Parable of a Monetary Economy

What follows is a simple parable. The post is long because it illustrates numerous scenarios and their implications, but the parable itself is simple and hopefully very easy to follow. The parable is designed to illustrate as simply as possible the difficulties that arise in a commodity-backed money system and the benefits of fiat money. It is based on Bill Mitchell’s ‘business-card economy’ teaching model but is adapted for present purposes.

Although the parable makes use of a highly simplified model, the basic insights emphasized carry over entirely to more detailed models. For instance, it would be possible to include private-sector employment, a capitalist class, a rentier class, a private banking system, an external sector, etc., in the model without altering the basic insights discussed. In the future, variations of the parable that include different features may be used to illustrate other aspects of a monetary economy. But the points discussed in this post can be seen at the most aggregated level in which we simply distinguish a government sector from a non-government sector.

The main points the parable is designed to illustrate are:

1. In a monetary economy, full employment and price stability can be maintained provided the government’s budget deficit equals the non-government sector’s desired level of net saving at full-capacity output.

2. In a commodity-backed monetary system (e.g. Bretton Woods), following this budgetary policy can ultimately result in the system breaking down if the non-government sector desires to net save (accumulate net financial wealth) on a more or less ongoing basis. Conversely, not to pursue this budgetary policy results in unemployment and/or deflation.

3. In a fiat-money system, governments have the capacity to pursue full employment and price stability at all times by endeavouring to keep the budget deficit in line with non-government net saving intentions. The practice of issuing government debt in such a system is a meaningless exercise, and choosing to focus on government debt as a policy target at the expense of full employment amounts to behaving as if the government is operating under a commodity-backed monetary regime and faces the same socially destructive constraints.

The Parable

It’s the summer holidays and Mr and Mrs Thompson (the “government”) need their kids (the “non-government sector”) to do a lot of work around the house. They know the kids love to play outdoors, so they decide they will require them to do some work before they play. To facilitate this, the parents decide to institute a monetary system in the household (“economy”). They decide to use some of Mrs Thompson’s business cards as the “currency”.

The parents know that their kids – Kenny and Prudence – like to play outdoors. To create a demand for the currency, they announce that from now on the kids will be required to pay a toll (tax) of 1 business card per hour of outdoor play. This toll also functions as a price: the price of outdoor play.

On the upside, the parents announce that the kids can earn business cards by doing work around the house, for which the parents will pay them a wage of 1 business card per hour.

The parents also reserve the right to impose a tax on income, but intend to keep this tax rate at zero unless the household economy for some reason needs to be stabilized.

Each day, the parents will determine how much they can afford in wages and then the kids can choose any amount of work up to that amount.

If possible, the parents would like to ensure two things:

1. Full employment;

2. Price and real-wage stability.

The kids are keen to earn as much playtime as they can, but in view of the summer heat, the parents think 3 hours per kid is about the daily work limit and so adhere to this “labor law”. That means 6 hours total employment per day represents full employment.

Price stability requires that there be no inflation or deflation. There is only one price, p, in this simple closed household economy. Currently it is set at p = 1. We can also think of this as the general price level (the weighted average of all prices in the economy). The reason the parents care about price stability is that they want business cards earned today to be worth the same as business cards earned tomorrow, no more and no less. That way, the kids have a reliable store of wealth. If they prefer, they can save business cards today for later and be confident that they will still buy as much outdoor play (no inflation or deflation).

The parents would also like to maintain the real wage (maintain a stable living standard) so that the kids could take a day off work and be confident that an hour’s work tomorrow will buy as much outdoor play as an hour’s work today. Currently the wage, w, is 1, and the real wage, w/p, is also 1.

Note that for the purposes of the parable, productivity is being taken as given, which is a reasonable approximation over a short time horizon and a common assumption in short-run macroeconomics models. Alternatively, productivity improvements could be thought of as occurring “under the surface” of what is described, manifesting as the kids learning over time to perform more or higher quality work within a given work day. The benefits of this could be enjoyed as a free public good (a nicer house and garden) or the parents could offer the kids various private rewards (in addition to the outdoor play on offer). In effect, there would be an increase in the real wage made possible by the productivity improvements. However, leaving these features out of the parable changes nothing important in relation to the aspects of a monetary economy to be illustrated.

Given the simplifying assumption of constant productivity, price and real-wage stability is an appropriate aim of the parents’ macroeconomic policy. Wage increases would be inflationary in the absence of productivity improvements or, in a more elaborate parable that included profit income, a redistribution of income from profits to wages.

Commodity-Backed Money: The Car Standard

Mr Thompson has always believed that money should represent something real. He convinces his wife that although the business cards are being used merely as tokens, they should commit to keeping the quantity of business cards in strict proportion to the number of cars they own. The total wage bill per day under full employment is 6 so the parents realise 6 business cards will be required. Since they happen to own 2 cars, they set the Car Standard at 3 business cards per car owned. This ensures that they are entitled to issue 3 business cards for each car, giving a total of 6.

In some situations it will be awkward to transact in physical business cards, so the parents set up a spreadsheet on the computer to record all transactions. This will especially come in handy when dealing in fractions of business cards.

Day 1 under the Car Standard

On the first day, the parents use the 6 business cards they have issued in accordance with the Car Standard to employ the kids for a total of 6 hours – 3 hours each.

Both kids respond by accepting 3 hours of employment and earn 3 business cards each.

Kenny spends all his wages to pay for 3 hours of outdoor play. Prudence prefers to spend 1 business card and save 2 by hoarding them in her bedroom dresser. She gets to play 1 hour on the first day and still has 2 business cards that she can spend in the future.

