Essays in Monetary Theory and Policy: On the Nature of Money (4)

By Kian Lua*

Money is a quintessential aspect of our society, however rarely would someone ponder upon and seek to understand what money really is or how it functions in the economy. There are several stories or theories about the origin, nature and functions of money, and both mainstream orthodox and heterodox have different views of how money work. Understanding the nature and function of money is crucial in shaping effective theories of money as well as sound economic policies. In the traditional mainstream perspective, money is neutral in the long run. It serves as a medium of exchange and measure of value. The central bank controls the supply of money, government obtains money from households and firms to spend and excessive government spending would lead to inflation. In the heterodox view however, money is not neutral. It is a unit of account and always a debt. The government as the sovereign issuer of the currency does not have budgetary constraints. It can spend as much as it needs to achieve full employment and price stability. The nature of money and its implications to policy-making will now be examined.

Orthodox nature of money

The traditional or orthodox story is that money originated from barter. It is said that under primitive conditions men lived by barter, where people exchange commodities through double coincident of wants. As life becomes more complex, barter becomes inefficient way to trade and by common consent a commodity that is generally acceptable and which therefore everyone will take for the things they produce or services they render is chosen as a “medium of exchange and measure of value” (Innes, 1914). This chosen commodity called “money” existed as a “lubricant” to facilitate the exchange of other commodities and to reduce transaction costs in trade. Therefore in the traditional view markets existed before money, and money existed as a medium of exchange to eliminate inefficiencies of barter. Gradually precious metals such as gold, silver, and copper became the common medium of exchange or money because of their inherent qualities and finesse and a certain fixed weight of these metals became a standard of value. States then issued paper money that is backed-up by gold. When United States stops pegging the dollar to gold reserves, the dollar became a “fiat money”. When countries stopped backing up money with gold “people feared that money would become worthless pieces of paper or electronic entries at banks (Wray, 2012), but it shall be explained later that “fiat money” is not worthless money.

Another prominent nature of money in the orthodox view is that money is neutral. Changes in the money supply do not affect the “real” economy such as production (employment) and consumption (output). Instead, the money supply only affects “nominal” factors such as prices, wages and exchange rates. The neutrality of money means that even if the change in quantity of money causes a short-term disruption in the economy, in the long run the economy will return to the equilibrium state of employment and output and any adjustment to manipulate the market is undesirable. In addition, according to Monetarists, inflation is always a monetary phenomenon when “too much money” is “chasing too few goods”. Expansion of money supply is inherently inflationary and governments should be cautious in doing that. Monetarists believe that the excessive creation of money is the cause of inflation; therefore monetary authorities should only focus on policies to maintain price stability and they should be prevented from “printing money” or spending excessively.

Orthodox Approach to Policy- Making

In orthodox policymaking tools such as open market operations, discount rate and the required reserve ratio are used by the central bank to achieve operating targets. The central bank’s short-term operating targets include controlling the monetary base, bank reserves, non-borrowed reserves, overnight interest rate, and short-term interest rates. Its intermediate target is to control the long-term interest rates. Hence, central bank controls the reserves in banks through the required reserve ratio and the money supply through the monetary base. All these tools and short to intermediate term targets are used to achieve the long-term goals of the orthodox economic policy which is low unemployment, low inflation and stable growth rate (Wray, 2013).

In Friedman’s Adaptive Expectations Theory, the labor market is “fooled” because in the short run labor that is backward-looking in expectations cannot foresee changes in the monetary expansion or contraction. If the central bank implements monetary expansion, prices and wages will be pushed up with prices rising faster than wages. Workers will think that their real wages have increased and they would supply more labor. However when they have adjusted their inflation expectations later, the labor market goes back to equilibrium. This effect can be seen in the long-run Phillips Curve. Therefore, to encourage workers to supply more labor, the central bank has to constantly “fool” workers with “unexpected” monetary expansions (Snowdon and Vane, 2005). However the central bank would lose credibility if it keeps doing so. Monetary fooling only affects worker’s expectations in the short run and in the long run money is still neutral because the economy will return to the natural rate of employment and output when inflation is fully expected. Monetarists think monetary policy would provide a faster and more reliable effect on output, and fiscal policy is undesirable. However because uncontrolled monetary policy might lead to hyperinflation, they believe that central banks should aim for stable money growth.

