Money inertia

This was originally provoked by a question and answer here.


The problem with the real price of money is that it is not real.

There is a view within economics – which was at one stage canonical – that money is an epiphenomenon; what matters is the “real price”, the price in terms of actual goods and services, and the “real economy”, the production, distribution, exchange and consumption of goods and services. (And assets, but we leave that aside.) To think that money mattered in its own right was to believe in the money illusion. As James Tobin wrote in 1972 (as quoted here [pdf]):

“An economic theorist can, of course, commit no greater crime than to assume money illusion”

Now it is obviously true that goods and services are what ultimately matters – we value money because we can buy goods and services with it and pay off obligations (to people who can then buy goods and services with it, and pay off obligations to people who can …: note that such obligations are typically implicit or explicit contracts – i.e. transactions operating across time). But if what matters is the “real price”, so that money is an epiphenomenon, the question then arises, why have money in the first place? What role is it playing?

To which the answer is: providing a huge reduction in transaction costs. What money provides is a universal transaction item. The more it does so, the more it is prized. It becomes the means by which transaction offers are made and accepted. It frames transaction offers and acceptances. It also frames obligations to pay. That is to say, its crucial value is being the medium of account (i.e., in Scott Sumner’s words, “the object that embodies the unit of account”).

For the alternative is barter, which is a much clumsier alternative: so much clumsier that even times of ludicrous hyperinflation, people still use money. What economists call ‘the real price’ is the barter price – the price in terms of goods and services. (Expressing this as ‘relative prices’ is another way of making this point, but one that continues to assume the use of money.) What economists call the ‘real price of money’ is its average barter price across all goods and services.

So, when I refer to ‘barter price’ I mean what economists call ‘real price’ as a barter price is a price in terms of goods and services and the real price is barter price expressed in a unit of account (typically money for a particular year) – a usage which in itself expresses the utility of money.

The real price of money is unknowable at the time of any given transaction. It can be (retrospectively) estimated, but that is all. If all prices were static for a known time period, so that the barter price for all goods and services relative to each other was known at the time of any given transaction, then any transferrable good or promise of service would do as payment, since its exchange value would be determinant for all parties. But money would still be used because it so reduces transaction costs (such as ease of movement and storage, allowing immediate transfer, economising on information and calculation, etc).
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Barter thus makes sense only when money is not available, or there is some strong penalty involved in using money sufficient to outweigh search and other costs involved in some specific barter or barters.

But all prices are not static for known time periods, so the real price of money is not knowable at the time of any given transaction. This means that prices and contracts will be in nominal values, because nominal values are specific, numeric (so can be added, subtracted, divided, multiplied, etc), applicable across goods and services and knowable. In that sense, nominal prices are real (in the sense of being knowable), and the “real” price (in terms of aggregation across all goods and services, or even just across one’s own budget set) is not. (The real price is not even numeric in quite the same sense, since it can easily involve odd fractions.)

Which means money can have real effects, because of the information lag between shifts in (nominal) supply and demand for money and overall price effects (i.e. shifts in the overall barter price of money). People will act according to nominal shifts because that is what they have immediate information on and it is what their prices, wages, contracts and obligations are specified in (money being the medium of account.) As the universal transaction item with a clear nominal value but a not-immediately-knowable overall barter price, money is not an epiphenomenon.

Moreover, as people tend to be loss averse (since people build up expectations and obligations based on existing income and wealth), and part of what is unknowable is how quickly other people’s prices will adjust to shifts in the real price, deflationary shocks (falling nominal prices, so rising barter prices for money) will tend to have more nominal stickiness than inflationary ones (rising nominal prices, so falling barter prices for money). This asymmetry in responsiveness (noted in a series of experiment here) is because raising one’s nominal price(s) is clearly compatible with being able to cover existing nominal prices, contracts and obligations. Lowering one’s nominal price is rather less so. Indeed, if it is known that certain prices, contracts and obligations will be slow to adjust or have already been set in nominal terms (such as, for example, tax obligations), then that effect is reinforced.

Remembering that, with regard to money, we are also dealing with powerful cognitive habits: which themselves are rational responses to the time and effort engaged in cognition and gathering information. Moreover, revealed rationality (rationality in behaviour) can easily vary from expressed justification. You do things because they work: one will not necessarily recall later all the considerations which led you to undertake an action, develop a habit, etc.

In particular, the slower one’s general cognitive responses and the more limited the relevant information available, the more dependant on cognitive habits and routines one will be. What people call ‘stupidity’ is often simple tardiness in responding to changed circumstances combined with some pertinent level of ignorance: hence the expression “x is slow on the uptake” and the importance of training to speed up responses (i.e. increasing the range and immediate availability of cognitive resources) to particular circumstances. So the higher the premium on cognitive economy (either in calculation or information), the greater will be the tendency to rely on nominal values.

Thus the term ‘money illusion’ is an illusion, because much of what is going on is not mere illusion, but (broadly) rational responses to information and other cognitive limitations as well as accrued obligations. It would be better to call it money inertia: the information lag to shifts in the overall barter price of money plus resistance to receiving less of the medium of account. Even when it is "pure" illusion, it is still a form of money inertia -- continuing to calculate in monetary terms rather than attempting to shift to (more complex) barter prices.