bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

28 MONETARY ECONOMICS
simplified views of the functioning of the economy and see what they imply
about the nature of money and hence its definition.
Money in a world with high levels of information
We begin by assuming an economic system in which all participants are
well informed. Markets tend towards equilibrium. When an existing equilibrium
is disturbed, the return to equilibrium is sufficiently rapid that
behaviour may be analysed as if the markets were always in equilibrium.
That is, we are not saying that the economic system is always in equilibrium
— merely that an assumption of equilibrium provides the best way to
analyse the system. Thus, we assume that current real income is always at
its equilibrium level and that this level is known. Savings decisions, then,
reflect the long-term choice between the present and future consumption (of
goods and services). This is a real not a monetary decision and is therefore
a function of the real rate of interest. All savings are invested and the level
of investment determines the rate of growth of capital stock, which in turn
ensures the desired future level of output. The real rate of interest is determined
by the actions of savers and investors. The plans of economic agents
are always fulfilled. There is no uncertainty and no scope for purely financial
transactions.
The money supply is exogenous — the monetary authorities determine
its size and rate of growth. We define money as all those assets, and only
those assets, that are acceptable in exchange. The price of money is the
inverse of an index of prices, which we can think of initially as an index of
the prices of all goods and services in the economy (1/Pt). The technical
relationship between money and economic activity is then expressed by the
equation of exchange:
MVt ≡ Pt T ...2.1
.
where M is the stock of money, Pt T is the value of all transactions undertaken
with money (including exchanges of second-hand goods and financial
assets as well as of newly-produced goods). Vt, the transactions velocity
of money, is the expression of the technical relationship between the
stock of money and the flow of transactions and is only likely to change
slowly as the financial system changes. Since it is only likely to change
slowly, we might even think of it as being constant, although this is not
essential. Crucially, Vt should be independent of M, Pt, and T. Shocks to Vt would influence Pt T, but, in the absence of such shocks, externally engineered
changes in M (exogenous money) would produce predictable