Educational (very educational): embarrassing questions about monetary systems

My editorial

This particular update on my blog is both a piece of educational content, and a piece of general research methodology in social sciences. It regards monetary systems. In terms of education, it mostly addresses those 3rd year students, Undergraduate, whom I am currently lecturing about Economic Policy. Still, the graduate Master’s students in the curriculum of International Economic Transactions can have some benefits out of it. I start with an old and classical one: the quantitative monetary equilibrium, or, in fancy economic writing:

P*T = M*V

P – the index of prices

T – the volume of transactions in the economy

M – the supply of money (monetary mass) in the economy

V – the velocity of money

This equation is both a mindfuck and a useful tool to understand how money works at the macroeconomic level. As for being a mindfuck, it is simple: both sides of this equation are equal to Q, or nominal aggregate output, measured in current prices. So you essentially start with the not-too-risky assumption that Q = Q and then you unleash yourself on maths. The nominal output is equal to the real output (i.e. the physical volume of goods and services produced), and it gets nominal by being nominated in a currency, i.e. by being multiplied by the current prices of things inclusive in the real output. Thus, Q = P*T is pretty intuitive. Now, the right side of the equation is more based on the current empirical observation. If you care to have a look at a statistic published by the World Bank under the label of supply of broad money as % of the GDP (you know, you click on the underlined phrase), you will get the current proportion between nominal output and the monetary mass supplied to the economy. The first observation is that it is never equal. In other words, you have very little chances to hit Q = P*T = M, with velocity V =1. When the equation of quantitative monetary equilibrium was being formulated, back in the 1950ies and 1960ies, the supply of money to the economy was consistently lower than the nominal output of the economy, i.e. we recurrently had: Q = P*T > M. Intuitively, you could guess that money supplied to the economy serves more than one transaction a year, or, in other words, money was seen as something circulating pretty quickly across the economy. There were even people who claimed that it circulates at a constant velocity. The well-known master of economic methodology, Milton Friedman, used to be one of those people. Still, as time passes, things change. Since the 1950ies the proportion between nominal output and the supply of money (look up that statistic with the World Bank) has been consistently shrinking as for the global economy. The monetary mass supplied made 50,465% of the global GDP in 1960 (velocity V = 1/0,50465 = 1,981571386). In 1990, the proportion climbed to 88.01%, thus velocity fell to V = 1/0,8801 = 1,136234519. Around 2007 – 2008, the global economy passed the magical threshold of Q = M. Interestingly, the global financial crisis broke out just then. In 2016 the supply of money in the world made 116,411% of the global GDP, with the velocity sadly falling down to V = 1/1,16411 = 0,85902535. Thus, in real life, money works differently in the economy, depending on the period of time. Currently, it seems to slow down its circulation. If people have more goods than money, so if we have like M = 50%*Q, you accumulate real goods rather than money, and you make those coins spin quickly, just to have all your goods well financed. Yet, when you have more money than real goods (case of the present day), you accumulate money and you speed up the flow of goods, so as to have any grounds for having the money. Over the last 70 years, the global monetary system has shifted from one monetary paradigm to another one, and we still don’t understand completely what has actually happened.

Now, when you switch from differences in time to those across space, and you take a snapshot from 2016, you have, for example: Argentina M = 28,9% * Q, Australia M = 118,8% * Q, Hong Kong M = 363% * Q, China M = 208,3%*Q, United Kingdom M = 144%*Q, United States M = 90,6%*Q. You can see that money works very differently across space. Each country seems to be a highly idiosyncratic monetary system. Good, so we keep on asking embarrassing questions. In textbooks, and in my lectures in the first year, you could have learnt that the supply of money is practically equal to the supply of credit from the banking system. It is generally true to the extent, that when banks get profuse on lending money, you can immediately see prices rise in the economy, and one of the best ways to slow down inflation is to make credit more expensive in terms of interest rates. Still, let’s check. In 2016, the global supply of credit (you know, click), from banks to the real side of the global economy, made 177,421% of the global GDP. Simple arithmetic indicate that we had [177,421/116,411] = 1,52 times more credit than money supplied. Back in 1990, the credit supplied from all banks in the world made 126,138% of the global GDP. Once again, we check credit for its attendance to the money being supplied, and we get [Credit/Money] = [126,138/88,01] = 1,433. Interesting: there seems to be more and more credit who lost its way from banks to purses (happens usually on a late hour at night), and there seems to be more and more credit in that awkward situation. Let’s snapshot across space in 2016. Argentina, credit = 38,8%*Q, credit/M = 38,8/28,9 = 1,34; Australia, credit = 183,4%*Q, credit/M = 183,4/118,8 = 1,544; Hong Kong, credit = 212%*Q, credit/M = 212/363 = 0,584; China, credit = 215%*Q, credit/M = 215/208,3 = 1,032; United Kingdom, credit = 167,8%*Q, credit/M = 167,8/144 = 1,1653; United States, credit = 242,6%*Q, credit/M = 242,6/90,6 = 2,677. Each country has a different system of transmission from credit lent to money supplied.

Now, if you are a government, you want two things on the left, P*T side of monetary equilibrium. You want to see your real output, or the volume of transactions T, gallop joyfully forward, i.e. grow like hell, whilst controlling the level of prices P. In order to do that, you need to control, somehow, the way your national monetary system works. As you can see from the numbers presented above, this is not obvious at all. The basic leverages you have are (check them at Wikipedia or elsewhere): the supply of currency through the central bank, the interest rates on credit, the ratio of mandatory reserves (the % of deposits held from customers that commercial banks have to hold, in turn, at the central bank), open market operations by the central bank and sometimes by the national Treasury (Minister of Finance in continental Europe), and the so-called quantitative ease (this is when the government buys financial assets in the domestic market; it acts on financial markets like a toilet plunger, you know, that big rubber sucker that you use to make your plumbing cooperative again).

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