To summarize day 1:

Employment = E = 6 hours
Wages = W = 6
Consumption = C = 4
Investment = I = 0 (no private investment in the model)
Saving = S = 2
Kids’ Net Financial Assets = Accumulated Saving = 2
Income = Y = C + S = 6
Parents’ Reserves = 4
Hoards = 2
Parents’ Expenditure = G = 6
Tax Revenue = T = 4

Budget Deficit = G – T = 2
Non-government Net Saving = S – I = 2

Parents’ Debt = Kids’ Net Financial Assets = 2

The parents’ budget is in deficit, since their spending, G, for the day was 6 whereas tax revenue, T, was 4. This has enabled the kids (the non-government sector) to net save 2 business cards.

Clearly, the parents’ budget deficit (G – T) equals the kids’ net saving (S – I), as must be the case in a closed economy. This aggregate relationship is an accounting identity, true by definition.

Note that it would also be possible for the kids to undertake transactions within their own (non-government) sector. For instance, rather than Prudence consuming 1 hour of outdoor play, she could offer to pay Kenny to clean her room. Provided the wage offer was competitive with the parents’ wage offer, Kenny might opt to work 2 hours for the parents (government) sector and 1 hour for Prudence in the kids (non-government) sector and still remain within the 3-hour limit set by the labor law. There would be a shift in the composition of employment between the two sectors, but no alteration in total employment or income. For present purposes, we can keep things simple by ignoring these compositional effects and simply assume all employment is in the parents (government) sector. This doesn’t alter the basic points under consideration.

Day 2 under the Car Standard

At the start of the second day, the parents notice that they only have 4 business cards in reserve, even though there are 6 on issue. The reason for this is that the kids, in aggregate, chose not to spend all the income they earnt. Since the parents are committed to maintaining the Car Standard of 3 business cards per car, they cannot issue any more business cards short of purchasing a third car.

At current wages, the parents realize they can only afford to employ the kids for a total of 4 hours out of their own reserves. But that would mean 2 hours of unemployment and they are committed to maintaining full employment.

The parents consider reducing the wage rate from 1 business card per hour to 2/3. That way, they could afford to pay the kids for 6 hours of work. The kids aren’t too pleased about each having to work 3 hours for 2 business cards instead of 3, but decide against forming a union because they were brought up to believe that unions distort wage and price signals.

However, the parents have second thoughts, realizing that reducing the wage rate would violate their objective of maintaining a constant real wage and/or threaten price stability. They want an hour worked today to buy the same amount of outdoor play as an hour of work performed in the past. They therefore recommit to the wage of 1 business card per hour.

This leaves the difficulty of maintaining full employment. It is clear that with 4 business cards in reserve, the parents simply cannot afford to employ both kids fully out of their own reserves. They feel stuck until they realize there is another option. They could borrow from the kids (the non-government sector). Although Kenny hasn’t saved, Prudence has saved 2 business cards. The parents ask Prudence if she would be willing to lend them 2 business cards in order to maintain employment at 6 hours per day. The parents would issue 2 bonds in exchange for the funds they need.

Prudence considers the request, makes some back-of-the-envelope calculations, and says that she is prepared to lend the business cards to her parents for ten days provided they pay her a daily interest rate on the loan of 10 percent first thing each morning.

The parents feel a bit put out but agree, reasoning that they will only owe interest at the end of the day and not the principal, and maybe things will pick up in the future and enable them to pay back the entire loan plus interest by the end of the ten days.

The parents use their reserves of 4 business cards and their borrowed 2 business cards to offer 6 hours of employment to the kids.

Kenny once again decides to spend all his wages (3 business cards) on outdoor play. Prudence prefers to save 2 business cards and consume only 1 hour of outdoor play. She now has accumulated 4 business cards in savings (2 on the first day and 2 on the second). She hoards the 2 business cards from today’s pay in her bedroom dresser. She has exchanged the other 2 business cards for bonds, which she keeps with her hoard of business cards.

The parents are pleased to have maintained full employment but are a little concerned about the lack of demand for outdoor play. If they reduce the price of playtime, it may induce some more demand from Prudence, but it will also bring about deflation. The parents would have failed to meet their goal of price stability. They decide to keep the price of playtime constant at 1 business card per hour and just wear the drop in demand.

To summarize day 2:

Employment = E = 6 hours
Wages = W = 6
Consumption = C = 4
Investment = I = 0
Saving = S = 2
Kids’ Net Financial Assets = 4
Income = Y = C + S = 6
Parents’ Reserves = 4
Hoards = 2
Bonds = 2
Interest Owed (Next Day) = 0.1(2) = 0.2
Parents’ Expenditure = G = 6
Tax Revenue = T = 4

Budget Deficit = G – T = 2
Non-government Net Saving = S – I = 2

Parents’ Debt = Kids’ Net Financial Assets = 4

Day 3 under the Car Standard

At the beginning of the third day, the parents notice that they have 4 business cards in reserve out of the 6 on issue. They also realize that they owe 0.2 of a business card in interest on their loan, leaving 3.8 business cards with which to employ the kids. They think it may be possible to maintain full employment if Prudence is willing to lend them enough business cards.

They approach Prudence rather gingerly and say they have entered her interest payment of 0.2 in the spreadsheet, leaving them with 3.8 business cards in reserve. They then ask if she would mind lending them 2.2 business cards to maintain full employment. They say they’re sure they’ll be able to make good on all the loans and interest once the economy picks up.

Prudence wonders where all this is heading. Her parents seem to be getting into more debt just to cover their earlier debt. They seem to be a riskier investment than they were a day earlier. She agrees to lend the business cards, but downgrades their credit rating. She requires her parents to pay 25 percent interest on the new loan to allow for the greater risk she is taking.