The Lucas’ Rational Expectations Theory on the other hand emphasizes on the “fooling” of production firms. When there is a price change, firms have to decide whether they are facing a real shift in demand for their products or a nominal shift in demand across all markets. The more “surprised” the firms are with changes in price level, the more they will think that the change is due to the demand for their products. Firms will then increase the supply of output and employment in the economy. In the short run, employment, output and nominal income will increase when firms are “surprised”. However in the long run through forward-looking rational expectation, firms are rational and expect a change in inflation rate. Therefore they are less likely to form expectations that are systematically wrong and output and employment will be in equilibrium (Snowdon and Vane, 2005).

In addition to the aforementioned policy examples, in the orthodox view governments must limit spending because it is believed that they are taxing, borrowing and printing money to fund their expenditures. Printing is inflationary and borrowing crowds out the private sector by increasing government spending at the expense of the households. Any attempt by the government to spend more than it can “afford” could destabilize the system on a whole. As such policies often recommend that government must limit its expenditures, and it would be preferable if government could balance its annual budget or achieve a budget surplus.

Heterodox Nature Of Money

Post-Keynesian economists present a very different view of the origins and nature or money. Money is not neutral and according to Wray (2012), the three basic concepts of money are that: 1) Goods do not buy goods but money buy goods and vice versa. 2) Money is always a debt or IOUs, and 3) There exists a “pyramid” or hierarchy of liabilities because not all IOUs or money things have equal creditworthiness. First of all the heterodox view is that markets did not exist before money because goods do not buy goods. As such the traditional story that money originated to eliminate inefficiencies of barter and that money is a commodity is untrue. Money is not a commodity that is produced or “harvested” by labor. This is because money does not need to be in the form of any commodity, it is just a general representation of value or a unit of account. Also, obtaining money is the main purpose for producing commodities. In fact, Wray (2012) states that the production process begins with money on the expectation of ending up with more money. Keynes mentions similar points in the General Theory. To set up production facilities, tools and raw materials, one needs money. Therefore, production begins with money with the aim of gaining more money in the end from the sale of commodities or services. The process cannot start with commodities because the commodities must have also been produced for sale for money, hence goods do not buy goods.

The second nature of money mentioned is that money is always a debt. Before explaining why money is a debt, it is important to recall the concept that money need not be something physical. Contrary to the orthodox commodity money view, money is a unit of account and is a liability or IOU of the issuer. The issuer of the currency determines a monetary unit of account, for example the U.S. Dollar, British Pound and Chinese Yuan. Items are valued and transactions are recorded in the unit of account, and money things are denominated the unit of account. Anthropological evidence shows that the foundation of all exchange is credit. Within a group, kinship and social custom necessitates that people share things with one another. Credit is always given within the group because it is known that the creditor will be repaid in some form. As interaction begins to occur between groups money develops (Graeber, 2011). Money is an easy way to measure social value of goods and services through credit and debit between groups. In this way a “Credit” is a correlative of debt, where my debt to you is what “I owe to you” (IOU), and your credit on me. Also, according to Wray (2012) the issuer of an IOU or credit must accept the IOU as a payment, and when this happens the IOU is “destroyed”. This operation can be seen when banks issue IOUs or loans. When someone takes a loan from the bank and issues an IOU to the bank, the bank’s asset increases. This person’s IOU is then matched by the bank’s IOUs or liabilities issued electronically with “keystrokes”, which is deposited as an asset in the borrower’s account. This is one of the ways money is created in endogenously within economy. When the borrower pays back the loan, the loan and deposit cancels each other, thus money created as a loan in the beginning is retired in the end, but since in a monetary economy the purpose of production or service is to produce more money, banks charge interest and fees to make a profit.

The third proposition about money states that not all IOUs or money things are created equal and there exists a hierarchy of liabilities with different creditworthiness, and creditworthiness depends on the IOU issuer’s risk of default. IOUs issued by the state of government and banks are more creditworthy compared to individual or private sector IOUs. These non-bank and private IOUs have higher default risk and are less liquid, while bank issued IOUs are less likely to default when government guarantees deposits. Government issued IOUs or state currency have almost no default risk and are the most liquid because people need to obtain government issued currency to settle monetary obligations to the government. Wray (2012) states that “Fiat” money is in demand and is widely accepted because government issued currency is the main thing accepted by the government in tax, fine or fee payments. We will return to the topic of “fiat” and tax-driven currency later.

