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Credit Expansion

In the previous two posts I tried to explain how currency, credit and banking come about organically in a free-market economy.  This post deals with the expansion of credit in such an economy.  This should help one better understand the relationship between the quantity of credit in circulation, velocity, and interest rates.  Next, I will delve into the role banks would naturally play in this process.

Credit Expansion

When the butcher and the baker use credit to trade, it is important that they sell as much as they buy. It is not necessary that they issue notes less than or equal to the amount of gold they have on hand. (Recall that we can have credit without having money at all.) The logic behind this is fairly simple. If the butcher issues 100 oz. worth of gold-notes but only has 50 oz. of gold, it is possible that these notes could come back to him for gold and he would have a problem. But if he is also producing meat worth 50 oz. of gold, he can sell the meat to cover the difference. If he produces 100 oz. worth of meat he can issue 150 oz. of notes and if he produces 1000 oz. of meat, he can issue 1050 oz. worth of notes before he has a problem. This, of course, assumes that he is always able to sell his goods at a certain market price. If this is not the case, he could run into trouble but I will deal with this possibility in more detail later on.

To see what I mean, consider an example. Taking the market prices for granted, assume that the butcher, the baker and the candlestick maker each have 100 oz. of gold and each produce 150 oz. of goods. Furthermore, assume that at the market prices, each prefers to consume 1/3 of their income in the form of each good (meat, bread and candlesticks). So trading directly with gold, we would see the following transactions:

1. The butcher buys 50 oz. worth of bread from the baker and 50 oz. worth of candlesticks from the candlestick maker.
2. The baker buys 50 oz. worth of candlesticks from the candlestick maker and 50 oz. of meat from the butcher.
3. The candlestick maker buys 50 oz. worth of meat from the butcher and 50 oz. of bread from the baker.

After all of this, each ends up with the same amount of gold as they started with (100 oz.) and all have the desired amount of each good. Now we can define the quantities of each good so that the price level is 1 oz./unit each and calculate the velocity of money to be 1 (this is accounting only for the goods which were transacted not the goods retained by their producers). This means that each oz. of gold, on average, changes hands 1 time.

Now consider what must happen if each person produces twice as much of their good but the price level stays the same.

1. The butcher buys 100 oz. worth of bread from the baker.
2. The baker buys 100 oz. of candlesticks from the candlestick maker.
3. The candlestick maker buys 100 oz. of meat from the butcher.
4. The baker buys 100 oz. of meat from the butcher.
5. The butcher buys 100 oz. of candlesticks from the candlestick maker.
6. The candlestick maker buys 100 oz. of bread from the baker.

Again, they all end up with the same amount of gold and the desired quantities of each good. But this time each ounce of gold had to change hands twice. The velocity increased. If the velocity can increase infinitely, it is possible for a fixed quantity of money (gold) to execute any amount of trade at a fixed price level. However, it becomes increasingly inconvenient as the velocity increases. To see what I mean consider one more example in which each person produces 3000 oz. worth of each good.

1. The butcher buys 100 oz. worth of bread from the baker.
2. The baker buys 100 oz. of candlesticks from the candlestick maker.
3. The candlestick maker buys 100 oz. of meat from the butcher.
4. The baker buys 100 oz. of meat from the butcher.
5. The butcher buys 100 oz. of candlesticks from the candlestick maker.
6. The candlestick maker buys 100 oz. of bread from the baker.
7. The butcher buys 100 oz. worth of bread from the baker.
8. The baker buys 100 oz. of candlesticks from the candlestick maker.
9. The candlestick maker buys 100 oz. of meat from the butcher.
10. The baker buys 100 oz. of meat from the butcher.
11. The butcher buys 100 oz. of candlesticks from the candlestick maker.
12. The candlestick maker buys 100 oz. of bread from the baker.
13. The butcher buys 100 oz. worth of bread from the baker.
14. ……

In order to transact the 6000 oz. worth of goods which they desire to trade, this list would continue until 60 transactions had been carried out causing each oz. of gold to change hands 20 times. Now consider the same situation in which the market participants trade in credit denominated in gold.