The parents figure the extra interest charge is worthwhile to maintain full employment and price stability. They reluctantly agree to the terms of the loan and issue bonds in exchange for the funds.

The parents use their reserves of 3.8 business cards plus the borrowed 2.2 business cards to pay for 6 hours of employment.

Kenny is happy with the balance in his life and continues to spend what he earns. He works 3 hours and plays for 3 hours. Prudence likes how her financial wealth is growing and decides to take her saving strategy to the limit. She works 3 hours but opts to forego playtime altogether, saving all 3 business cards she earned from work around the house as well as the 0.2 she earned in interest.

To summarize day 3:

Employment = E = 6 hours
Wages = W = 6
Consumption = C = 3
Investment = I = 0
Saving = S = 3 (out of wages) + 0.2 (interest) = 3.2
Kids’ Net Financial Assets = 7.2
Income = Y = C + S = 6.2
Parents’ Reserves = 3
Hoards = 3
Bonds = 2 + 2.2 = 4.2
Interest Owed = 0.1(2) + 0.25(2.2) = 0.75
Parents’ Expenditure = G = 6 + 0.2 (interest) = 6.2
Tax Revenue = T = 3

Budget Deficit = G – T = 3.2
Non-government Net Saving = S – I = 3.2

Parents’ Debt = Kids’ Net Financial Assets = 7.2

Day 4 under the Car Standard

The parents are beginning to think they may have a problem. They have reserves of 3 business cards, but owe 0.75 in interest, leaving 2.25. To maintain full employment at the current wage rate they’ll need to borrow 3.75 business cards.

They approach Prudence to ask for the loan. In response, she says she’s been doing some calculations and the parents’ current course is unsustainable. She demands that her parents make budget cuts to demonstrate their capacity to bring household finances under control.

The parents complain, saying they want to maintain full employment, but Prudence insists that the household can’t afford full employment at current wages. Either the parents should cut employment levels or cut the wage rate. Prudence says she will lend her parents 1.75 business cards at a slightly increased daily interest rate of 28 4/7 percent provided the parents show some resolve and cut spending.

The parents agree to this and issue bonds in exchange for the funds. They now have 4 business cards (2.25 reserves and 1.75 borrowed) with which to employ the kids. They reflect for a moment on how best to use the business cards. They could maintain the current wage rate and cut employment, or they could cut the wage rate and possibly maintain full employment. They realize that if they cut the wage rate to 2/3, they can pay 4 business cards to get 6 hours of employment. On the face of it, this seems better for the parents than paying 4 business cards for 4 hours of employment. It means they’ll get more work done around the house.

The parents set the wage at 2/3 and ask the kids how much they want to work. Kenny is unhappy at this turn of events, but is not a union member, so reluctantly accepts the wage cut. He realizes that even if he works 3 hours, at current prices he will only be able to afford 2 hours of play. He asks if the parents are prepared to cut the price of play to 2/3 as well, to prevent a fall in his real living standards.

The parents are torn on this issue. On the one hand, they would like Kenny’s real living standards to be maintained. On the other hand, reducing the price of play violates price stability and would mean that the purchasing power of Prudence’s saved business cards would increase. For example, each hour of work Kenny has performed in the past has bought him 1 hour of playtime. But if the price of playtime is reduced to 2/3, Prudence’s saved business cards would each buy 1.5 hours of outdoor play, even though she only worked 1 hour to obtain them.

Mrs Thompson wonders aloud whether they should introduce a tax on saving but Prudence overhears and goes into a fit of rage, screaming something barely decipherable about theft. Besides, Mr Thompson was taught at Sunday School that thrift is a virtue. On balance, the parents decide to lower the price of playtime.

The parents use their reserves of 2.25 business cards and their 1.75 borrowed business cards to pay for 6 hours of labor at the new wage of 2/3.

Both kids choose to work 3 hours and earn 2 business cards. Kenny, as before, spends what he earns, playing for 3 hours.

Prudence is momentarily tempted by the new lower price of playtime but decides she will keep saving. She has noticed that falling wages mean that work today is paid better than work will be paid tomorrow. That means demand for playtime will be even weaker tomorrow than it is today. The longer she waits, the lower the price of playtime will be likely to fall, and the more hours of playtime she can buy thanks to her accumulated savings, which she earned while wages were still relatively high. Soon she’ll be able to retire and live off the interest.

She has also noticed that deflation makes the loans she made to her parents more profitable in real terms. The loan is denominated in nominal terms. Falling prices make the amount owed more valuable in real terms. For example, the interest payment of 0.75 she received at the beginning of the day only purchased 0.75 hours of play prior to the price change, whereas now it buys more than an hour of play. If she keeps waiting, maybe the price of play will fall even further. Plus, she has cottoned on to the fact that it is her saving that is causing the weak demand. It would be silly to stop now when before long she might own all the business cards in the entire household!

To summarize day 4 in nominal terms (unadjusted for the price level):

Employment = E = 6 hours
Wages = W = 4
Consumption = C = 2
Investment = I = 0
Saving = S = 2 (out of wages) + 0.75 (interest) = 2.75
Kids’ Net Financial Assets = 9.95
Income = Y = C + S = 4.75
Parents’ Reserves = 2
Hoards = 2
Bonds = 2 + 2.2 + 1.75 = 5.95
Interest Owed = 0.1(2) + 0.25(2.2) + 0.29(1.75) = 1.25
Parents’ Expenditure = G = 4.75
Tax Revenue = T = 2

Budget Deficit = BD = G – T = 2.75
Non-government Net Saving = S – I = 2.75

Parents’ Debt = Kids’ Net Financial Assets = 9.95

In nominal terms, the expenditure cuts have succeeded in reducing the budget deficit (from 3.2 the previous day down to 2.75). However, the price level has fallen from 1 to 2/3, so in real terms the budget deficit is BD/p = 4.125, which is larger than it was on day 3. In real terms, the parents’ (government’s) debt of 9.95 stands at 14.925. It has continued to increase despite the expenditure cuts.

