3 Money in the economy General equilibrium analysis ‘hie is a core analytical chapter from a microeconomic perspective on money i the economy It treats real balances ae a good like other goods such as commodities and labor inthe economy and derives their demand in the overall context of the demands and supplies forall goods in the economy, It uses these in a Walrasian general equilibrium model to determine the relative and absolute prices of goods, and examines their properties, In particular, it addresses rigorously the controversial and important questions of the nextalty and super-newtrality of money. ‘While the analysis ofthis chapter is based in microeconomics, its conclusions apply to both the microeconomics and macroeconomics of money. Therefore, this chapter ean be covered immediately after Chapter 2 as a continuation ofthe heritage of monetary economics to the ‘Walrasian model. Alternatively, it ean be covered after Chapter 12 and thereby be a precursor to the macroeconomics Chapters 13 to 17 on money inthe macroeconomy, ‘The analysis of this chapter is fundamental to a rigorous consideration of the foundations of monetary theory. Key concepts introduced in this chapter Definition ofa good in economies Money as a good ‘The demand for real balances Numersire User cost of money Money inthe uly fanetion (MIUF) Money in the production function (IPF) Relative veraus absolute prices Homogensity of degree zero Neutrality of money Super-neutrality of money Dichotomy between the real and monctary sectors ‘The real balance effect . . . This chapter considers real balances as a “good” in economies and presents its analysis. In conformity with preference-based analysis in economies, it defines a good as anything80 Money in the economy of which more is desired to less. It then lists the stylized facts about money in a monetary economy, which also has labor, commodities and bonds among other goods. It then presents three models to derive the demand for money. If a model's implications do not meet the stylized facts, itis rejected as inappropriate for monetary economies, This is so for a model ‘commonly used in macroeconomics, ‘his chapter then derives the demand for money as an element of the Walrasian (general equilibrium) model, which forms the foundation of the microeconomic analysis of the markets of the economy and the determination of individual prices. It also forms the basis of the modem classical and neoclassical macroeconomic models, and the standard against which Keynesian macroeconomics lays out its differences. This chapter therefore serves as the prelude to Chapters 4 to 10 on the microeconomic aspects of monetary analysis — that is, the demand and supply of money. It also serves as a prelude to Chapters 13 to 17 on the macroeconomic aspects of monetary economics — that is, money and monetary policy in macroeconomic models. The reader more interested in these macroeconomic aspects can, therefore, proceed after this chapter directly to Chapters 13 to 18 3.1 Money and other goods in the economy Definition of a “good” ‘To consider whether money is a good or not, we nced a definition of “goods.” From the analysis of the behavior of individuals or households, we define a good as something of which an individual desires more rather than less, or less rather than more, ceteris paribus, A particular good may or may not be marketed; thus silence may be a good in the midst of overwhelming noise and yet may not be matketed.! From the point of view of the relevance to a market economy, only those goods that are marketed at some price or other need to be considered. Fusther, note that economic analysis docs not ask why mote of a good is desited to less of it. Therefore, it does not need to consider whether the good is in some sense beneficial or injurious for the individual, or whether there is something innate to the individual as a biological entity or something in the social or physical environment, or any other factor, which affects the individual's desire for its acquisition. To take some odd examples, diamonds, cigarettes, drugs, labor time spent in a criminal activity, guns and bombs, etc., are all treated as goods (or “bads") in microeconomic analysis. So is money, though it is not “directly consumed” and even though its components (such as the currency of the particular country and the demand deposits in it) only constitute money by virtue of the social and economic environment that make them acceptable as a medium of payments. Note that this is also so for diamonds, as for many other commodities, whose demand arises not because they of theit services are “directly used in consumption or production” but because of the social and economic environment which creates utility for them or their services. The desire of an individual to hold diamonds or real balances constitutes adequate reason for treating them as goods in his utility function. The fact that money can only be held and used at a cost only adds 1 is, however, meted in some cases a inthe cave of “soundproof apartments” commanding higher rents than oer apartmentsGeneral equilibrium analysis 81 confirmation to the treatment of money as a good for individuals, but is strictly not necessary to this treatment. From the point of view of a firm, an input (Which is a type of good) is anything of which more rather than less increases (or decreases) its production, Economic theory does not ask why it does so and, therefore, does not consider whether 2 good “directly” enters production or whether more or less of it increases production by virtue of the environment ‘in which the firm functions. The desire of firms to hold real balances constitutes an adequate reason for treating money as an input to their production, so that it constitutes a good for them, Money and other goods in macroeconomic analysis For macroeconomic modeling, goods are subdivided into the categories of commodities or products, labor or its converse as leisure, money and bonds, where the term “bonds” is defined to encompass all non-monetary fmancial assets.? Compared with other goods, money is the most liquid good and serves as the medium of payments. This chapter assumes that commodities, labor