Sunday, December 2, 2012

Why Money is Like Light

Traditionally money is defined as three things:

1.A unit of account
2.A medium of exchange
3.A store of value.

All of these things are true, but to really understand money, we need to understand how agents exchange. 

Imagine that these dots are economics agents spread out over space. People tend to live in groups, so I have arranged the dots in clusters.

Now, imagine that each agent produces some sort of good for exchange, like bread, beer or shoes, and exchanges it for the product of some other agent.  They can exchange with one agent, multiple agents, or no agents, The lines represent a pattern of exchange that could occur in a fixed period of time, say a year. Exchange tends to occur more often between agents who live closer together, so I have drawn more lines between the dots in clusters.*

The classical economists conceived of money as a “veil," a layer that lies over but does not change the pattern of exchange. Imagine that the grey dots are pieces of money, and that every exchange maps to exactly one piece of money in the “veil.”

Of, course, a single piece of money can be used more than once in a year.  When the same piece of money is used to facilitate multiple exchanges, but the number of exchanges and the number of pieces of money remain the same, extra money is allocated to existing exchanges and the price level increases. 

Of course, it’s also possible not to use a piece of money at all in a year. There are probably a few dollar bills hiding in your house that have been there for longer than that.  Karl Marx called holding money without exchanging hoardingWhen agents hoard money, but the number of exchanges and the number of pieces of money remain the same, the price level decreases.

By itself the number of grey dots really doesn’t matter at all.  What matters is the product of the number of grey dots and the number of times they are used, or money times its velocity. 

Now I can make my point.  Like light can be measured either as a mass or a wave, money can be measured either as a stock, a quantity in the possession of single agent, or a flow, a quantity in transit to somewhere else. The last two graphs show money as a stock and a flow. 

The relationship between money, it's velocity, and price is captured by the Equation of Exchange, first introduced by John Stuart Mill and then developed by Irving Fisher

*These exchanges represent transactions, and therefore could be final, as when the baker wears the shoes he swapped for the bread the shoemaker ate, or not, as when the baker later swaps the shoemaker's shoes with the brewer for beer. Say that 5 times fast! 

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