Day 5 under the Car Standard

At the beginning of the day, the parents have 2 business cards in reserve. They pay interest of 1.25 business cards to Prudence and request a new loan. Prudence says she no longer considers her parents to be a sound credit risk, but she’ll lend them 1.25 business cards at an interest rate of 60% to reflect the tremendous risk she is taking. The parents feel they have little choice but to issue more bonds in exchange for the funds.

The parents use their 2 business cards (0.75 from reserves and 1.25 borrowed) to offer each kid 3 hours of work at a reduced wage of 1/3. Kenny and Prudence accept once they are assured that the price of playtime will likewise be reduced to p = 1/3.

While working in the hot sun, Kenny reflects on his plight. He realizes that by saving, Prudence has got herself into a position where she can take advantage of deflation. Soon she won’t have to work at all. He figures he should be saving more himself.

At the end of the work day, both kids opt to save their wages.

To summarize day 5 in nominal terms (unadjusted for the price level):

Employment = E = 6 hours
Wages = W = 2
Consumption = C = 0
Investment = I = 0
Saving = S = 2 (out of wages) + 1.25 (interest) = 3.25
Kids’ Net Financial Assets = 13.2
Income = Y = C + S = 3
Parents’ Reserves = 0
Hoards = 2
Bonds = 2 + 2.2 + 1.75 + 1.25 = 7.2
Interest Owed = 0.2 + 0.55 + 0.5 + 0.6(1.25) = 2
Parents’ Expenditure = G = 2 (wages) + 1.25 (int) = 3.25
Tax Revenue = T = 0

Budget Deficit = BD = G – T = 3.25
Non-government Net Saving = S – I = 3.25

Parents’ Debt = Kids’ Net Financial Assets = 13.2

Despite the spending cuts, the budget deficit has increased in nominal terms (from 2.75 to 3.25). Since the price level has fallen from 2/3 to 1/3, in real terms the budget deficit is BD/p = 9.75, compared to 4.125 the previous day. In real terms, the parents’ (government’s) debt of 13.2 stands at 39.6. It has escalated out of control despite the expenditure cuts.

Day 6 – The Car Standard Abandoned

The parents realize they have no business cards in reserve. They can’t even pay the 2 business cards they owe in interest payments. If they employ the kids, the entire wage bill along with the interest payment would need to be paid with borrowed business cards. The kids will no doubt demand steeper terms on the loan and even deeper spending cuts.

The parents consider their other options. They could purchase two new cars. That way, they would have 4 cars and, in accordance with the Car Standard, could issue an additional 6 business cards. Unfortunately, times are tough for Mr Thompson in his real-world day job due to real-world government cutbacks, so buying a couple of extra cars is not really affordable. Besides, with two cars already, there wouldn’t be much use for them other than to serve as a real basis for the household monetary system.

It seems borrowing from the kids is the only option, but on reflection, the parents don’t really want to keep doing that. Already they need to borrow the entire wage bill plus all interest owed. Continuing down this path would mean that before long the interest payment would exceed 6 business cards – the entire money supply – and the parents would have to default on the loan.

Even if the parents did want to borrow more, Prudence and Kenny would not agree to it. They have carried out their own back-of-the-envelope calculations and realize insolvency is inevitable.

Resigned to the situation, the parents figure all they can do is wait till the kids decide of their own volition to reduce their net saving. Maybe one day Prudence will finally consume some outdoor play. If she does, they’ll get some business cards back and will again be able to pay for much needed work around the house. In the meantime, real economic activity ceases.

The parents wonder how this could have happened. After all, there is an available labor supply (the kids), just no business cards with which to pay them. There are plenty of hours of playtime on offer, but no demand. The only thing preventing 6 hours of work and 6 hours of play each day seems to be the monetary system itself.

Mrs Thompson is beginning to suspect the root of their problems is the Car Standard. Why, for instance, should they have to keep their business card reserves in strict proportion to the number of cars they own? Granted, a car is a real thing, but what bearing does that have on whether and to what ends resources get utilized within the household economy?

Just when it seems things could not get any worse, Kenny and Prudence approach their parents in the living room. They say they’ve been doing some reading and it appears that, in accordance with the Car Standard, they are entitled to convert their 6 business cards into 2 family cars on demand. The parents are horrified. They point out that the kids are too young to drive cars. Prudence says they’ve considered that and decided they will lease the cars out to the parents in return for the parents doing work around the house.

This is the final straw for Mr Thompson. His faith in commodity-backed money has been tested to the limit and found wanting. He announces that the household monetary system is officially dissolved.

Mrs Thompson is relieved, but the kids are taken aback and disillusioned. Feeling responsible, Mr Thompson decides to make amends. He offers the kids lollypops and a day at Sea World. The kids accept.

Fiat Money: Business Cards

Mr and Mrs Thompson are relieved to have come out of the whole Car Standard experience still alive and with free access to the family cars, but they continue to have a problem. A couple of weeks have gone by since the day out at Sea World and no work has been done around the house. The place is unkempt.

While browsing the internet, Mrs Thompson stumbles upon some internet posts (here, here and here) describing a family that uses a monetary system similar to the one the Thompsons had used prior to the collapse of their household economy. There only seems to be one difference. Apparently, the parents of this family simply alter the number of business cards on issue as they see fit without any regard to the number of cars in the garage.

