In Part II of the course we examined the two major real-sector models of the economy: Classical theory and Keynesian theory. What we mean by real-sector is that our primary focus is on production, consumption, and investment – economic activities involving “real” economic goods, services, assets, and resources. This is not to say that money was absent in our analyses of the real sectors. Indeed, we were analyzing markets for resources such as the labor market and markets for goods. In markets, real economic goods or resources are exchanged for money. But in our analyses so far, we have assumed that money itself was just another good like food. The major utility of money, we have implicitly assumed, is its ability to be exchanged for anything else that we want to acquire. This utility or function, by the way, is called “medium of exchange”. This point of view, the idea that money is just another good albeit one with advantage being universally exchangeable, seems intuitively correct. After all, money is a “good” in the microeconomic sense – we would all like to have more of it and it seems like a scarce thing to us individually.
But we aren’t studying microeconomics. We’re looking at the big picture, macroeconomics. That means we have to take a much closer look at this thing called “money”. Purely real sector theories, as we’ve been studying so far, pretty much assume that the quantity of money in an economy is constant, or at least controlled from outside the economy. The formal term for this assumption is that “money is exogenous” – that is money has its origin or source from outside the workings of the economy itself. This might have appeared to be a reasonable assumption 90 years ago when most nations’ money was backed by holdings of a physical commodity: either gold or silver. A country with more gold could create more money. A country without gold couldn’t. But it really wasn’t and isn’t a good assumption. Money is only partly exogenous. The creation of money is endogenous to the economy, meaning activities by firms and households determine how much money exists subject to limits and creation of “base money” by government. In the middle of all this money creation is a peculiar institution called “banking”.
Banks have been integral to market capitalism and industrialization. While the story of the trade revolution (1600’s) and industrial revolution (1700’s-to present) have gotten the most attention in history books, these revolutions went hand-in-hand with the invention and evolution of banking. Today we live in a world of “fiat money” dominated by “fractional-reserve banking”. We have fiat money, which means what we think is money (dollars in the US, euros in Europe, etc), only has value because some government says it has value and will accept it as payment for taxes. There is no gold backing it up. There is no gold or other commodity backing the money.
Jim’s Observation: Warning! Thinking about money, banking, and credit, particularly at the macroeconomic level, is not easy. It’s also often somewhat uncomfortable for people. We grow up since we were little kids just knowing that money is a valuable asset or commodity. It’s a convenient good thing that we carry around and exchange for other things. It’s’ “real” we think. Think again. It’s not “real” in the economic sense and it’s not natural. Money is purely a social invention. Money isn’t really a valuable commodity. Instead, money is just credit. It’s a promise to deliver real economic value sometime in the future. That’s it. It’s just promises. One suggestion: think about how money is treated in science-fiction movies like Star Wars. In those movies, people buy things by exchanging digital “credits”.
Also, we grow up thinking banks are safe places that store our valuable money for us. They don’t. Banks actually create the money they lend to us, and they lend out the money we deposit with them, all in an effort to make profits for themselves. Their ability to do this depends on the confidence we have in the banks. Banking is quite definitely, as you will see, a “confidence game”.
If, at some point in thinking about money and banking, you don’t feel like you’ve fallen down the rabbit hole like Alice in Wonderland, then you’re probably not thinking about it clearly enough. Even some of the greatest monetary economists have said that same. I will help you through this, but I’m just warning that a lot of long-held assumptions about what money is might be disturbed.