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ELSEVIER Journal of EconomicBehaviorand Organization Vol. 26 (1995) 445-455 ~Z


The New Monetary Economics and the Theory of Money 1
Filippo Cesarano
Banca d'Italia - Servizio Studi, Via Nazionale, 91, 00184 Roma, Italy

Received June 1992, final versionreceived September 1992

A critical analysis of the main tenets of the New Monetary Economics (NME) is carded out from the viewpoint of received monetary theory. It is shown that the essential properties of a monetary economy are independent of the tangible character of the means of payment and, in particular, that these properties establish a relationship between the medium of exchange and the unit of account (section 2). Dwelling upon these results, the NME proposition, according to which money is a product of regulation, is found to be untenable (section 3).
JEL classification: E42

1. Introduction
The recent outgrowth of literature on competitive payments systems may seem concerned with rather esoteric matters of but little interest to the profession. When closely examined, however, the discussion appears to touch upon questions which are momentous for both the theory of money and the development of monetary arrangements. Indeed, the scope of the contributions is thought to have originated

1Thanks are due to Robert W. Clower, Milton Friedman, and Lawrence H. White for helpful comments on a first draft. The usual caveat applies. The views expressed herein are those of the author and not necessarilythose of the Banca d'Italia. 016%2681/95/$09.50 © 1995 Elsevier Science B.V. All rights reserved
SSDI 0167-2681(94)00033-B

. 1970. Critical reviews are due to White (1984. would have such far-reaching implications as to "make current monetary theory almost completely invalid. The eventual emergence of alternative institutional frameworks. according to which money is a product of regulation. 2. 1982b. Greenfield and Yeager (1983).. 1555) 2. pp. 1982b. p. 1-6) and Barro (1985). In particular. forsaking a tangible means of payment. An accounting system works through bookkeeping entries. 9). of Economic Behavior & Org. Currency is a physical medium which can be characterized as money. which do not require any physical medium or the concept of money" (1980. 26 (1995) 445-455 a "new school of monetary economics" (Hall. debits and credits. Fama (1980). As Fama puts it: " .. in a 1989 symposium. p. 1555). The New Monetary Economics and the foundations of money The basic feature of the NME consists in the absence of a tangible means of payment and the consequent separation of the medium of exchange from the unit of account. but is deemed conspicuous to the point of determining the very phenomenon of money: "the money stock itself is a creature of inefficient regulation" (Hall. 39). is independent of the tangible character of the means of payment (section 2). the fundamental NME proposition. Dwelling upon these theoretical findings. is found to be untenable (section 3). In the present such a world. McCallum (1985) and Hoover (1988).446 F. Bilson (1981). p.. neither the quantity theory of money nor the liquidity preference theory of money would be applicable" (Black.. A further and basic element of the new school's teachings concerns the role of the government in today's monetary arrangements. Yeager (1985). above all. The relationship between the unit of account and the medium of exchange is analyzed to show that it is well grounded on the foundations of both classical and contemporary monetary theory and.1982b). The groundwork of the new school's propositions is the institution-laden character of monetary economics. the separation of the unit of account from own-unit of payment media and the consequences of this separation for the different payments systems are both questioned. Yeager and White discuss these issues from a Post Keynesian perspective. Hall (1982a. . p.1987). The presence of a public authority is not merely opposed following an extreme laissez-faire approach. 2 The main references include Black (1970). the main tenets of the New Monetary Economics (henceforth NME) are critically appraised. Cesarano /J. . Mott. one of our main points is that currency and an accounting system are entirely different methods for exchanging wealth. Cowen and Kroszner (1987) deal with the subject from a history of economics viewpoint while. see also the short but pregnant remarks by Brunner and Meltzer (1985.