The way it works is simple. Whenever the parents want to spend, they just issue the necessary amount of business cards (parents’ spending creates money). Whenever the kids pay tax, it takes some business cards out of circulation (taxes destroy money).

Mrs Thompson explains the idea to her husband who is by now desperate enough to try anything. He’s skeptical, but decides to give it a shot.

He does ask how they can possibly maintain price stability without a Car Standard. Mrs Thompson explains that it all comes down to issuing just the right amount of business cards. Apparently the trick is to issue enough business cards to maintain full employment and accommodate the kids’ net saving plans, but never any more than this.

Mrs Thompson calls in the kids, who by now are frustrated at being permanently confined indoors with no means of purchasing outdoor play.

Day 1 with Fiat Money

Mrs Thompson announces to the kids that they are reintroducing business cards (money) into the household economy but that there will no longer be a Car Standard. The parents will simply issue business cards as they see fit.

Prudence is suspicious until her parents assure her that saving will still be allowed under the new system. Kenny is just happy that he’ll soon be able to play outdoors again.

The parents announce that the wage rate and price (toll) of outdoor play have both been reset to 1 business card per hour and that the income tax rate will remain at zero unless economic activity requires stabilization.

Kenny and Prudence choose to work 3 hours each. The parents pay their wages by issuing 6 business cards.

Kenny, trusting that his parents will keep their promise on wage and price stability, spends all his wages to pay for 3 hours of outdoor play. Prudence, as is her way, prefers to spend 1 business card and save 2. She gets to play 1 hour on the first day and still has 2 business cards that she can spend in the future.

Overall, the parents have created more business cards through spending (6) than have been destroyed through tax (toll) payments (4). The net injection of business cards is 2, which facilitates the kids’ net saving behavior alongside full employment.

The kids’ net saving behavior results in some reserves building up in the spreadsheet. Even though the parents haven’t had to borrow in order to net spend, Mr Thompson has read in the newspaper that the real-world government in his country issues bonds (government debt) in exchange for reserves, which drains the reserves from the system. He has read that the government, through its agent the central bank, pays interest on the bonds at a rate the central bank considers appropriate. Acting as the central banker of the household economy, Mr Thompson unilaterally sets the daily interest rate at 0 percent. (The parents actually have no reason to care if the kids choose not to save, and hence no incentive other than an ideological one to set a positive rate of interest. Since the choice of interest rate doesn’t actually change anything important for present purposes, a zero rate has been assumed for simplicity.)

Notice that whereas under the Car Standard the parents were at the mercy of their kids when it came to setting the terms of loans, with fiat money the parents have no real need to “borrow” at all and if they do issue bonds, they are in a position to completely dictate terms. They have the capacity to spend irrespective of any bonds they might choose to issue. The kids may be unhappy with the interest rate offered on bonds, but there is not much they can do about it. If they refuse to purchase the bonds, their savings will simply mount in the form of reserves rather than bonds. If they decide to stop saving “in protest”, this is no concern at all for the parents. It would simply mean they could maintain full employment with a smaller budget deficit, or even a balanced budget or budget surplus. Under the Car Standard, the government was at the mercy of the kids. With fiat money, the parents are in complete control.

To summarize day 1:

Employment = E = 6 hours
Wages = W = 6
Consumption = C = 4
Investment = I = 0
Saving = S = 2
Kids’ Net Financial Assets = 2
Income = Y = C + S = 6
Parents’ Expenditure = G = 6
Tax Revenue = T = 4
Bonds = Parents’ Debt = 2
Interest Owed Next Day = 0(2) = 0

Budget Deficit = G – T = 2
Non-government Net Saving = S – I = 2

Parents’ Debt = Kids’ Net Financial Assets = Accumulated Budget Deficits = 2

Day 2 with Fiat Money

The parents issue 6 new business cards: 6 as wages to employ the kids for 6 hours and 0 to pay interest on bonds. This is the amount that seems just necessary to maintain full employment given the kids’ current saving behavior.

Kenny decides to spend all his wages (3 business cards) on playtime. Prudence, however, decides to save all her wages and forego playtime altogether. She now has accumulated 5 business cards (2 on the first day and 3 on the second).

To summarize day 2:

Employment = E = 6 hours
Wages = W = 6
Consumption = C = 3
Investment = I = 0
Saving = S = 3
Kids’ Net Financial Assets = 5
Income = Y = C + S = 6
Parents’ Expenditure = G = 6
Tax Revenue = T = 3
Bonds = Parents’ Debt = 5
Interest Owed Next Day = 0(5) = 0

Budget Deficit = G – T = 3
Non-government Net Saving = S – I = 3

Parents’ Debt = Kids’ Net Financial Assets = 5

The budget deficit has increased to 3, the mirror image of non-government net saving, and was necessary to maintain full employment along with price stability. Since the wage and price level have remained the same, the real wage, w/p, is stable and there is no change in real living standards. This is in contrast to the Car Standard, where saving resulted in either unemployment or deflation once a section of the non-government sector (the creditors) began to make demands for cutbacks and austerity measures.

At some point Prudence may want to take time off work while still purchasing playtime (by running down her savings). If and when she does, there will be some temporary reduction in employment levels. But because wages and prices are stable, she will only be able to buy the same amount of playtime with her saved business cards as she could have purchased on the day she earned them. Alternatively, Prudence may opt to run down her savings without any reduction in work hours by consuming more than 3 hours of outdoor play in a day. This will not cause price pressures provided more output (in this case summer daylight hours) can be supplied at the going price. If Prudence increased her demand to such a great extent that it hit up against this real limit to the supply of outdoor play, it would be necessary to increase income tax (above its current rate of zero) to withdraw some of the kids’ demand for play that day. This would be necessary to prevent inflation.

