquidity of currency, and the downward-sloping demand curve for liquidity, to explain why people demand to hold a positive stock of currency despite it yielding negative 2% real interest.
In the special case where the supply curve of apples is perfectly elastic, the supply curve determines the price of apples, and the demand curve determines the quantity at that price. But in the general case we need both supply and demand curves to determine both P and Q. Same with money.
Put it another way: the “rules of finance” do fine — provided you add a downward-sloping liquidity yield demand function.
@ Nick
Yes, and it is money that is produced in such a ways that I believe csissoko refers to as fiat and in her paper is reserved for the central bank. Commercial banks, OTH engage only in acceptance banking.
Her claim then seems to be that a: acceptance banking is sufficiently self stabilising that it can be viewed as a stand alone theory of money creation. and b: that fiat banking can be added as a bonus because it relieves the non-bank public of having to borrow.
My point, which is probably idiotically trivial, is that the privilege of fiat comes at a price. Namely at the price of the income attached to the bond, which would otherwise accrue to the non-bank public. Seignorage, in other words. The non-bank public can either borrow and pay interest or pay seignorage to the banking sector.
Nick,
From your post and later comment:
“Just use the liquidity demand function (we call it a “money demand function”) to figure out the P(0) at which the ratio of market capitalisation to NGDP gives us an r=0% ………………. Put it another way: the “rules of finance” do fine — provided you add a downward-sloping liquidity yield demand function.”
That’s 3 slightly different terminologies for presumably the same thing.
Can you indulge me – and describe more precisely what you intend by this function – the axes and what it applies to?
E.g. my starting point for trying to understand what you mean by the money demand function is my understanding of it as portrayed along with the supply function that go into constructing the standard (old fashioned) LM curve in ISLM. So the demand for money is downward sloping with respect to some general level of interest rates on the y axis and quantity of money on the x axis. And the old fashioned fixed supply cuts that vertically. And then logically trace an upward sloping LM curve as you expand NGDP. That all seems intuitively consistent with what you are describing.
But you have also generalized to non-money liquid assets, extended somehow to P and 1/P, and have also talked about a demand/desire for yield on money.
I think I see this all intuitively, but I’m struggling to see exactly what this particular demand function you’re referring to looks like. As with other things, do you construct this sort of thing differently from other monetary economists, or is it all standard? Is there an implicit iterative development of curves here? Does it apply to bonds as well as money?
Sorry, this is a bit of a teaching request, and probably ponderous for you to respond to.
(After that, I have a comment on why I think you’ve gotten the nature of the finance responses you have, given the particular logical organization of your post.)
JKH: Here is the conventional textbook money demand function:
Md = P.L(Y,r)
(It is conventional to use L( ) rather than F( ) as the letter for that function, following Keynes’ “Liquidity Preference”.)
L( ) is a positive function of Y (real GDP) and a negative function of r (the interest rate on “other” (non-money) assets.
I have simplified it slightly, by assuming Md is strictly proportional to Y (not a bad assumption, empirically), so we can re-write it as:
Md = P.Y.F(r) or (Md/NGDP) = F(r)
That implicitly assumes M pays 0% interest. If instead M pays rm% interest, we can re-write it as:
(Md/NGDP) = F(r-rm) (Note that r-rm is the opportunity cost of holding M instead of “other” assets.)
Now any demand function or curve can be inverted, so we talk about the “demand price” Pd for apples as a function of quantity of apples bought (the amount people would be just willing to pay for that quantity of apples). We can do the same for this one, and write it as:
rmd = r + H(M/NGDP) where H is some function that starts out as a negative number and gets bigger (less negative) as M/NGDP increases.
In words, the rate of interest paid for holding money, at which people would be just willing to hold that stock of money, is less than the rate of interest paid on other assets, and is an increasing function of money’s market cap (M/P) as a ratio to RGDP.
In the simplest case, where M=Ms is fixed, r is fixed, and RGDP is fixed, P adjusts until rmd=0%. (That’s what macroeconomists call the Long Run equilibrium, where P is perfectly flexible.)
The same should be true for any asset that performs some sort of unique service, where the demand for that service slopes down.
I’m still puzzled about the reaction this post has got from finance people. I really thought: “OK, they understand that people are willing to accept a lower yield on more liquid assets. All I need do is note that the demand curve for liquidity slopes down, so people will be willing to pay a lot for liquidity if the market cap/GDP of the very liquid asset is small, and less as it gets bigger. Done.” I reckon it’s got something to do with the unit of account function. “A dollar is a dollar is a dollar”?
