GDP and Inflation

Money Matters, Monumentally

Wednesday October 11, 2017 Konrad Hurren

Part two: A dollar a day


In our previous article on this topic we very briefly described the history of currency in New Zealand; cited some dead economists for further exposition; and, identified the key issue at hand: loss of your purchasing power. Now, we step back for a light treatment of how money's value arises. Next, we'll put on our serious hats and identify fractional reserve banking in New Zealand.


How money obtains its value without interference


To keep this brief and non-technical we'll use introspection. Ask yourself why you intend to hold the specific amount of money (cash balances) you do. Probably to: buy stuff sometime; have some on hand for emergencies; have some on hand for serendipitous investment opportunities; in short, holding cash serves you some purpose, it has utility for you. How do you estimate how much you need? Arguably, by considering the most recent prices of the goods you buy, and then examining your preferences, all in the context of an uncertain world.


Of course you will say you want an infinite amount of money, but to actually demand any amount of money you have to be able to pay for it. You do so by selling stuff (or labour).


How cool is that, we just derived your demand for money from data revealed in the choices you make. We've also been super careful to avoid fallaciously assuming you have perfect foresight. Axiomatically, you're just doing the best you can; given your estimate of the state of the world.


Further, because economists have flawless logic (this is undisputable), we can say that if some stuff (a cup) costs $7 then it must be true that $7 costs one cup! This is the price of money in terms of cups. This seems a lot less silly when you frame your wage in a similar manner. i.e. $30 might cost you 3 hours of labour (assuming your contracted wage rate is $10 an hour).


The supply of money is basically every note, coin, demand deposit etc in existence all held by somebody at some point. As with all economic analysis if supply increases price decreases. We won't cover the technicals of this. This increase in money supply, properly named, is inflation. It results in the deterioration of your purchasing power (price of money in terms of goods).


Where demand and supply coincide is where the price of money (in terms of stuff – like cups, or labour) will be.


And so, money obtains its value through the choices made by people, guided by preferences which themselves are driven the human desire to make life a little bit more comfortable.


A neat part of this derivation is that the price of money (in terms of goods) is determined by the demand for money which is itself determined by the price of money in some prior period. To resolve this circularity all we do is trace back over and over until we realize that the original supply of money must have been a commodity in common use at the time, which then became the most marketable good.


This last step then is what precedes the familiar requirements that money be fungible, not easily replicable, durable etc. These attributes make various goods better at being money. Historically, gold and silver have been used due to their physical attributes. But also salt (hence, we get our word "salary") and shells have been used.


berl note salt


How money obtain its value in the real world with plenty of interference


See above, but we need to add in the following:


The State: "I've made thi" really pretty plastic note, look it's even got a bird on it! By the way if you settle liabilities with anything else (salt, gold, silver) it's not enforceable, capiche?"


Us: "but… fine" Who even uses the word 'capiche' anymore?"


And so, plastic notes with birds on them become accepted (by force) as money.


There is not much chance of a person blindly accepting a pretty plastic note with a bird on it without such a threat. Why not just accept gold, silver, salt, shells, or even a warehouse receipt granting the bearer some amount of money commodity?


We'll get to the answer in future articles. Next, we dig into the machinations of "Fractional Reserve Banking" – the process by which the money supply is continually increased and purchasing power eroded.