As a parable of the monetary economy we live in, however, it is more likely that Prudence will seek to lend out business cards to Kenny at interest rather than spend beyond the potential supply of outdoor play. Her lending behavior will be conditioned by Kenny’s capacity to repay such loans. Prudence is transforming herself into a rentier within the kids (non-government) sector, whereas Kenny is playing the part of a worker in that sector. Whether the parents wish to allow this transformation will depend on their ideology. They could prevent it by taxing away most saved income (and interest income). Alternatively, they can allow the creditor-debtor relationship to develop between the kids and simply net spend to the extent necessary to keep Kenny fully employed at the stable real wage w/p.

In either case, by setting the budget deficit equal to the amount just necessary to maintain full employment given the kids’ net saving intentions, the parents ensure both full employment and price stability.

Day 3 with Fiat Money

To maintain total employment at 6 hours, the parents once again issue 6 new business cards in wage payments. If they had chosen to set a positive interest rate on bonds, they would also issue the amount necessary to meet this obligation.

Kenny feels his life is pretty nicely balanced and sticks to working 3 hours and playing 3 hours, again opting not to save.

Prudence feels like having some fun for a change. She decides to take advantage of her past savings by arranging for some friends to come around for an extended get-together after work. She puts in 3 hours of work but purchases 5 hours of playtime by running down her savings by 2. It’s summer time, so there are more than enough hours in the day to enable the parents to supply the demanded outdoor play at the current price.

To summarize day 3:

Employment = E = 6 hours
Wages = W = 6
Consumption = C = 8
Investment = I = 0
Saving = S = -2 (dissaving)
Kids’ Net Financial Assets = 3
Income = Y = C + S = 6
Parents’ Expenditure = G = 6
Tax Revenue = T = 8
Bonds = Parents’ Debt = 3
Interest Owed Next Day = 0(3) = 0

Budget Deficit = G – T = -2
Non-government Net Saving = S – I = -2

Parents’ Debt = Kids’ Net Financial Assets = 3

The parents’ budget is in surplus due to the dissaving of the kids on day 3.

By allowing the budget balance to move to just the right level to maintain full employment, the parents ensure that as much work as possible is done around the house over the summer holidays and that the kids can always earn as much playtime as the parents deem appropriate. By making sure the budget deficit never exceeds this amount, there is no upward pressure on the price of outdoor play.

If the parents become unhappy over time with the kids’ saving behavior, they can seek to encourage or discourage them from saving through appropriate use of tax policy – i.e. by taxing work and play differently or introducing a tax on savings or interest income.

Day 4 with Fiat Money

The parents issue 6 business cards to pay wages to maintain full employment.

Kenny wants to buy 5 hours of outdoor play to have an extended get-together with his friends like Prudence did, but the parents’ labor law prevents him from working more than 3 hours in a given day and he hasn’t accumulated any savings.

He approaches Prudence and asks if he can borrow 2 business cards. She says yes provided he pays her back 3 business cards tomorrow, a daily interest rate of 50 per cent.

Kenny realizes he can do this at the current wage rate provided he works as normal tomorrow and foregoes outdoor play. He’s keen to have his friends over, so agrees to his sister’s conditions.

Prudence chooses to work 3 hours, play 2 hours and save 1 business card, figuring her financial wealth will still accumulate at a good rate thanks to the interest return on her loan to Kenny owed the next day.

To summarize day 4:

Employment = E = 6 hours
Wages = W = 6
Consumption = C = 7
Investment = I = 0
Kenny’s Saving = -2
Prudence’s Saving = 1
Saving = S = -1
Kids’ Net Financial Assets = 2
Income = Y = C + S = 6
Parents’ Expenditure = G = 6
Tax Revenue = T = 7
Bonds = Parents’ Debt = 2
Interest Owed Next Day = 0(2) = 0

Budget Deficit = G – T = -1
Non-government Net Saving = S – I = -1

Parents’ Debt = Kids’ Net Financial Assets = 2

Day 5 with Fiat Money – Austerity Drive

Although the parents have managed to maintain full employment and price stability, Mr Thompson has been reading in the newspaper that governments around the world are bringing in austerity measures to get their crippling debt burdens under control. He tells his wife that its time they tightened their belts. Mrs Thompson is annoyed, saying it will merely lead to the same problems they experienced under the old Car Standard, but Mr Thompson puts his faith in credible news services and won’t hear of any opposition to his new fiscally responsible position. Mrs Thompson senses her husband will just have to learn the lesson for himself.

Mr Thompson announces to the kids that to eliminate the parents’ debt, he needs to cut expenditure by 2. This means he can only offer each kid 2 hours of work, which reduces total employment to 4 hours and creates 2 hours of unemployment.

The kids both choose to work 2 hours and are paid 2 business cards each. Kenny owes 3 business cards to Prudence to pay back his loan from the previous day but because of the cut in employment he can’t make his repayment. He pays back his wages of 2 business cards and says he’ll have to make up the difference later.

Prudence is annoyed because the cuts to employment and Kenny’s partial loan default have meant she has failed to reach her savings target. She responds by saving her whole day’s pay of 2 business cards in addition to Kenny’s partial loan repayment.