every particular commodity is more frequently exchanged for money than for any other commodity. Before the end of the eighteenth century. A natural implication of this theory is the use of the medium of exchange as the measure of value (Schumpeter. Cesarano / J . but he carries them to the market. 62-63). in order to exchange them for bread or for beer. of Economic Behavior & Org. the necessary assignment of the latter to a commodity. and 2. the theory of money had already reached a fairly advanced status relative to other fields of economics. The overwhelming influence of this view 3 is apparent in Adam Smith's classic analysis of the inconveniences of barter (1776. this theory. chapter IV) which develops the notion of money as a 'common' or 'universal instrument of commerce'. It is the basis of the bulk of all analytic work in the field of money" (Schumpeter. than by that of bread and beer. These principles characterize the development of monetary theory throughout and have been held even after a major institutional change. p. It is more natural and obvious to him. to estimate their value by the quantity of money. it has been dominated by a single approach attributed to Aristotle and suitably called by Schumpeter the Metallist Theory of Money . though never unchallenged. 63). a penetrating passage explains the assignment of the unit of account function to the same commodity that emerges as the means of payment. Although the literature on the subject is extensive.e. much more substantial than the transition from fiat to non-tangible money. or the brewer. The quantity of money which he gets for them regulates too the quantity of bread and beer which he can afterwards purchase. these properties being in fact independent of eventual progress in transactions technology. The butcher seldom carries his beef or his mutton to the baker. the primacy of the medium of exchange function. the commodity for which he immediately exchanges them. and afterwards exchanges that money for bread and for beer. and rather to say that his butcher's meat is worth three or four pounds of bread. the evolution from a commodity to a fiat money system (Friedman. In the fifth chapter of the Wealth of Nations.founded on two basic principles: 1. have pointed out the implausibility of divorcing the unit of account from the medium of exchange. that the exchangeable value of every commodity is more frequently estimated by the quantity of money. pp. 1954. the commodities for which he can exchange them only by the intervention of another commodity. 26 (1995) 445-455 447 Both classical and contemporary economists.F. prevailed substantially to the end of the nineteenth century and even beyond. 1986). i. than by the quantity 3 "Whatever its shortcomings. "But when barter ceases. or three or four quarts of small beer. . however. Hence it comes to pass. and money has become the common instrument of commerce. Such an intimate connection is not related in any essential way to the physical character of money but to the distinguishing properties of a monetary economy as contrasted with a Walrasian economy. therefore. where he exchanges them for money. 1954.

on a pure fiat standard" (Friedman and Schwartz. Mill (1848. it is not a requisite for money to consist in a commodity. 13-14). An explicit analysis of the unit of account is absent in this literature because the latter envisages a general equilibrium setting where an arbitrary numeraire is assumed. directly or indirectly. conveys the intellectual climate of that period. In 4 It should be stressed that. Law. Earlier writers . However. Menger (1871.S.reported by a student in 1763 .448 F. Keynes. is unprecedented: a system in which essentially every currency in the world is. These events brought about an equally unprecedented evolution in the theory of money as theoretical metallism began to fade away s. Jevons (1875. in the Wealth of Nations. . this proposition was reinforced by recognizing that. footnote 3). paper money dissociated from gold is a monetary disease. Police. it should be noticed. the principles linking the medium of exchange and the unit of account are taken for granted and often are just mentioned in passing. The abuse of paper money became so prevalent during and after the World War. 564). 1929. In the nineteenth century. followed rather than anticipated the institutional reforms. pp. As Cannan recalls in his introduction. J. Representative examples are McCulloch (1825. 26 (1995) 445-455 either of labour or of any other commodity which can be had in exchange for it" (1776. pp. did not examine the relationships between them. . in the Lectures on Justice. The momentous changes affecting monetary arrangements after 1914 led to "the emergence of a world monetary system that . from an analytical standpoint. Nevertheless such departures do occur. 36) 4 An analysis as perspicuous as Smith's is not easy to find in previous and subsequent periods. written by Hawtrey for the Encyclopaedia Britannica. as the majority of economists firmly abided by metallism.and its corollary establishing the necessary identity of the means of payments and the unit of account . VIII). 5 The latter development. p. albeit for opposite reasons. 692-698). p. Departures from it occur only at times of emergency and transition. Cesarano / J . 483-488.though they discussed the functions of money separately. and some times years. p. This appears from contemporary contributions prompted by the challenging problem of money in a Walrasian economy. 6-8)..Smith considers money "first as the measure of value and then as the medium of permutation or exchange" (1776. and Hume . Nevertheless. . pp. the basic proposition concerning the primacy of the medium of exchange function . pp. some authors do grapple with the issue. ch. Apart from schemes of the type favoured by Mr. and Wicksell (1906. XVII-XVIII. pp. of Economic Behavior & Org. 32. . XLII-XLIII). Cantillon. Revenue andArms . this view being borrowed by Hutcheson's System of Moral Philosophy (1776. and even generations pass before the theoretically normal standard is restored . Smith reversed his previous opinion on the primacy of the medium of exchange function. pp. 38). 77-78). 1986.did not collapse with the abandonment of the Metallist Theory of Money. that it has been given an almost disproportionately important place in latter-day monetary theory" (Hawtrey.. " A metallic standard is the universally accepted monetary policy. The article " M o n e y " .