and bonds are relatively illiquid goods and cannot be used directly for exchanges against commodities. ‘One general trend of thought throughout the nineteenth century, and increasingly since the 1930s, argued that the demand for money should be analyzed as that of a choice of one good among many. This approach claimed that the analytical framework for determining ‘the demand for real balances to be held by an individual or firm is the same as that for determining the demand for commodities in general, and that this framework is that of utility ‘maximization for the individual or household and profit maximization for the firm, This approach is a present the dominant one in monetary theory, and Friedman's (1956) version of it was presented in Chapter 2. Such an approach can be formulated in terms of a timeless analysis, a one-period one or an intertemporal one. Different approaches to deriving the demand for money ‘There are three main approaches to deriving the demand for money and its role inthe economy, These are’ 1 Money yields utility and can therefore be incorporated into the utility function. Similarly ‘money can be incorporated into the production function, Alternatively, while money is not directly a component of the utility and production functions, it saves labor time in ‘making payments, so that it can be indirectly introduced into the utility and production functions. These two components of this approach are presented in this chapter. Money is not ditectly or indirectly in the utility and production functions but is required for certain types of transactions, so that a cash-in-advance analysis becomes appropriate, This cashein-advance approach can be found in Chapter 23 3 Money is not directly or indirectly in the wility and production functions and is not used as a medium of payments in a cash-in-advance manner. However, money is an asset that 2 Intuitively, commodiie ae goode directly sed in consumption or proton, Financial sets ae paper or ook eeping claims to commodities and are wed fo thi quid serves ero wansfer purchasing owe! fom the present to the fture82. Money in the economy ccan be used for transferring purchasing power across petiads. This approach is used in the overlapping generations models of money, presented in Chapters 21 and 22. Of these three approaches, the most common isthe first; money can be treated as a component ofthe utility and production functions Money in the utility function and the production function ‘Our preferred approach to money in this chapter puts it inthe individual's utility function and the firm's production function because it is the medium of payments in a monetary economy in which commodities (bonds) do not trade against other commodities or bonds but do so only against money. This approach is known as the money in the utility function (MIUF) and the ‘money in the production function (MIPF) approach. Many economists object to this approach ‘on the grounds that real balances do not “directly yield satisfaction ot increase production, ‘An indirect route to this approach isa “transactions” approach that initially keeps money out of the utility and production functions; however, the use of money allows the consumer to reduce transactions time for payments and therefore to increase leisure by using money, and its use also allows the firm to save on its labor resources. These arguments lead to the indirect utility and production functions, which are briefly presented in Sections 3.3.2 and 3.6.2 of this chapter. However, many economists prefer to completely eschew the above lines of analyses, with, some of them opting for money in an overlapping generations framework. This approach is presented in Chapters 21 to 23. Money as a durable good Financial assets are durable goods in an economic sense. The concept of the economic durability of money can be quite confusing and needs clarification. ‘The demand for money is taken to be a demand for the average money balances held by the individual in a period and is often designated as the demand for nominal balances to hold. This demand differs from the amounts that the individual would hold at various points in time during the period but is a weighted average of the latter amounts, with the weights being the duration a particular amount is held? However, an individual may or may not hold a durable good fr its transactions services. He may instead use it as a means of transferring his wealth or real purchasing power from 5 To consider an example, atsume tha an individual holds $100 atthe beginning of a weck and spends ita a continuous even rate ovr the week, His average money balances ~ designated as his demand fr money ~ held lover the month are $50 (= 100/2) which clearly differ fom his money balance of $100 athe beginning ofthe ‘week and his money balance of zero dolae athe end ofthe wesk For comparable period analysis, seme that he spent S100°T (81429) por day of he week. He would then old $45 71 (-100 ~ 14.28) for 6 day, $71.42 (© #5:71~ 14.29) for days, andso on. The weighted average (ve. weighted bythe numberof day hed of thee amounts would be $42.85, so that there isa slight ference between the continuous andthe discret cases for the average calelation. We wll proceed with the continuous even expen assumption, which implied the weighted average balance tobe $50, Under this assumption, the individal woul be taken to have had an average demand for $80 of money balances, a durable good, andto ave wsedit services is Gnancing his purchases dung the week, See alto Chapter 40n this pointGeneral equilibrium analysis $3 one week to the next.* Such a usage would be one of a store of value.’ For convenience, ‘monetary theory has generally treated the demand for money as a medium of payments under the category of the transactions demand for money and the demand for money as a store of value (relative to other assets) as the speculative or portfolio demand for money, But any particular unit of money balances can be used for either function, and the division into the ‘uansactions and speculative balances must be taken to be an analytical division and not necessarily applicable to the real world. This chapter confines itself to general propositions oa the total demand for money 3.2 Stylized facts of a monetary economy As pointed out at many points earlier in this book, the essential role of money is that of ‘medium of payments, To perform this role, it needs to be a store of value, at least over short intervals from receipt of money to its payment to others. The macroeconomic definition of bonds is non-monetary financial assets, Such assets also function as stores of value, often better than money since they usually provide higher returns than money. What are the main stylized facts related to money in a modem economy that a theory that purports to have money in it must satisfy? Our simple and shortlist of these stylized facts on money is as follows: 1 Commodities, labor and bonds do not exchange against each other but only against money. The income from the supply of labor or accruing in other ways is received in money, “while the purchases of commodities and bonds have to be paid for in money. Since these two actions do not occur at the same instant, money is held in every period (which is long enough to include both the receipt of income and expenditures from it). By its very nature as a store of value, it can also be held from one period to the next. Therefore, in monetary economy, there is a positive demand for money in every period ® 3 The demand for money is positive, irrespective of whether the retum on itis higher or lower than the return on bonds, In fact, the retu on money is usually less than on bonds, but money demand is nevertheless positive. The positive demand for money as ‘the medium of payments coexists with a positive demand for both risky and riskless bonds.” 4 A pute sore of value without any transaction utage would occur if the individual held $50 consistently ~ and never spent aty of t— fom the beginning ofthe week othe end ofthe week. He would then have beseathed his amount othe beginning ofthe fllowing week, much in the manner of durable consumer good sich 2s gerator, which oats the curent week of age adie waiable tthe individ at the hegining ofthe Following week Thus, or the pure toe-o-vale fnetion, the indvidsal cold store the unplugged refrigerator cor the $50 of money balances though the week without any intention of wing their services for weHigertion ot ‘Snancing payments, respectively. n practice, both the refrigerator andthe money balances wil ce sone sage ‘he ater for financing tansactons ~ during the wesk and sll acta stores of vale. Chapter 4 presents the analysis ofthe tansacion eae combined with the store of value role of money Fridman called the teuporary store of value fr which money i weed an abode of purchasing power, ‘This implies that in any model involving mote than oe peviod money needs o have still positive demand in all periods, including both the st period andthe last period ofthe analysis [fatnodel implies that both the demand fr money and for bonds ae not simultancoutly positive, tithe demand for bonds tat has tobe zo,84 Money in the economy 4 The demand for money is positive, inrespective of whether the return on it is higher or lower than the retum on commodities through storage or production of other commodities, It is also positive even if a positive rate of inflation is expected. 5 For individuals, the demand for money is a function of total expenditures or of consumption expenditures, not of saving. In particular, it can be either greater than or less than saving, but virtually never equals the saving in a given period. 6 The velocity of circulation of money is positive over periods that include both the receipt of income and the purchases of commodities, but is nevertheless not constant Students should check the validity of points 1 to $ with their own behavior, For many of them, expenditures are equal to or below their incomes. Therefore, they dissave, with the dissaving financed by their issue of bonds (IOUs to parents, loans from the universities and the government, et.) In spite of zero or negative saving, they hold positive amounts of ‘money (in fact, both currency and demand deposits). Chapters 14, 21 and 23 provide longer lists ofthe stylized facts on money in the economy. Macroeconomics and monetary economics provide several models with money listed as 4 Variable in the model. Itis often designated, by assumption, as an asset that is riskless and has a zero return, However, neither of these is among the essential characteristics of, ‘money, £0 that including an asset with these characteristics and calling it “money” does ‘not mean that there really is money in the model. Money would be a misnomer for such aan asset unless it meets the preceding list of stylized facts. In short, our intention is to use these facts to discriminate (reject or accept) among models that include an asset that they call ‘The next section presents a commonly used macroeconomic model that claims to include money. However, its implications for the demand for money run foul of the stylized facts, 0 we argue that there is really no money in it, which leads to its rejection as a valid model for a monetary economy. Chapters 21 to 23 present some OLG models with “money.” The benchmark mode! of this approach, specified in Chapters 21 and 22, also fails to satisfy the stylized facts on money. 3.3. Optimization without money in the utility function ‘As discussed above, the essential role of money is that of medium of payments. To perform this role, money also has to be a store of value, at least for short durations, or, as Milton Friedman put it, “a temporary store of value.” What is the appropriate model of consumer behavior for capturing these roles? This section motivates discussion on this issue by the use ofa standard two-period model, without uncertainty, of consumer behavior for an economy with commodities, money and bonds. Assume that, in period I, the individual has the frequently used two period utility function of the form: UCemeam) w where c; and mj are respectively the consumption of commodities and the supply of labor in the ith period, U() is assumed to be an ordinal neoclassical utility function with continuous first-and second-order partial derivatives. Note that money does not appear inthis