Why it is important to define money correctly..

An interesting and timely piece by Frank Shostak.

He says currently we are trying to take out new measures for money just to fit their correlation with economic indicators. This is no way to define money:

The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. A definition is to tell us what the fundamentals of a particular entity are.

In this sense money is that for which all other goods and services are traded. The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved from the most marketable commodity. 

This fundamental characteristic of money must be contrasted with those of other goods. For instance, food supplies the necessary energy to human beings, while capital goods permit the expansion of infrastructure that in turn permits the production of a larger quantity of goods and services.

Through an ongoing selection process people have historically settled on gold as money. In other words, gold served as the standard money.

In today’s monetary system, money supply is no longer gold but coins and notes issued by the government and the central bank. Consequently, coins and notes constitute the standard money, known as cash that is employed in transactions. In other words, goods and services are sold for cash.

A correct definition of money is a must if one wants to get the right information from monetary indicators. Unfortunately most popular ways of defining money are flawed.

Well said.

He critiques old money measure and the new one – MZM:

The problem of double counting is also not resolved by the “money of zero maturity” definition of money (MZM) — a relatively recent money supply definition.

The essence of MZM is that it encompasses financial assets with zero maturity. Assets included in MZM are redeemable at par on demand. This definition excludes all securities, which are subject to risk of capital loss, and time deposits, which carry penalties for early withdrawal. The MZM includes all types of financial instruments that can be easily converted into money without penalty or risk of capital loss.2

Observe that MZM includes assets that can be converted into money. This is precisely what is wrong with this definition, since it doesn’t identify money but rather various assets that can be easily converted into money. It doesn’t tell us what money actually is and this is what a definition of money is supposed to do.

Likewise the issue of a valid definition is not resolved by the Divisia monetary gauge. As we have seen this gauge is not trying to establish what money is but rather to improve the correlation between the money such as M2 with an economic activity indicator. In this sense the construction of the Divisia gauge is an exercise in curve fitting.

Once it is established that the definition is sound, one must stick to it regardless of whether it is well correlated with some other economic data or not.

Finally to the idea of e-money:

The introduction of electronic money seems to cast doubt on the view that money is coins and notes.

Notwithstanding, various forms of electronic money don’t have a “life of their own.” Electronic money can function as long as individuals know that they can obtain cash on demand.

Various financial innovations do not create new forms of money, but rather new ways of employing existing money in transactions.

Regardless of these financial innovations, the nature of money does not change. It is the thing that all other goods and services are traded for.


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