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From AD and Y=C+I+G to QEII and PQ=MV etc…

November 11, 2010

When fiscal policy was all the rage, I had to hear about multipliers, government spending, aggregate demand. That didn’t work as expected, so now monetary policy is making a come-back. Should I be scrambling to get up to speed with QEII, the “quantity of money” and PQ=MV?

My skepticism towards this kind of aggregation is getting worse and worse. I am now fairly convinced that there’s no such thing as AD (Aggregate Demand): you cannot “add” my desire to buy fagioli borlotti with someone else’s dream to go to Disneyland. They just don’t add up. If you add up the price of those two things, you’re adding up two signals. Prices are signals, Hayek used to say, and some economists even think that they are signals directed at specific slices of the consumer population. Just because we know how to add two numbers, it doesn’t mean that we should. We don’t usually add 2 meters to 3 degrees Fahrenheit.

But if you shouldn’t be too cavalier in adding prices up without proper justification, then what does it mean to add changes in prices? What’s inflation? The general price level, what is that? Some prices go up, others come down. Some are not even monetized yet, some are internalized, etc…what a mess. Being skeptical is healthy, but how can I deny such phenomena as “hyperinflation”? Isn’t there such a thing as a government abusing the printing press? Maybe “hyperinflation” is just an extreme pathological event, and we shouldn’t hope to understand a complex system from it’s non-stationary phases. It’d be like deducing the functioning of a healthy human body from its state during an extreme illness. It doesn’t seem like you could get very many insights. I could be wrong.

Ok so that was P, now what about Q? And all the other variables? What is money? What’s its quantity and what’s its velocity? I was stumped at ‘hello’. Money should enter in every transaction, so the bigger the economy, the more transactions are happening, the more money there is. And yet when I bought my house I don’t remember handing over a big bag of money to the previous owners. I transacted a deal with a bank so that some numbers will be modified in a certain way on some electronic files for the next 15 years. In fact the bank that gave me the deal then sold it to another bank that has now failed and was bought by another bank, but I didn’t even notice: just some letters in some electronic files were edited out. Where’s the money? Where’s the gold bullion? Was it better before when gold and silver and copper where the medium of exchange? I’m skeptical of that too. Presumably the bank did give the previous owners a bunch of money, but again no actual money would have to be involved if they’d decide to just invest it. How can you measure the speed of such transactions with any accuracy?

So prices are not actually numbers, but signals, and money is not actually a physical token, but more of an agreement, an understanding, a measure of trust. A macro-economist reading this would think that I’m just going off on an anti-intellectual screed, and maybe I am. Or maybe we’re really stuck in a mental-model-of-liquidity trap.

From → Economics

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