To summarize day 5:

Employment = E = 4 hours
Unemployment = UE = 2 hours
Wages = W = 4
Consumption = C = 0
Investment = I = 0
Kenny’s Saving = 0
Prudence’s Saving = 2 (wages) + 2 (loan repayment) = 4
Saving = S = 4
Kids’ Net Financial Assets = 6
Income = Y = C + S = 4
Parents’ Expenditure = G = 4
Tax Revenue = T = 0
Bonds = Parents’ Debt = 6
Interest Owed Next Day = 0(6) = 0

Budget Deficit = G – T = 4
Non-government Net Saving = S – I = 4

Parents’ Debt = Kids’ Net Financial Assets = 6

Mr Thompson is appalled. Despite his brave attempts to increase the budget surplus and eliminate the parents’ debt, the budget has actually gone from surplus into deficit and the parents’ (government’s) debt has exploded to 6.

Mr Thompson’s austerity measures have not only caused unemployment but also created a need within the kids (non-government) sector to deleverage and pay off debt, which is impacting negatively on demand for outdoor play. Kenny who had intended to abstain from outdoor play today and then revert to normal consumption levels tomorrow now realizes he will also have to reduce demand tomorrow in order to meet the remainder of his debt obligation to Prudence. If the parents had instead maintained full employment, he would not have got himself into debt stress and tax revenues would not be threatened to the same extent.

At the same time, Prudence’s saving plans were frustrated both by the cut to employment opportunities and Kenny’s inability to meet his debt obligation. As a result, she has redoubled her effort to save, exacerbating the negative impact on the parents’ tax revenue.

In real terms, all Mr Thompson’s austerity drive has succeeded in doing is to reduce the amount of work done around the house and unnecessarily limit the kids’ access to pleasurable outdoor play.

Day 6 with Fiat Money – Austerity on Steroids

Mr Thompson doesn’t see things this way. He wakes in a cold sweat and is not thinking clearly. He figures he will have to eliminate the parents’ burdensome debt once and for all by slashing the parents’ spending by 6. He wakes his wife and kids and announces that it is no longer affordable to employ anyone. Employment drops to zero.

With no employment, Kenny realizes he won’t be able to purchase any outdoor play because he has no savings. He asks Prudence for a new loan, but she considers him a bad credit risk. He has no employment prospects and no way to pay her back. He asks for a job cleaning her room, but Prudence doesn’t want to eat in to her own savings given that her ability to accumulate financial wealth for the rest of the summer has been severely curtailed by her own loss of employment. For the same reason, Prudence is reluctant to spend any business cards on outdoor play. If she spends business cards now, she won’t have many left for the future, and there is no way to earn more in the current employment environment other than through interest on her savings. The zero rate of interest on bonds means even this avenue to income is blocked.

To summarize day 6:

Employment = E = 0 hours
Unemployment = UE = 6 hours
Wages = W = 0
Consumption = C = 0
Investment = I = 0
Saving = S = 0
Kids’ Net Financial Assets = 6
Income = Y = C + S = 0
Parents’ Expenditure = G = 0
Tax Revenue = T = 0
Bonds = Parents’ Debt = 6
Interest Owed Next Day = 0(6) = 0

Budget Deficit = G – T = 0
Non-government Net Saving = S – I = 0

Parents’ Debt = Kids’ Net Financial Assets = 6

Mr Thompson can’t believe it. Despite cutting expenditure to the bone and balancing the budget, the parents’ debt has not budged.

Day 7 with Fiat Money – Sanity Prevails

Mrs Thompson can see that her husband is going about things the wrong way. Their ultimate aim is not to eliminate the kids’ net financial assets (parents’ debt) but to ensure work gets done around the house and the kids get some leisure time outdoors. Austerity measures have brought no reduction in the parents’ debt and a catastrophic reduction in actual productive activity around the house.

Mrs Thompson tells Mr Thompson to have a lie down while she takes care of matters. She calls in the kids and announces a wage of 1 business card per hour and recommits to maintaining the current wage level, price level and full employment. The kids agree to work 3 hours each.

Kenny’s keen to return to his old, balanced routine of 3 hours of work and 3 hours of outdoor play, but first he needs to pay off his debt to Prudence. He works for 3 hours, earning 3 business cards. He uses 1 of them to pay back Prudence in full, who has agreed to give him an extension on the loan at no extra interest charge, and purchases 2 hours of outdoor play with the remainder.

Prudence purchases 2 hours of play and saves 1 business card. In addition to Kenny’s loan repayment, this allows her to save 2 business cards. She is happy to be getting her wealth accumulation back on track.

To summarize day 7:

Employment = E = 6 hours
Unemployment = UE = 0 hours
Wages = W = 6
Consumption = C = 4
Investment = I = 0
Saving = S = 2
Kids’ Net Financial Assets = 8
Income = Y = C + S = 6
Parents’ Expenditure = G = 6
Tax Revenue = T = 4
Bonds = Parents’ Debt = 8
Interest Owed Next Day = 0(8) = 0

Budget Deficit = G – T = 2
Non-government Net Saving = S – I = 2

Parents’ Debt = Kids’ Net Financial Assets = 8

Mrs Thompson ponders the day’s outcome with satisfaction. Full employment has been restored, ensuring 6 hours of work was carried out around the house, and price stability has been maintained. Sure, the parents’ (government’s) debt has increased, but what is this debt? It is simply entries in a spreadsheet. Paying it back, if this is ever called for, will require only new entries in the spreadsheet. However, why would it ever need to be paid back? The parents’ debt is the kids’ net financial assets. Unless the kids decide that they want to eliminate their net financial wealth, the parents’ debt will never need to be repaid.