Nick Rowe: “The face value (and market value) of one apple is one apple. But that says nothing about the price of apples in terms of other goods.”
What other goods do you wish to evaluate money in? Nothing else appears in your equations.
Min: simplest answer: all the goods in RGDP, which does appear in my equations.
I reckon it’s got something to do with the unit of account function. “A dollar is a dollar is a dollar”?
I reckon it has something to do with separating the money – goods nexus from the money – other financial assets nexus. As far as the latter is concerned, my guess is finance people would agree with you.
Oliver: so they keep thinking about Wall Street, not Wall Street and Main Street? 😉
Thanks Nick
“In words, the rate of interest paid for holding money, at which people would be just willing to hold that stock of money, is less than the rate of interest paid on other assets, and is an increasing function of money’s market cap (M/P) as a ratio to RGDP.”
You see, I get that word intuition pretty readily. But for some reason, I really struggle with the algebraic notation in this area. My brain, like yours, is old, and in my case, exposure to introductory economics was just too long ago. You would think that with the number of your posts I’ve read over the years, the intuition for the algebraic notation would have sunk in by now. I’ll try to work on this.
“I’m still puzzled about the reaction this post has got from finance people.”
I will comment later today or tomorrow morning on how I interpret the reason for this reaction. I think it is interesting.
The other way around, really. They accuse economists of thinking you’re solving ‘real’ problems, whereas what you’re doing in their eyes is just stirring around in a sea of nominal claims. Or are you just pulling my leg?
Nick,
Again, regarding:
“I’m still puzzled about the reaction this post has got from finance people.”
In summary, you started out by exploring a “nominal space” calculation for the price/value of money as represented in the form of a 0 coupon perpetual bond and concluded that this doesn’t work. You then switched over into a “real space” more macro analysis of what determines the price of money P (t) in real terms – although your market capitalization/GDP ratio criterion can be expressed in nominal terms as well.
I think you’ve gotten the reaction you have from the finance types because you abandoned that nominal space bond calculation under what they would allege to be false pretences.
In fact, money is not properly represented as a (plain vanilla) 0 coupon perpetual bond. It has optionality that makes it exactly the opposite of that from a maturity perspective. Its effective maturity is immediate – as I think all of Eric, Brian, and Nick E. explain or at least infer in their own way.
This is more subtle and meaningful than “a dollar is a dollar”, although I suspect you may disagree.
My own interpretation is probably more general than the others’ from an optionality perspective. Start out by acknowledging that the underlying form of money is that of a zero coupon perpetual bond. Attach to that bond a put option. And I would say that it is a put option in a most general way. Money can buy anything at any time. Viewed this way, it is an option to put a special type of perpetual bond at any time for any purpose.
The put option converts a zero coupon plain vanilla perpetual to something that contingently represents what is in effect a “stripped” bond in form. A stripped bond is a derivative of a regular bond where the bond has been stripped of its coupons and what remains is the final maturity cash flow only. That cash flow becomes a “bullet” payment at maturity without any intervening coupons.
In the case of a plain vanilla zero coupon bond, the bond has already been “stripped” of its coupons – in effect. Moreover, nothing of substance remains in terms of cash flow because the final maturity payment has already been extinguished the perpetuity condition. Such a bond is worth zilch in nominal terms.
But attach a put option to that bond, and it effectively converts to an immediate maturity cash flow on exercise, sans any intervening coupons. And because that cash flow is continuously available, until the option is exercised, it is trivial to conclude that it is worth the face value of the money that constitutes such a “bond”. The effective term of the bond is continuously zero. Moreover, it doesn’t matter what the discount rate is – because the discount rate operates over a zero time horizon.
This is more than “a dollar is a dollar”. It is an option adjusted explanation of how money resembles a particular type of bond. I’ve explained it intuitively, while Brian has gone into an explanation using legitimate option math heuristics. (I don’t know if Brian would agree with my intuition).
So I think you are getting the finance push back you are on this – not necessarily because of the way you are modelling the price/value of money starting out in real space – but because you departed nominal space with an incorrect interpretation of the bond math you started out with – as it should apply to money. You may be getting additional push back on the real value approach with the demand curve, but you’re probably getting more of it because of your premature/incorrect abandonment of the nominal bond approach.
I think of the two approaches as entirely complementary. I think I understand what Brian is doing and I think I understand the intuition of what you are doing. So I don’t think your approach displaces the validity of the option adjusted bond approach. It may well be more interesting, but I think it is incomplete in that it presumes to displace what I think is a legitimate micro optionality approach.
