Money, Markets, and Macroeconomics: Core Economic Concepts

Money as a Medium of Exchange and Store of Value

The existence of money makes exchange easier compared with barter systems because money provides a stable store of value. If exchange is conducted with physical goods only — as in a barter system — there are many points of friction that will inhibit exchange. First, goods have different physical characteristics that can limit exchange. Some goods are perishable, others too large to transport, and still others difficult to move. Two goods may have equivalent value, but these physical limitations create barriers to exchange. How does one exchange a house for a year's supply of fish, for example? They might have roughly the same value, but you cannot take all the fish at once, you cannot trust that the fish will be delivered later, and if the person wishes to reclaim the house because the deal fell through but the other party has already eaten all the fish, there is no means by which to settle the dispute. Money as a medium of exchange therefore removes some of the barriers associated with the physical nature of goods.

Further, money allows for market-based exchange, which enables goods and services to find their true value. In a moneyless world, a painter might paint all day on one occasion in exchange for a week's food, and then paint all day on another occasion for a simple shoe repair. With money, the painter can find fair value for work done and then use that money in any way seen fit. The divisibility of money is one of its best attributes as a medium of exchange.

The last aspect that makes money a powerful means of exchange is that it serves as a store of value. This connects again to the physical limitations on both services and barter goods — money can withstand time, whereas many physical goods and most services cannot. This removes friction from the creation and transference of value. Money's lack of temporal constraint is one of its best attributes because of how readily it enables the creation and transference of value.

As a unit of account, money is consistent, at least when compared with barter goods. Barter goods can fall in or out of fashion in ways that money never does. Many goods see spikes and crashes in demand over time, so that a good that is highly valuable today might not be valuable six months from now. Money, however, retains its value far more reliably.

Graeber (2011) does not really argue that money is not a medium of exchange; he mostly spends time arguing against metaphorical anecdotes explaining why barter is efficient. By attacking the anecdotes rather than the nature of barter itself, he is arguing against a straw man. His alternative is a system of credits, which he describes as frequently the norm in societies with a limited money supply. Those societies were also relatively compact and simple, which enabled the maintenance of credit schemes. Money as a medium of exchange allowed for the development of far more sophisticated economic systems — something Graeber largely ignores because his focus on dismantling the straw man prevents him from fully engaging with what those anecdotes about barter were trying to convey.

Markets as Coordination Mechanisms

Markets serve as a decentralized coordination mechanism linking buyers and sellers. They do this by performing a number of critical functions. First, markets allow prices to more accurately reflect the interests of multiple buyers and sellers because they operate with transparency. By reducing information asymmetry, markets reduce friction related to exchange, and the value of goods is more accurately reflected as a result.

Markets are quite different from central planning. In central planning, the central planning body determines the value of goods. This is typically done relative to a common medium of exchange, but ultimately the cost of goods and the price paid for labor are determined centrally. This typically produces two outcomes. First, the value of things reflects the central body's vision of what it wants for the economy. Second, the value of things does not reflect what the people living within that economy actually value. This creates a disconnect. In a planned economy, setting prices serves as the government's way of ensuring demand for goods it has in abundance and of reducing demand for goods that are scarce. However, there are limits on how well this works; ultimately, a gap will emerge between the official price of a good and the real demand for it.

Inflation: Structural vs. Cyclical Causes

Structural inflation is inflation that arises from monetary policy, whereas cyclical inflation arises from a temporary misalignment of demand and supply for money. Demand for money rises and falls as a result of economic activity, which changes over time — rising during productive periods driven by innovation or population growth, and falling when those factors are weaker. The central bank can create inflation outside of this natural cyclicality by producing cheap money, which then leads to an overheated economy in which a portion of economic activity exists only because of the central bank's policy stance.

Several factors can lead to inflation. In general, economic activity creates demand for money, and this leads to inflation. Low unemployment in particular is linked to wage growth, which in turn generates inflation to the extent that wages are a major cost input for businesses. The Fed notes that there is a trade-off between inflation and employment because an economy at full employment will naturally see higher inflation due to higher demand, while an economy with higher unemployment — and thus lower buying power for its citizens — will have lower inflation rates ("Central Banking," 2018). This trade-off is known as the Phillips Curve, and it holds that the relationship exists primarily in the short run (Pettinger, 2017).

Inflation has a number of different impacts. The most significant is that buying power declines, because wages are stickier than prices. As buying power is reduced, people are genuinely poorer in real terms. In the long run, wages will rise to accommodate inflation, but wage growth typically lags. Another impact is that inflation erodes savings. This is especially true for savings locked in at a fixed interest rate — the buying power associated with that money declines as inflation takes hold.

References

Akerlof, G. & Yellen, J. (2013). The fair wage-effort hypothesis. Princeton University. Retrieved May 17, 2018, from http://blog.press.princeton.edu/wp-content/uploads/2013/10/camerer-chapter-16.pdf

Central Banks and the Federal Reserve System. In possession of the author.

Graeber, D. (2011). Debt: The first 5,000 years. In possession of the author.

Pettinger, T. (2017). Trade off between unemployment and inflation. Economics Help. Retrieved May 17, 2018, from https://www.economicshelp.org/blog/571/unemployment/trade-off-between-unemployment-and-inflation/