. Clower and Howitt. Despite the variety of approaches. Money is not simply a unit of account" (Ostroy. 1986). 87). 121).that receives 'checks' by all individuals providing information about their trading history . 1971. " W h i l e this convention is essential to the operation of the record-keeping system.leads to a competitive equilibrium allocation. the transmission of information about market prices and the qualities of goods and services (Brunner and Meltzer. of Economic Behavior & Org. Ostroy (1973) views money as an abstract 'record-keeping device' which saves time in the attainment of equilibrium since it preserves the enforcement of budget constraints without imposing quid p r o quo at each exchange. 211). it has arrived at a much deeper understanding of the distinctive character of money. Cesarano / J. The different ways of tackling the subject all point to the informational role of money in solving the problem of enforcing budget constraints (Ostroy and Starr. Alchian. a convention must require the use of a common unit of account but the latter does not define the specific role of money. However. 1977. in this respect. p. it does not help to provide each individual with a price list giving all prices just in terms of apples. 1990). the provision of a record-keeping device to avoid inconsistent claims on resources (Ostroy. these contributions regard the physical or tangible configuration as incidental and link the essential property of money to other specific factors: the role of transactions costs (Hahn. But it is hard to imagine. the use of a common numeraire or unit of account does not logically compel the use of a common money in transactions. the main difficulty. 608). . Niehans. p. The saving of accounting costs only materializes if the other markets are dosed down" (1978. King and Plosser. 26 (1995) 445-455 449 particular. 1971. In particular. The introduction of a monetary authority . being the identification of sufficient conditions for monetary exchange to emerge in an Arrow-Debreu economy (Clower. 1977..F. 1973). . p. Clearly. Modern literature has not provided a settled treatment of money. chapter 7) formally demonstrates the ancillary character of the unit of account with respect to the medium of exchange by dwelling upon the notion of 'accounting costs' 6. a unit of account disembodied from a generally accepted means of payment" (1980. as long as all ½q(q . it is not identical to it.. tangibility is 6 It should be noted that the advantages of a common medium of account can only be realized if the medium of account is also elevated to the role of the common medium of exchange. he would still have to take the time and trouble to compute the prices at all other trading posts from this basic set. 1973. and I suspect even harder to illustrate historically. In order to measure quantities traded at the competitive price vector. 1978). p. Likewise. Niehans (1978. 1971. Ostroy and Starr (1974) investigate the logistics of exchange and identify the function of a common medium of exchange with allowing decentralization of the trading process.1) potential trading posts are active. James Tobin makes the same point and adds the following remark: ". Commodity-for-commodity barters could be and are made with values equated by reference to numeraire or unit-of-accountprices. In order to perform such a function.

