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Money – The Window to Understanding the Economy

We live in a monetary economy. That is, unlike a barter system we have created “money” which serves as the medium by which we exchange goods and services in our economy. Therefore, to understand the economy you must understand money. You must define it, understand where it comes from and understand how it impacts the economy.  Money is the language of the economy. For instance, if you wanted to understand human interaction it would be essential to understand the tool we use to communicate. As Steven Pinker says, linguistics is the window to understanding the brain. Likewise, money is the window to understanding a monetary economy.

In a recent post, Paul Krugman discusses the “sad” state of macroeconomics specifically citing this piece by Olivier Blanchard discussing DSGE models. I generally agree with the view that DSGE models are deficient, but not for the reasons cited by Blanchard and Krugman. I think these models are flawed because, like most of mainstream economics, they contain no generally accepted general equilibrium theory of money.¹ The result is that these models are constructed in a way that is similar to an alien trying to understand human beings without understanding the language we speak (good luck you dopey aliens!).

While I am hesitant to call myself Post-Keynesian (it has its own set of problems), one of the main reasons I sympathize with PKE is that it has a general theory of money in which private banks are accepted as important and central money creation institutions. Although some PKE views are imperfect, (for instance, I disagree with the MMT view of money as a creature of the state) the embedding of banks as money creators in the PKE model has made for very good predictions in the last 7 years. More importantly, it helped PKE advocates avoid the disastrous types of predictions made by this list of prominent people when they assumed that QE could lead to high inflation or banks “lending out” their reserves.

As Krugman notes, predictions really do matter and PKE models with endogenous bank money have generated far better predictions in the last 7 years than most other economic schools. Does it mean we should dump “mainstream” DSGE models and replace them with PKE models? Most certainly not. But perhaps the big lesson of the last 7 years is that a general theory of money is a very helpful component to making good predictions about the future.

¹ – There have been reasonable attempts to include money in these models such as the development of money-in-the-utility-function (see Woodford, 2003, Interest and Prices: Foundations of a Theory of Monetary), however, we are a long way from a general theory of money in DSGE.