(I have a feeling you will disagree with all of this, and maintain your “dollar is a dollar” reaction.)
As a distant corollary to the above, I absolutely loathe the proposal by some hard core helicopter droppers that the central bank should extend 0 coupon perpetual loans as a way to right its balance sheet optics upon making drops. Such loans are plain vanilla, and are worth zero. The perpetual loan proposal is a ruse in an attempt to circumvent the indignation expressed by some (I wonder who) that central banks should not be running negative equity as an accommodation to facilitate helicopter drops. Plain vanilla perpetual loans don’t change that negative equity result.
@Oliver
Yes, my view is that money can be private or public. What you need is some reason to “trust” the issuer, so that the value of money is expected to be maintained.
When the finance people say money should be represented as a put option, they are making assumptions about the behavior of the issuer that will support the value of the put option. There’s no reason properly calibrated incentive constraints can’t be used to support the private sector as issuer.
Yes, when people substitute fiat money for inside money the banks lose income — and this affects their incentive constraints. My paper — and many others — find that the Friedman Rule is sub-optimal because it is incompatible with the incentive structure of the banking system.
JKH said: “Start out by acknowledging that the underlying form of money is that of a zero coupon perpetual bond.”
Why can’t currency be viewed as a commodity that yields 0%?
Let’s assume there is no paper currency and gold is used as MOA and MOE. Wouldn’t gold be considered a commodity that yields 0%, and wouldn’t gold be considered “money” then?
Oliver: I wasn’t pulling your leg.
JKH: I think it’s easier if we start out thinking about money not being the unit of account, so it is a very liquid asset (used as medium of exchange) that has a price Pm, just like stocks and bonds do, in terms of some other numeraire (like apples or gold). So then the market cap of money is just Pm.M, just like bonds are shares. And we ask what determines Pm (or the market cap Pm.M). Then, after we have explained what determines Pm, or Pm.M, or Pm/NGDP, we do a last minute flip, and say “Hang on, we measure prices in money, not apples or gold, so Pm is just 1/P”.
But as a way of explaining my thinking to finance people, it seems to have failed badly, just making things harder.
Moi: “What other goods do you wish to evaluate money in? Nothing else appears in your equations.”
Nick Rowe: “simplest answer: all the goods in RGDP, which does appear in my equations.”
But not as a vector, right?
Nick,
Here’s what some of the finance oriented people have said:
Nick E:
“If I take a $100 bill to the bank, I can have $100 credited to an account of my direction, creating an asset or extinguishing a liability. The earliest date I can do so is today. So its discounted value is just its face value.”
So he’s responding to your exploration of a bond calculation for money by pointing out the discounting period is 0 (i.e. 0 days, since the liquidity/put can be exercised intraday).
Ramanan:
“Nick R, as Brian says, you ignored the optionality in valuation of the bond …”
Same issue
Eric T:
“Monetary instruments are not perpetual, they have an instantaneous maturity (zero term to maturity) i.e. due on demand. While some of them are not convertible, they are all redeemable at face value to the issuer on demand…”
Same issue
And:
“Nick R about Nick E: issues of bond valuations are about determining the nominal value not real value….
Same issue
“Main point though is that one must make a difference between what determines nominal value (structure of financial instrument and creditworthiness of issuer) and real value (theory of inflation)”
That’s the issue of the difference between nominal bond valuation (including the value of money when interpreted as a puttable bond) and your real valuation using the money demand curve.
And so on.
The point being that people at the outset are not rejecting your approach to real valuation. They are objecting to your methodology whereby you rejected a nominal bond valuation approach outright – because you’ve ignored the liquidity option in the underlying bond analogy for money as a perpetual zero coupon bond. And those are two different things. I don’t see anybody else paying much attention in comments to your real valuation approach, so it’s actually hard to tell what they may think of it.
Again Eric:
“To Adam P: the fact that gov accepts its monetary instruments at any time at face value value in payment of gov dues is what makes its monetary instrument perfectly liquid (i.e. constant nominal value). Again, mon instruments are securities, we all agree on that, but their term to maturity is not infinite, it is zero so promise of issuer to take back its instrument at face value is central… Point is creditworthiness is central like for any other securities to determine the nominal value at which an instrument circulate. Now issues of what determine the purchasing power of that nominal value is a different issue.”
Again, he’s referring to money liquidity as optionality and money being representable as a type of bond with optionality. And the real value issue is separate. But no criticism or actual rejection there of your real value approach.