11). so that in " t h e n e w s c h o o l ' s v i e w . 370). what is called for is a record-keeping device . in a real w o r l d m o n e t a r y system without central coordination of trade. Therefore.has some economic value. the physical character o f the m o n e y ' o b j e c t ' b e i n g the latter d e v e l o p m e n t i n v o l v e s nothing but the mere shape o f an irredeemable p a y m e n t instrument. similarly approach m o n e y as " a kind of transfer credit s y s t e m " (Ulph and Ulph. Cesarano /J. p. . p. the transition f r o m a theory w h i c h requires m o n e y to be a c o m m o d ity to another one w h i c h does not. passing f r o m physical fiat m o n e y to an accounting system o f e x c h a n g e . 1111). . The New Monetary Economics and regulation A l t h o u g h the teachings o f the N M E differ a m o n g its exponents. Starrett. 1975." (1990. the government thereby controls the price level" (Hall. of Economic Beha~'ior & Org. That the device is embodied in a tangible commodity is clearly inessential" (Ostroy and Starr. such a transition has far m o r e m o m e n t u m than the one considered by N M E theorists . the government controls the relative price of reserves and goods and services in general. Of course a commodity record-keeping device is a relatively crude instrument. 26 (1995) 445-455 not required 7. . s "The new monetary economics views the quantity theory as nothing more than an artifact of government regulation. Again. Because prices are quoted in terms of reserves. pp.i. . 1554) 8. . An economy organized along free-market principles could function without money at all . Through manipulation of the quantity of reserves or changes in regulations. in w h i c h alternative organizational structures are postulated. F r o m a theoretical point of v i e w . allows us to depart f r o m barter exchange. Thus. 1982b. F o l l o w i n g the 7 "The sole purpose of trade in commodity m (the money commodity) is to establish a counting device to insure that the sum of additions to and subtractions from the value of one's holdings during the course of trade is zero. . m o n e y can w e l l be immaterial but this does not m e a n that its ' s e r v i c e s ' disappear. Kurz. The same function could be abstracted by a system of electronic funds transfers provided that accounts were monitored by an agency with sufficient police powers to punish 'overissuers'. In their recent survey. Ostroy and Starr state: "The problem is how to enforce the overall budget constraint underlying market-clearing excess demands while also permitting individuals temporarily to violate those constraints in the course of fulfilling those excess demands. 1982b. p.e. A s far as m o n e t a r y theory is concerned. it a reserve . either because it is intrinsically useful or because the government creates an artificial demand for it through regulation. the government's monetary liability . Other w o r k s by Hahn. All in all. Ulph and Ulph. 1552-1553).450 F. . the important point is not so m u c h the tangibility of the m e a n s o f p a y m e n t s as the m e d i u m of e x c h a n g e f u n c t i o n which. . m o n e y is exactly a creation of r e g u l a t i o n " (Hall. a c o m m o n starting-point can be identified with the critique o f the role o f g o v e r n m e n t in a m o n e t a r y system based on a tangible asset. leaves the main proposition linking the unit o f account to the m e a n s of p a y m e n t unaffected. 3. 1974. the innovation d o i n g a w a y with tangible e x c h a n g e m e d i a could hardly falsify the proposition in question. .

not between tangible money and intangible accounting systems. 43) has been prompted by the need to standardize the coinage and certify its quality. of Economic Behavior & Org. Specifically. Thus. these issues are not even contemplated by equilibrium theory. These arrangements. The immediate implication of the correct taxonomy is that monetary institutions. this proposition does not seem valid since the basic features of a monetary economy have little to do with either the physical character of the means of payment or the nature of the issuer. the latter concern intervention on the part of the government in resource allocation. 1984. In this connection. do not belong to the realm of general equilibrium theory. the question concerning the role to be assigned to the government and to private agents respectively arises with regard to rules as well (King.e. Indeed. 26 (1995) 445-455 451 arguments put forward in section 2. both rationales of the usefulness of money set forth by Hall . needed to ensure operationality. Cesarano / J .i. government involvement in monetary affairs (White. From a historical viewpoint. Of course. The unfettered working of market forces is sufficient to account for the origin of money and for the successive stages of monetary development. In fact. Menger's (1892) classic hypothesis about the origin of money is based on an 'invisible hand'. then. and price support programs are typical examples of regulations.F. Hall's statement (see footnote 8) about the 'artificial demand' for money created by the government through regulation is not easy to follow. information producing activities germane to a commodity standard. Indeed. i. 1986. Friedman and Schwartz.are analytically irrelevant inasmuch as the foundations of monetary theory respectively prescind from the outward form of money and the presence of government. it is difficult to see any artificiality or any instance of regulation. The relevant contrast is between Walrasian and decentralized exchange economies. driven by self-interested individuals striving to overcome the inconveniences of barter. the relevant issue is to explain both the emergence and the necessity of rules. Monetary arrangements. While the former concern the specific requirements stipulated for granting viability of a monetary standard. licensing. in the phenomenon of money. fixing the gold content of the monetary unit in the gold standard and setting a limit to the quantity of fiat money in order to maintain its value are examples of rules. which may aptly be called rules of the game. p. the mere fact that the paper money circulating today in all countries is issued by the government bears no relation whatsoever to regulation. Price ceilings.e. There too. the latter does not set out to analyze the implementation of trades and the related problems raised by informational decentralization. the intrinsic value of a money commodity and the artificial demand for money created by the government . do not primarily impinge upon relative prices or resource allocation. the whole history of monetary . fostered by the thrust of resource saving. involving no collective decision. vary with the kind of monetary system but their nature is quite distinct from that of regulations. money is an artifact of efficient decentralized market behavior. section II. 1983).