Before delving into the issue of economic policies, it is also important to understand sectorial balance in a domestic economy, how money is created and how governments spend. According to Wray (2012) a country’s economy can mainly be separated into three sectors: The domestic private sector, domestic public sector, and a “rest of the world” sector or foreign sector. The domestic private sector consists of households and firms, domestic public sector the government and foreign sector consists of foreign governments, households and firms. Basic principle of accounting demonstrates that financial assets will always be offset by equal amounts financial liability, and that deficit in one sector must always equal to a surplus in another sector. The sectorial balance equation is derived from this accounting principle and can be expressed as: Domestic Private Balance + Domestic Government Balance + Foreign Balance = 0 (Wray, 2012). It is clear that when there is budget surplus in a sector, the other sector(s) must run deficits in order for the identity to hold.

As mentioned previously, money is always a debt or IOU. State issued currencies IOUs or debts issued by sovereign governments. When the government spends money into existence to obtain services from its citizens, the government issues IOUs to its citizens. In essence, the government chooses a national money of account, issues a currency denominated in the money of account, and levy taxes in the money of account. Sovereign currencies issued by governments are “fiat” money. Today, many people still instinctively believe that money must have some real physical existence, or at least needs to be backed up by hoards of precious metals. In 1970 President Nixon took the United States off the gold standard, effectively neutralizing all gold reserves and turning the U.S. Dollar into “fiat” money. After countries stopped backing up money with gold, people fear that the money has become “false”, a worthless piece of paper or electronic entry at the bank. This belief is erroneous simply because government issued “fiat” money is backed-up by the government’s obligation to accept them in return for payments of taxes, fines and fees. This is the concept of “taxes drive money” as stated by Innes (1914) and Wray (2012). In addition to levying taxes, fines and fees, the government also makes payments in its own currency. This is sufficient to ensure that government issued money will be in demand because assets, debts and prices are denominated in the government specified money of account (Innes, 1914). Thus, money or debt is an instrument of the power of the state and markets are a means of distributing the state’s power. The relationship between markets and states is reciprocal, as one cannot exercise power without the other. The state requires that the total debt not be repaid since if all debt was repaid there would no longer be a power relationship over the people (Graeber, 2011).

Furthermore, as the sole issuer of the currency, the government has the power to spend its currency without constraints. In other words, the myth that governments need to borrow or tax in order to spend is wrong because a sovereign currency issuer can create money electronically with “keystrokes” and spend as much as it needs to by crediting bank reserves (Wray, 2012). Hence government IOUs are the most liquid and creditworthy type of IOUs without the risk of solvency or default because the government can always service debts and issue payments. However this does not mean that governments should spend aimlessly because over-spending can cause inflation and affect currency exchange rates. Governments that peg their exchange rates might protect their currency’s exchange rates by spending less and keeping its interest rate target high, but governments in a floating exchange rate do not face this constraint.

Fundamentally, the government as the issuer of the sovereign currency can always afford to spend or make payments. It can spend as much as it wants because there is no limit to the numbers that can be entered in the central bank’s computers. Thus, there is very little chance that government will default on its own currency. Also, Government issued currency or IOUs will always be in demand and circulation as long as the government levies taxes and fines, and makes payments in the currency. As seen from the sectorial balance equation, for one of the sectors to gain a surplus, either one or two of the other sectors must be in deficit. When governments spend, because it is the only sector that creates money or wealth in the economy, money from the government sector must flow into either the private or the foreign sector or both. Again, just because the government sector can always afford to spend, this does not mean it should spend unrestrictedly. Overspending by the government could cause inflation and pressure interest rates. Additionally according to Wray (2012), by restricting spending, government can leave some resources for private interests, they can better control and manage government projects, and they can avoid perverse impacts on incentives to other sectors.

The government should control spending because although the government is not financially constrained, excessive spending would result in it directly competing with other sectors for the use resources such as labor. This could result in a “bidding war” where the private sector bids-up wages or prices to obtain resources and labor, leading to higher wages and production costs or less output in sectors employing skilled labor. Therefore government policy should take into account the opportunity cost of pulling resources away from other sectors. Correct measures need to be taken so that the economy is not too “heated-up” or pushed beyond the point of full employment to avoid increasing rate of inflation and pressure on interest rates due to increasing trade deficits (Wray, 2012). Secondly, if government spends excessively in welfare payments individuals would be less likely to contribute to the economy in a more productive manner and lax government bailout policies for businesses would encourage firms to be less prudent or even encourage fraudulent behavior. There is also the risk of decreased productivity within the government sector if it is “bloated” with excessive resources. The right amount of resources should be left for the private sector. Finally, with government’s self imposed budgetary constraints, mismanagement or corruption could be detected more easily when there is overspending (Wray, 2012). As observed, self-imposed spending constrains are useful to regulate the economy and allocate resources, not to prevent the government from running out of money or from going “bankrupt”.