Etc.
The entire reaction can be boiled down to a collective focus on the fact that you ignored the put option in your bond analogy.
Apart from that, I see little push back on your real value approach, which as Eric says is quite a separate issue.
i.e. ships passing in the night
and you may find the liquidity optionality approach to be uninteresting (perhaps in the sense of “a dollar is a dollar”), and your P(t) demand curve approach more interesting – which is fair – but the optionality approach is in fact the correct reconciliation of the bond analogy that you introduced at the start of your post
Min: simplest answer: as a scalar. The GDP Deflator tells you (one way) to convert that vector into a scalar.
More complex answer: strictly speaking, I could and should leave it as a vector. Md is a function of that whole vector of prices of new and used goods. But that’s taking way off into unconventional territory.
JKH: “i.e. ships passing in the night”
That’s the metaphor I was looking for! I was moving my hands together, offset a bit.
Here’s the way I see it: the (canadian) dollar is defined as Bank of Canada currency. The Bank of Montreal dollar is not defined as being worth one dollar, but we can explain why it is worth one dollar (as long as BMO is solvent and liquid and lets you convert your BMO dollars into BoC dollars at par). So what Eric said (for example) is great for explaining the value of the BMO dollar in terms of BoC dollars. But it gets us nowhere if we want to explain why either of those two dollars has any (real) value. It’s circular: explaining BMO dollar in terms of BoC dollar, then BoC dollar in terms of BMO dollar. “But what makes any of those bits of paper or electrons worth anything?” The finance guys can’t get out of Wall street.
You might say that the finance types in their comments on this post have for the most part have provided an answer to the following question:
“Why does money viewed as a 0 coupon perpetual bond not have a value of zero?”
(Similarly, I think of Chartalism/MMT answering the question “Why does fiat money not have a value of zero” – i.e, why is fiat money “accepted”)
Whereas I think you are answering the question:
“What determines the real value of money?” (including how the interest rate earned on money (zero or non-zero affects that determination)
I think these are all legitimate, complementary questions
Nick,
“The finance guys can’t get out of Wall street.”
To be fair, they are responding in this post mostly to a specific point on the bond analogy that you introduced.
And the rest of it depends on what question one is interested in answering.
The real value of money is a specific question. There are others.
I think one of the benefits of the blogosphere SHOULD HAVE BEEN more integration of finance and economic perspectives by now. There has been a general massive failure in this regard, in my view. That said, you’ve probably done more than your share in the attempt. However, I do think that the economics profession in general deserves its share of the blame for failing at this.
Yep JHK, that’s exactly the point. Finance guys like to deal with nominal values (one must keep that balance sheet in shape), most of my fellow economists just want to talk about real values (focusing merely on that may end up killing that balance sheet). One needs both to get a complete picture of what goes on in the economy.
Nick: the argument about nominal value is not circular. It all boils down to the creditworthiness of the issuers.
-I accept BMO monetary instruments because BMO promised that I can convert at par into BoC mon instrument and that I can pay BMO with its monetary instruments at par. Redemption at par (via conversion or payment) was not a given in the past and BMO mon instrument would trade at a discount relative to face value.
-I accept BoC mon inst at par because BoC promised that I can pay gov with BoC mon inst at anytime at par (either directly or through the banking system).
If BoC or BMO decide to default of their promise by removing convertibility (or changing it) or by refusing their monetary instruments at par (or at all) in payments, then their instrument will trade below face value.
None of this relies on the circular argument that “I accept a $100 at $100 because I expect someone else to accept it at $100.” The creditworthiness of issuer is the anchor that allows to get rid of the circularity.
Also, with all this stuff, one can understand why bitcoins that were alluded above have a fair price of $0 and are not monetary instruments.
Eric: Great, so they are all “creditworthy”, meaning they can all fulfill their promises to convert their bits of paper into each others’ bits of paper. They all trade “at par” with each other. So what? How come all those bits of paper aren’t equally worthless? And we give worthless bits of paper to government at tax time, and it gives us back worthless bits of paper as welfare cheques. Like a giant game of Monopoly.
How come I can buy a kilo of apples with one of those bits of paper?
Nick, remember there is also that “payment” promise. One is dealing with the value of the promise for itself not relative to others. All this is similar to the valuation of a stock or a bond. One is merely concern with what goes on with the creditworthiness of that issuer in terms of itself, not relative to the creditworthiness of others.