O n c e the e s t a b l i s h m e n t o f rules is d e e m e d a n e c e s s a r y e l e m e n t o f the s t a n d a r d . M o r e t h a n often. t h e r e m u s t b e a d e m a n d for a n d s u p p l y o f a m e d i u m o f e x c h a n g e a c t i n g as a n ' a n c h o r ' o f the s y s t e m .w h i c h acts as a p i v o t or p e g in the m o n e t a r y s y s t e m . p r o p o s a l s a b o u t n e w m o n e t a r y a r r a n g e m e n t s h a v e s i m p l y c h a n g e d the t y p e o f p e g 11 9 "There is the same incentive to find ways of reducing transaction costs as of reducing other costs. See also Patinkin (1965. 1967. he must have some idea about other prices before he can say whether or not a particular price-offer is acceptable" (Hicks.i. . pp. changes in it must impinge on aggregate real behavior in some market . 10 . a market in which absolute prices . there is therefore no supply-demand equation to determine its value. p. . In his Lecture I. F r o m the r e a d i n g o f the historical record. T h e s a m e c o n c l u s i o n is r e a c h e d b y H i c k s w h o s e a n a l y s i s ( 1 9 6 7 . of doubtful value. one way of looking at monetary evolution is to regard it as the development of ever more sophisticated ways of reducing transaction costs" (Hicks. . it is with this organization (the clearing system) that we first meet a clear case of the Wicksellian phenomenon. . The money prices can be at any level.. as is now the case. 9-10). That money does not enter into the Walras equations.e. and choose something different by which the goal in view. it is altogether outside them. prices (that is) in terms of one of the traded commodities taken as numrraire. of Economic Behavior & Org. a stable price level. but this numrraire is not the money in terms of which calculations are made. 1967. must create excess demands in some market" (Patinkin. in order for the absolute price level to be determined by market-equilibrating forces. p. yet the same Walras equilibrium will be attained. therefore. The Walras equations are sufficient to determine relative prices. . . when he is deciding whether or not to sell (or how much to sell) at a particular price. italics in the original). 113. c h a p t e r 1). italics in the original).. it is not one of the traded w h i c h there is n o d e l i v e r y o f i n t e r m e d i a t e c o m m o d i t i e s s h o w s the l i m i t s o f the W a l r a s i a n a p p a r a t u s to tackle the p r o b l e m at stake 10. "The real advantage of Fisher's method is that. and not gold.. 11 The following comment by Wickseil about Fisher's plan for a compensated dollar is quite telling. may be secured with reasonable certainty?" (1906. pp. however. P a t i n k i n h a s i n d i c a t e d the p r i n c i p l e that s o l v e s the p r o b l e m o f price level d e t e r m i n a c y . 309). should implicitly consider what that price may be worth in terms of other goods. 1961. even in a market of the kind we are discussing. s u c h a r e s o u r c e s a v i n g c a n b e a t t a i n e d o n l y if s u i t a b l e i n s t i t u t i o n s are set u p (Hicks. p. thus l i n k i n g the m o n e t a r y to the real sector o f the e c o n o m y . T h u s . that the seller. A s o l u t i o n exists o n l y if t h e r e is a m e c h a n i s m .i n v o l v i n g the c o n t r o l o f s o m e n o m i n a l q u a n t i t y . The money is simply a unit of account. v i a b l e m o n e t a r y s t a n d a r d s m u s t rest o n a peg. 228.. Hicks observes: " . Why not. T o m a k e the g e n e r a l p r i c e level d e t e r m i n a t e . so that the general public would not even notice the change. O n the o t h e r h a n d . the n e x t q u e s t i o n r e g a r d s t h e i r scope. It is inevitable. externally. p. 26 (1995) 445-455 a r r a n g e m e n t s c a n b e s e e n as a s e a r c h for less costly w a y s to settle t r a n s a c t i o n s 9. The very substance of the proposed reform is to raise something else to the position of a measure of value. t h e r e s e e m s to b e a n i n v e r s e r e l a t i o n s h i p b e t w e e n the a m o u n t o f r e s o u r c e s s a v e d a n d the c o m p l e x i t y o f the i n s t i t u t i o n a l s t r u c t u r e o f e x c h a n g e . everything would continue as at present.. Lawrence White (1984. 1967. Such an argumentum ad ignoratum seems. Cesarano / J .money prices are indeterminate. go the whole way. section II) admirably illustrates this evolutionary process. I n v e s t i g a t i n g the m i n i m u m r e q u i r e m e n t s o f a m o n e t a r y s y s t e m .1 0 ) o f the ' c l e a r i n g s y s t e m ' .452 F. 8 . 7).