Heterodox Approach to Policy Making

Unrestrained or imprudent government spending could result in negative disturbances in the economy; good economic and spending policies on the other hand, could help government achieve public purpose and socioeconomic stability in the country. Having understood the nature of money, how the three sectors must balance in an economy, and how governments can spend, it is now appropriate to examine the Post-Keynesian approach to domestic fiscal and monetary policy as well as the question of how governments should spend to achieve public purpose. According to Wray (2012), Modern Money Theory (MMT) recommends that governments aim for full employment and price stability in the economy. This concept originated from Abba Lerner’s functional finance approach. Lerner believes that the government should use its spending authority to achieve full employment while taking appropriate steps to fight inflation. Lerner proposes two principles that should be applied in the economy to achieve this target. The first principle addresses fiscal policy. He states that unemployment is evidence that domestic income is too low. Unemployment exists because the government is spending too little or taxing too much, this government needs to spend more relative to taxes to reduce unemployment. Lerner’s second principle addresses monetary policy. When the domestic interest rate is too high, government needs to lower the interest rate by “pumping” money into the economy, mostly in the form of bank reserves (Wray, 2012). These principles correspond with the fact that a government as the issuer of sovereign currency has the fiscal and monetary policy space to spend enough to achieve full employment in the economy and to achieve interest rate targets.

As mention before, government spends by issuing IOUs and crediting bank accounts with those IOUs. Naturally, when there is unemployed labor that wants to work, the government can always afford to hire them. Similarly when interest rate is “off” target, the central bank uses monetary policy to stabilize interest rate. This technique of hitting the interest rate target is also called the “Horizontalist” approach, which states that the central bank cannot control money supply or bank reserves, instead it accommodates the demand for reserves (Wray 2012) in order to maintain an interest rate target. Thus, the reserve supply is “horizontal” and at the same level as the targeted rate. To elaborate, when banks have excess reserves, the overnight interbank rate falls below target and the central bank conducts open market sale of bonds to drain reserves and increase interest rate to the target rate. When banks are short on reserves the opposite happens. The overnight interbank rate rises above target and central bank conducts open market purchase of bonds to inject reserves, causing the interest rate to fall to the target rate. Reserve creation by the central bank to accommodate reserve demand also shows that money is created endogenously within the banking system, hence MMT calls this the “endogenous money, horizontal reserve” concept (Wray, 2012).

With functional finance, there is no reason for balancing the government’s the budget yearly because government should deficit spend when needed to achieve public purpose. As such Abba Lerner rejected the notion of “sound finance” – the belief that government ought to run its finances as if it were like a household or a firm. Again, government as the issuer of sovereign currency does not have budgetary constraints. It does not need to collect taxes, sell bonds to “borrow” money, or “print” money in order to spend. Government collects taxes to control inflation and to “drive” its currency; it conducts open market operations to achieve an interest rate target, and spends with “keystrokes” by crediting bank accounts with its own IOUs. With functional finance the government spends the correct amount of deficit to propel the economy to full employment. As will be seen later, the government can achieve the target of full employment and low or no inflation with employment programs. Therefore sound finance is not functional because it prevents the government from achieving the public purpose including full employment. However with the government constantly spending to reach full employment people might start worrying about hyperinflation.

With regards to hyperinflation, the fact that governments can always issue IOUs to spend on anything that is for sale in its own currency without causing high inflation might be surprising to some. The common belief is that when governments start “printing” money hyperinflation would occur and the economy would end up in the likes of the Weimar Republic and Zimbabwe. The traditional Monetarist will mention that when government prints too much money, rapid inflation will follow, causing velocity of circulation will increase as the currency’s value fall rapidly. Government will not be able to keep up with rising prices as it prints more money and in the end there will be hyperinflation in the economy because there is “too much money chasing too few goods”. Therefore in the Monetarist view, government that finance deficits by printing money is the cause of high rate of hyperinflation. MMT provides a different view on the cause of hyperinflation. According to Wray (2012), studies of past cases do not prove that there is direct link between issuing currency and hyperinflation. It can also be observed that hyperinflation is caused by specific circumstances such as political and social unrest and the nation losing sufficient productive capacity to support the economy. Both situations were present in the Weimar Republic and Zimbabwe. Hyperinflation could also be caused by a nation holding too much foreign debt denominated in external currency or gold. Such was also the case for Weimar Republic. Further, nations that have large budget deficits like the United States, United Kingdom and Japan did not experience hyperinflation. Therefore government creating money by “keystroking” numbers into bank accounts is not the root of hyperinflation because as mentioned earlier it can always afford to issue its own IOUs and there is no other way it can spend.

