Friday, September 17, 2010

money and bounded rationality

The three functions of money, in freshman economics, are as a store of value, a unit of account, and, last but most, a medium of exchange. Writers occasionally construct examples of something serving one purpose but not another, but by and large crippling any of these functions will to some extent cripple all of them. This is especially true in the case of storing value. If a prospective currency can't store value, then users have to use it in a hurry, and the buying and selling process that a medium of exchange is supposed to allow to be separate are forced to be more temporally proximate; in the extreme, if you have to spend your money within minutes of getting it, you're largely stuck looking for someone who wants to buy what you want to sell and vice versa, and you're effectively back to a barter economy. Similarly, it becomes less useful as a unit of account if its value can't be counted on.

Money as a store of value is also a great technology for savings. A (closed) economy as a whole can "save" only by investing resources in capital — physical capital, intellectual capital (technology), human capital (education) — but an individual can "save" by lending to others who wish to borrow, and in a large economy with a well-run central bank and so on, this typically works better.* If I have a good year, and expect less year will be worse, I can simply pile up cash; if I get paid a lump sum for a contract job, I can spread my spending over the time until my next job. If I want to make a big purchase, I don't have to make a big sale at the same time; I can save up ahead of time — or afterward, by borrowing at the time of purchase and then paying back the loan. The ability to choose between spending today or tomorrow is as valuable as the ability to choose between apples and grapefruit.

It's often noted, and, especially recently, quite notable, that people who are bad at saving money often lose much of this ability. If you don't have the self-control to let hundreds of dollars go unspent for a few weeks, you can't trade spending now for spending later. (If you buy durable goods, you can stretch some of your consumption into the future, but not quite as effectively.) The money, in this case, doesn't provide an effective store of value. This also, as I noted in the first paragraph, will affect its ability even to function as a medium of exchange.

I recently read an example of this; unfortunately, I don't now remember it. It was something along the lines, though, of a person who had trouble saving, and was engaging in a certain amount of barter (and running into the attendant double-coincidence-of-wants problems) due to an inability to build up even enough "working cash" to engage in what I think of as normal quotidian economic activity. If I remember or otherwise reacquire the example, I'll probably update this post.

* It occurs to me I've taken for granted that holding onto currency is the equivalent of lending to the central bank (or "bank of issue", if we still had non-central banks of issue), and that keeping money in a bank account is making a loan to that bank. If that's not obvious, take my word for it.

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