Regarding the worthless bit, given what has been said above, one must recognize that there are two cases of worthlessness:
1- Hyperinflation: The note themselves still trade at par but one needs a truckload of them to buy anything.
2- Default: The notes suddenly trade at a heavy discount (relative to face value of those same notes) instead of parity, even though the price level of goods and services has not changed since the beginning of time.
Finance people in the comments are focused on case 2 and apply that to the nature and analysis of monetary systems. Starting with issues of present value, perpetuity, and coupon, usually puts a reader in a frame of thought related to case 2, not case 1. Your post mixes both to talk about case 1 so that is confusing.
I believe the full chartalist argument depends in part on the capacity of the government to influence prices by spending on some non-trivial subset of goods and services – i.e. not just transfer payments. Taxation enforces the acceptance of those payments in the relevant currency (at those prices).
@ csissoko
Thanks for clarifying. I think I agree with that.
@ Nick
OK, thanks. Not that that would have been a problem.
Nick Rowe:
“Min: simplest answer: as a scalar. The GDP Deflator tells you (one way) to convert that vector into a scalar.
“More complex answer: strictly speaking, I could and should leave it as a vector. Md is a function of that whole vector of prices of new and used goods. But that’s taking way off into unconventional territory.”
It’s not only unconventional, it’s problematic. At least as far as the GDP is concerned, the vector is different in every time period.
Nick Rowe:
“How come all those bits of paper aren’t equally worthless? And we give worthless bits of paper to government at tax time, and it gives us back worthless bits of paper as welfare cheques. Like a giant game of Monopoly.
“How come I can buy a kilo of apples with one of those bits of paper?”
Somebody gives you something of value in exchange for them. When nobody does, they quickly lose value, like the Continental Dollar did.
“I guess what I really want is a GFTPL (Generalised FTPL.) This would cover models where there is no government, rather just a pair of households.”
I think the question can and should be first thought in the most simple setup. Having two parties and some monetary contracts (plus their enforcement system) will already create some demand for money. And also it is simply to see that money needs to be backed by real assets to have real convertible value.
I think Brian is correct that money always has the optionality and thus its discounting period is zero days and NPV is the face value. But this tells us nothing about the real value in terms of other stuff.
Money is just a liability which derives its value from a pool of real assets (usually through many layers of financial assets). The pool of asset might be an asset side of a legal entity (like a bank) or just a pool of collateral. Nowadays the biggest asset is usually the future value of currency issuer’s tax payments. But going back to two household economy: it can be also the assets pledged against the money used (eg borrower might have pledged some physical assets or future production to secure the loan).
Brian Romanch: “I guess what I really want is a GFTPL (Generalised FTPL.) This would cover models where there is no government, rather just a pair of households.”
Jussi: “I think the question can and should be first thought in the most simple setup. Having two parties and some monetary contracts (plus their enforcement system) will already create some demand for money. And also it is simply to see that money needs to be backed by real assets to have real convertible value.”
Enforcement system = gov’t.
As for real assets, it depends on what you mean by real. If social obligations are real liabilities, no problem.
Min: I would say social obligations are the most basic enforcement system, which allows the economy to create liabilities and (financial) assets. Rule of law is just a set of formalized social conventions.
By real assets I meant something that is (or will be) a factor of production (ie capital goods) or inventory of real goods. In the end of the day a financial asset is just a legal ownership claim on real assets or other financial assets that are linked in the end to real assets (aside of speculative assets like bitcoin). That applies to money as well. I think that is easy to see if we think very simple economy. One might argue that doesn’t hold if the economy is complex enough but I do not see what is the critical step after money doesn’t need to be backed by real assets anymore?
Nick,
“How come all those bits of paper aren’t equally worthless? And we give worthless bits of paper to government at tax time, and it gives us back worthless bits of paper as welfare cheques. Like a giant game of Monopoly.”
“How come I can buy a kilo of apples with one of those bits of paper?”
Not sure about the Canadian Government, but:
https://en.wikipedia.org/wiki/Article_One_of_the_United_States_Constitution
Section 8: Powers of Congress
“To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures.”
You ask why you can buy a kilo of apples with bits of paper and I would answer for the same reason that you will always get the same amount of apple when you request a kilo (or 2.20 pounds U. S.) of it.
Seriously, that is all you think that a government does (welfare cheques)?
Bank notes are fundamentally different from zero coupon perps. . That seems clear.
A better description of bank notes is that they are securitised government bonds.
Bank notes could be issued by an SPV Which owns only treasuries.