. 235). 1970. John F. 1985. 589-610. according to Jevons (1875). 9-20. Banking and Interest Rates in a World Without Money: The Effects of Uncontrolled Banking. of Economic Behavior & Org. can retain its full value" (p. Conclusion The Metallist Theory of Money. Journal of Bank Research 1. Journal of Money. it is astonishing that almost all leading economists up to the nineteenth century rejected. p. an undeniable merit of the NME is to have raised several provocative and intellectually stimulating questions. Carnegie-Rochester Conference Series on Public Policy 23. In fact. Laidler notes: "Even though. 77).O. the 'applied' counterpart to the theoretical foundations of money examined in section 2 above. 47-54.g. Bilson.. e. Brunner. A Positive Theory of Monetary Policy in a Natural Rate Model. Therefore. It may well be that monetary economics currently is not sufficiently advanced to deal satisfactorily with the issues raised by an accounting system of exchange. 1983. reigned almost unchallenged for over two millennia. to use his own (p. References Alchian. Barro. This is suggestive of the complexity of monetary theory which has often lagged behind innovation stimulated by market forces.A Comment on the McCallum Paper. Karl and Allan H. 1977. largely unexplored. a fiduciary standard 12. Credit. The analysis of the latter pertains to the theory of a monetary economy being. 12 Referring to Jevons' Money and the Mechanism of Exchange. in fact. inconvertible paper money was regarded as an 'abnormal phenomenon'. associated in particular. Fischer. A Proposal for Monetary Reform (University of Chicago). Barro. Bank Deregulation. Cesarano /J. albeit generally disparaged at present. Why Money?. if carefully limited in quantity. Gordon. thus originating a debate on the relationships between analytical and institutional aspects of money that are. Black. Armen. 1981. 191) phrase. Meltzer. John Law's System). The Uses of Money: Money in the Theory of an Exchange Economy.F. the proposition that money is a product of regulation appears to derive from a price-theoretical approach that is downright misleading when the subject is money. Without enquiring about the reasons for such a puzzling development (a tentative explanation may hinge on the difficulty of accounting for the value of fiat money and the fatal outcome of some early experiments. and David B. 26 (1995) 445-455 453 Monetary institutions mostly find their rationale in the necessity of rules to preserve viability of the monetary system. and Banking 9. 1971. Robert J. 4. and the Unit of Account: A Critical Review . though not exclusively with wartime finance" (1988. American Economic Review 61. 133-140. Journal of Political Economy 91. as yet. on theoretical grounds. Robert J. Accounting Systems of Exchange.784-805. . "There is plenty of evidence to prove that an inconvertible paper money.

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