Monday, February 17, 2014

Simplest argument for monetary explanations of the business cycle

In one of his many excellent posts, Scott Summer discusses how much difficulty folk have in accepting monetary explanations of major economic downturns, particularly when in the midst of them. One can see the underlying intuition -- money is just the stuff I use for transactions, it's just a tool of exchange, how can it matter so much? Real business cycle theorists just take this common intuition all the way. But the intuition is very widespread and has considerable power way beyond high level economic theorising.

I would turn it the other way: money is the stuff everyone uses for transactions in all industries, what else could be the key factor in downturns, particularly major ones? The notable thing about recessions is that there are simultaneous downturns in activities right across all (or almost all) industries. So, what could drive down activity in all (or almost all)  industries at the same time? Remembering that "driving down activity" means fewer and smaller transactions. And, in a monetised economy, what do we use in all (or almost all) transactions?

That would be money. Now, whether the medium of account or medium of exchange role of money is the crucial thing here is something that economists argue about. But money should be the first suspect, not the last (or no) suspect in explaining economic downturns. 

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