In the present parable, the kids will be likely to want to run down their net financial assets eventually, because their time horizons (focused on the summer holidays) are finite. In the real-world economy, this is not the case, because the non-government sector of one generation typically passes on its net financial wealth to the next generation. However, even in the present parable, the kids running down their net financial wealth does not cause inflation provided there can be a sufficient output response at current prices. In terms of the parable, the supply of daylight hours is perfectly elastic up until nightfall. The parents can sell more outdoor play each day if it is demanded without altering its price. Inflationary pressures would only emerge if Prudence happened to leave her efforts to consume her net wealth until so late in the holiday period that it was impossible to purchase all the hours she had saved up for at current prices. In that case, the parents would indeed need to increase the income tax rate or impose a tax on saving or interest income. But they would only need to do this for as long as demand exceeded the supply limit (daylight hours). Alternatively, the parents could allow the savings to carry over to future summer holiday periods, expanding the supply of outdoor play in that way.

This aspect of the parable is representative of developed economies in which the two dominant sectors are manufacturing and services. In these sectors, firms typically operate with a degree of planned excess capacity. This enables them to respond to positive demand fluctuations by increasing output at current prices. There is a competitive imperative for them to do this. If they can’t, they risk losing market share to firms who can. This feature of manufacturing and services sectors gives developed economies a considerable degree of supply elasticity.

In reflecting on the family’s experiences under the fiat-money system, Mrs Thompson comes to recognize the obvious. Since the parents’ debt is not really debt at all, there is no need for the parents to issue debt (bonds). They could simply allow reserves to mount in the spreadsheet by entering the appropriate numbers. Allowing savings to build in the form of reserves will not be inflationary any more than allowing savings in the form of bonds. Either way, inflation won’t emerge unless the kids attempt to consume too much of their net financial wealth all at once. Even if they do choose to spend their wealth too rapidly for the real economy to absorb at current prices (by demanding too much outdoor play in a single day), the parents’ can simply raise taxes. The higher taxes would not in any sense fund the parents’ net expenditure. They would simply prevent inflation (maintain stability of the price of outdoor play). In any case, whether savings are held as reserves or bonds does not affect these considerations one iota.

Mrs Thompson calls in her husband and kids and makes an announcement. She explains that in the spreadsheet containing daily summaries of economic activity she has replaced the entry for “Bonds” with an entry for “Reserves”. In addition, the entry for “Parents’ Debt” has been deleted altogether, defined out of existence.

For the rest of the summer the parents simply issue enough business cards each morning to ensure the kids can obtain all the work they want at the going wage of 1 (full employment is maintained) and then monitor demand and tax levels to ensure the price of play remains stable (neither inflation nor deflation). The budget balance oscillates from one day to the next. Since there is full employment and price stability, nobody gives it a second thought.

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4 thoughts on “Parable of a Monetary Economy

  1. Talking around the subject a little bit, we’re seeing austerity and tax protests in Greece, Ireland and now the UK – where next? It’s not like the economic situation will be improving very soon. What’s needed is encouraging growth, not cut it off at the knees.

  2. I agree, Steve. Austerity will be highly destructive, and already has been in some of the peripheral EMU nations. The last thing needed right now.

  3. What a wonderfully constructed parable! Very creative! I notice I am 3 years late in reading and commenting, but such is the internet.

    What I find most fascination about this story, is how it reveals (inevitably?) a particular view of the relationship between government and people. The parents, who make the rules, represent the government, and the children are the electorate (oops, I mean the subjects). The parents issue currency, and set arbitrarily prices, maximum working hours, wages and interest rates. The only goods that are demanded are the hours of playtime, which are fully “owned” by the parents, with a zero production cost.

    The superiority of a fiat currency is a given, under a government that controls the people. Of course the parents can run up an infinite debt without consequence, when the “product” they sell has zero production cost, and the “customers” have no choice but to buy it from them. If a real government were able to tax the air we breathe, they too could do whatever they like!

    I suppose the foundation of any economic analysis is always going to be a philosophical one. And philosophically, I find one that is based on government needs (getting work done around the house), and where the people are a means to fulfilling those needs, very disturbing.

    I prefer an analysis to start out with *my* needs, and how the system can be made to work in *my* interests. I appreciate that in order for such a system to flourish, it must equally accomodate the needs of my fellow citizens, but any system that presumes that individuals are there to serve the common good, is not one to which I can subscribe.

    I was also a bit amused at your passing shot about the evil of unions being that they distort markets and wages. While that criticism is undoubtedly true, the main reason that unions and cartels are bad, is that differerent individuals have different marginal utilities. A union or a cartel prevents two parties from trading voluntarily at a price that suits them individually. That’s why free-market capitalism is so insistent that the market be competitive.

  4. The significance of the kids being the non-government and the parents being the government should not be overplayed, because in the real world the government is meant to be the people’s agent. So, in principle, the people have ultimate authority. But in the present context, the analogy is appropriate because it is the government’s authority to enforce the tax obligation that is relevant.

    You say you want the analysis to start with your needs and your interests. There is nothing stopping you from creating your own currency in which you are the ‘parent’ and others are the ‘kids’. Your problem will be getting your currency widely accepted.

    MMT in Simple Parables

    The idea of taxes underpinning a demand for the currency has a long history in economic thought, dating back at least to Adam Smith:

    More on Cranks at the Financial Times

    The kids can pay each other for various services or transact in any way they want provided they adhere to the labor law (3 hours each of employment on any given day). I mentioned at one point, for example, that Prudence could pay Kenny to tidy her room. But, equally, she could pay him to make something for her, or whatever. The only restriction is that it doesn’t cause either kid’s labor time to exceed 3 hours in a day.

    Note that there is no compulsion on the kids in the parable to work for the parents more than they desire outdoor playtime, because the tax is in the form of a toll. The kids are free to conduct most activity within the kids sector, transacting among themselves.

    There is nothing either “big government” or “small government” about the economy depicted. The economy can be as dominated by the kids sector as the kids desire.

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