Why money matters

I think this is an absolutely fantastic, clear and concise explanation for why money matters in macroeconomics:

In normal times, people receive apples and money from the sky in the form of endowments (i.e. their wealth), and they make decisions about how to balance their cash and apple balances. Apples are transacted, bellies are filled, and life is good.
But suddenly, a recession hits. What does this look like? By definition, a recession is when there is a general glut of goods that aren’t consumed. In this toy economy, this corresponds to a situation in which some people have apples but choose not to eat them! This may seem peculiar, but remember that the market for apples in this model represents a composite of all goods markets. So it could be the case that while everybody has apples, some want Red Delicious while others are looking for the tartness of Granny Smith. In more formal economic models, this is glibly incorporated by requiring that people do not consume their own endowment and instead trade for consumption. In any case, apples aren’t eaten and we have a rotten general glut.

But this seems peculiar — aren’t markets supposed to clear? Not necessarily. Prices don’t always adjust instantly, so we can have excess supplies and excess demands. However, economists do have a way to constrain what this non-clearing state looks like. In particular, according to Walras’ law, assuming everybody spends all of their wealth, if there are excess supplies (i.e. too much produced) in some markets, then they must add up to excess demands (i.e. too little produced) in other markets. In other words, even if supply does not equal demand in each market, supplies must add up to demands across markets.

The requirement that everybody spends their endowment is crucial. It means that Walras’ law doesn’t apply just to the market for apples because not everybody spends all their wealth on apples. Instead, some people may put their wealth in money. But once we include the money market, we do have the condition that everybody spends their endowment, and therefore Walras’ law does apply to the entire macroeconomy of apples and money.

This leads to the most important conclusion from general equilibrium theory as related to monetary economics:

If there is an excess supply of goods, it must be the result of excess demand for money.

Go read the whole thing and follow Yichuan Wang’s blog. He’s one of the best communicators in economics right now.

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