After understanding the basics of functional finance and dispelling concerns about hyperinflation that some believe could occur from the government spending, it is appropriate to learn about policies and programs that can be implemented to achieve full employment and price stability. MMT proposes an “employer of last resort” (ELR) program, also known as the “job guarantee” (JG) program. According to Wray (2012), the ELR/JG program funded by the government would provide jobs to qualifying individuals who are ready and willing to work. It should have a fixed wage with wage increase subject to government approval and it should include benefits such as health care, childcare, social security and personal leaves. This ELR/JG program acts as an automatic employment stabilizer and promotes price stability. In other words full employment without inflation. To accomplish this, firstly the ELR/JG program absorbs workers who are laid off from the private sector during a recession, and releases workers during a boom, thereby ensuring stable aggregate demand and unemployment data. Secondly the program’s uniform basic wage would stabilize prices by “reducing inflationary pressure in a boom and deflationary pressure in a bust” (Wray, 2012, p. 224). Basically the uniform wage in the program sets a floor wage in the economy where private employers need to pay a higher wage to attract workers in the program. The floor wage effectively sets the mark on how low private sector wages can drop in a recession. In a boom however, the floor wage can dampen wage pressures as some workers move back to the private sector. Wray (2012) mentions several key social and economic benefits of the program, which includes poverty reduction, lessening social issues associated with unemployment such as crime and health problems, and enhancing working skills. This program would also improve working conditions in private sector as employees would have the option of moving into the program. Hence private sector employers would at least have to match the working conditions and wages offered in the ELR/JG program to attract workers. Thus the ELR/JG program is designed to let the government achieve the public purpose of full employment and stable prices.

To conclude, the orthodox analysis of money and approach to policy is very different from the heterodox or Post-Keynesian approach. Orthodox views may have misrepresented the nature and functions of modern money, which implies orthodox policy prescriptions for the economy may be flawed. Hence, economists and policy makers need more understanding of how modern money and the financial system functions to set correct fiscal and monetary policies that would benefit the nation as a whole.

*A Note:

For the next few weeks we will be running a series of articles on monetary theory and policy. These are final essays written by MA students in my class this past Fall semester. I was very happy with the results—students indicated that they had a firm grasp of both the orthodox approach as well as the heterodox approach to the subject. Most of them also included some Modern Money Theory in their answers. I asked about half of the students in the class if they would like to contribute their essay to this series. Sometimes students are the best teachers because they see things with a fresh eye and cut to what is important. They are usually less concerned with esoteric academic debates than are their professors. Note that these contributions are voluntary and are written by Masters students. I told students they could choose to use their own names, or they could choose an alias. Comments are welcome, but please be nice—remember these are students.

For your reference, here were the topics for the paper. The paper had a maximum  limit of 6000 words.

Choose one of the following. You must consider and address both the orthodox approach and the heterodox approach in your essay. Where relevant, include various strands of each.

A) What is the nature of money? Given the nature of money, what approach should be taken to policy-making?

B) What is the nature of banking? Given the nature of banking, what approach should be taken to policy-making?

C) According to John Smithin there are several main themes throughout controversies of monetary economics, each typically addressed by each of the various approaches to monetary theory and policy. In your essay, discuss how each of the approaches we covered this semester tackles these themes enumerated by Smithin. 

L. Randall Wray


Graeber, D.,(2011). Debt: The first 5000 years. Brooklyn, NY: Melville House

Innes, A. M. (1914). What is money? The Banking Law Journal, 24 (95), 377-408.

Snowdon, B., & Vane, H.R., (2005). Modern macroeconomics: Its origins, development and current state.   Cheltenham, UK: Edward Elgar Publishing Limited

Wray, R. L., (2013). Economics 531 lecture: Orthodox vs heterodox policy. University of Missouri-Kansas  City.

Wray, L. R., (2012). Modern Money Theory: A primer on macroeconomics for sovereign monetary    systems. London, UK: Palgrave Macmillan

Comments are closed.