1. The butcher creates 1000 oz. worth of gold notes and uses them to buy bread from the baker.
2. The baker trades the notes from the butcher to the candlestick maker for 1000 oz. worth of candlesticks.
3. The candlestick maker trades the notes back to the butcher for 1000 oz. worth of meat.
4. The candlestick maker creates 1000 oz. worth of gold notes and trades them to the baker for 1000 oz. worth of bread.
5. The baker trades the candlestick maker’s notes to the butcher for 1000 oz. worth of meat.
6. The butcher trades the notes back to the candlestick maker for 1000 oz. worth of candlesticks.

Again, everyone ends up with the same amount of gold and the desired quantities of all goods but the use of credit allows them to carry out the transactions in the times and amounts which they find most convenient without being constrained by the quantity of gold in the economy. Note that the butcher and the candlestick maker both issue more credit than they have gold but not more than they have total wealth. Also note that, again assuming that everyone trusts everyone else and nobody violates this trust by issuing too many notes, it doesn’t matter who initially creates the credit. I could have had any of them create any quantity up to 2000 oz. worth of notes and done the transactions in any order.

Calculating the velocity is now no longer a matter of calculating how many times the average oz. of gold changes hands, since no gold changed hands at all, but calculating the average number of times that each gold note changed hands. Since the quantity of gold notes in circulation was 2000, and 6000 oz. worth of goods were traded, the velocity of these notes was 3. However, notice that They did not need to create exactly this amount of credit, they could have created less and used more transactions.

Credit, prices and velocity

In the above example, the price level is held constant. This, of course, is not likely to be the case when total output of other goods increases relative to the stock of gold. Recall that the price of gold is determined by the long-run demand for gold in consumption along with the premium φ, which gold carries due to its use as a store of wealth and medium of exchange. When the quantities of other goods increase relative to the quantity of gold, the demand for gold in consumption will likely increase which would tend to raise the price of gold in terms of other goods (lowering the price level of other goods). However, it is unlikely that this change in the price of gold will be one-for-one with the increase in the quantity of other goods.

If this were the case, then if output doubled, the price level would fall by ½ and velocity would remain unchanged. However, if output doubles and the effect on the price of gold from increased demand for consumption is less than double, then, if all trade is carried out using gold directly, velocity will have to increase. This increase in velocity will increase the premium gold carries for use as a store of value and medium of exchange. This will raise the price of gold further, mitigating the increase in φ but will result in a lower price level (but greater than ½ of the original price level), higher velocity and higher φ.

In essence, what is happening here is that the limited stock of gold is being allocated by the market in the most efficient way between competing uses: consumption today, consumption in the future, storing value and carrying out transactions. But credit works as a substitute for gold in storing wealth and transacting. This relaxes the constraint on the price of gold due to these uses. Since credit can be expanded indefinitely along with output, it allows people to store more wealth and carry out more trade without using gold and this allows the velocity of credit in the economy and the corresponding premium φ to be decoupled from the price of gold.

In an economy with credit, the price of gold would reflect more purely, the relationship between its own long-run supply and demand. If credit were a perfect substitute for gold and anyone could create credit costlessly, then φ would be zero, there would be no premium for holding gold compared to other assets and the price of gold would be determined in exactly the same way as any other durable non-renewable commodity. Of course, this is not likely to be the case since holding someone’s gold notes is likely to be considered somewhat more risky than holding the metal itself and so there will still be some premium associated with it. However, the ability for credit to expand along with the economy adds an additional degree of freedom in the market and acts as a buffer between changes in output and changes in velocity.

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  1. January 31, 2014 at 12:52 am
  2. February 19, 2014 at 3:06 am
  3. March 12, 2014 at 12:26 am

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