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Virtual money, descriptive explanation

If the short description of the concept of virtual money is not enough for you, here is a more descriptive explanation (with illustrative pictures).

Let’s start from the beginning i.e. from the Say’s Law (Jean Baptiste Say was the French economists from the beginning of XIXth century). According to this law:

The total amount of money in economy will be always equal to the total amount of goods and services sold. In other words: "Supply creates its own demand" - all money people have earned will be spent for manufactured goods and services, even treasured money (i.e. saved for future) will be eventually spent. Therefore the aggregate supply will be always equal the aggregate demand. So, in a free market economy will be no such phenomena like: oversupply, underconsumption, overproduction...

Here is the graphical illustration of this law (probably the first illustration in every Macroeconomics book):

There is a closed circulation of money and goods in the country economy:
Circulation of money, goods and means of production in economy
Consumers (households) are earning money selling means of production they have (i.e. labour, capital) and spend whole money on goods and serviced sold by firms. Firms are earning money from selling production, and spending the whole income on means of production.

There are two problems wits Say’s law:

  • First, it must have some flaw, because we can for time to time observe overproduction, underconsumption, inflation and other examples of situations, when supply of goods do not equals with supply of money.
  • Second, all contradctory explanations (like for example explanation given by Keynes) are very weak and are not explaining what is wrong with Say’s law.

So, If we want to understand economic crises, we first have to understand why Say's law is not true.
Let’s add the time to our schema of money circulation in economy:

Circulation of money in economy with timeline taken into account
Circulation of money in economy with time taken into account  
This schema of circulation looks better, because this time the stream of money doesn’t look like snake eating his own tail. We can see that the money does not have a quantum nature, and could not be present in two places the same time. Money paid by firms (and spent by households) doesn’t come from nowhere, but have to be earned in antecedent period and the same is true for money spent by firms - they have to be earned before they are spent (even if that mean only one or two seconds before). Still everything is okay - the supply equals the demand. But the economy is stagnated - there is no economic growth at all. Leett see what will happen, if we have economic growth:

Circulation of money in economy with timeline and economic growth
Role of the virtual money for the economic growth
This time the country’s national product (ex. gross national product, GNP) increases - this is represented by increasing sizes of Households and Firms squares.
But the volume of money earned in antecedent period (blue arrows) is too small to buy all the goods and services produced in next period. Without some extra money, economic growth will be damped down by the undersupply of money.
So, the extra money are needed (marked with red arrows). Money that was not earned in antecedent period, and are taken from nowhere - the virtual money

The virtual money are really a kind of magic trick (or accountancy trick). They have no real value, they was not earned by selling some real good or service - simply someone spends more money than he (or she or institution) really has. Publicity (other market players) accepts this extra spendings because they believe that a player (I will call him debtor), who offers virtual money is solvent. To be more precise: they believe that the future growth of income will allow debtor to repay the debt (i.e. repay virtual money).

So, the virtual money is really the debt or the money borrowed from the future. And have value only when we have economic growth. If the rate of growth is not as high as the publicity (and debtors) expected, the virtual money will became worthless.

Virtual money can be created using any kind of money:

  • Can be created in bank, when the bank lends more money than have deposits.
  • Can be created by the government, when government prints some fiat money or “paper money”.
  • Can be created by monarch, when he mints coins that have smaller percentage of precious metals than the monarch states.
  • Can be created by a corporation, when firm sells bonds or stocks.
  • Can be created by the government selling government bonds.
  • Can be created by households (ordinary people), when they make debts using credit cards, or borrow money from banks, or take mortgage credit.
  • Can be created by the government, when government revaluates national currency to make easier borrowing money from abroad (and then repaying external debt).

etc.

Virtual money is only the small part of a particular “kind of money” inside which virtual money was created (small part of fiat money, small part of coin value, or stocks value). But when the crisis comes and the publicity loses belief in virtual money, the whole kind of money loses its value - its price falls. So, we can observe a spectacular fall on market (an effect of the collapse of value):

  • People go to the bank to take their money away and the bank bankrupts.
  • Price of fiat money falls and high inflation (or even hyper-inflation) starts.
  • We can observe a rapid fall on the stock market.
  • The national currency rapidly depreciates.

To recapitulate:

1. There will be no economic growth without some reasonable amount of virtual money - i.e. without some economic stimulation.

2. Generally the reason for crisis is almost always the previous growth. Or to be more precise, some unexpected change in economic environment that slows down the rate of economic growth (or starts the recession) and thus causes problems with repaying debts taken in antecedent periods. There are many possible reasons for this kind of changes in the economic environment:

  • Some natural disaster
  • Political changes in neighbouring state
  • Change of economic policy in neighbouring state
  • Important shift of trade routes
  • Some changes in size of neighbouring economies or volumes and directions of market flows (the South-Asia crisis of 1997 is a good example here)

Of course, some times (especially in ancient times) great natural disasters like flood, plague, or drought could be only one reason for crisis, and these times we don’t need the concept of virtual money to explain the crisis.

To simplify the whole pattern you should know that, generally speaking, there are three most important ways to create virtual money:

  1. Expansive fiscal policy of government - when economy is government-stimulated.
  2. Expansive actions of private firms and financial institutions - when free market (laissez-faire economy) dominates.
  3. Too highly revaluated national currency (or “over-valued”) - when the poor country borrows money from abroad. 

But of course there are a hundred and one ways to create virtual money. Recalling the first picture presented here - we can complicate it a little, and add a few more players:

Money circulation in economy, advanced schema
Money circullation with some extra players added
We have added the government, financial institutions (banks, stock market, etc.) and the abroad. And marked the money flows between all players. Virtual money can be created on any of these flows: ex. between financial institutions and households (like credit cards). And we can still add more players. Moreover, economy could be concurrently stimulated with two or more types of virtual money. I hope this picture clarifies, why the reasons for economic crises are so complicated.

Three elements that wasn’t mentioned here

1. First there are other methods to create additional supply of money without using the virtual money.

If you recall the Fischer’s Equation of Money, which states that the price level in economy and the velocity of money are also important factors for the money supply:

The Fischer’s Equation of Money:

P × Q = M × V

where:
P = the current price level (the implicit price deflator of GNP)
Q = the current level of output (real GNP)
M  = the current money supply
V = the velocity of money (the number of times each banknote or coin is spent each year)

You can easy notice that the higher velocity of money circulation also increases the money supply. This was the reason for inventing: the credit, coins, banks, paper money, stock market, derivates, internet transactions, etc.

2. Second - I skipped here the diffusion of wealth from richer countries to poorer ones. This diffusion is one of the most important reasons for economic crises and economic growth.

3. Third - one of consequences of the virtual money is that no one economic equation is absolutely true, because most equations describe the static economy only.


Warsaw, 3 January 2004.


Clarification

Model of virtual money presented here is (using the words of Jack Cohen and Ian Stewart) no more than “a lie for children” - i.e. is a simplification needed to present this concept to unprepared reader.

I have assumed here that prices are not changing (see Fischer’s Equation of Money above), because models with the changing prices are much more complicated. A careful analyze of models with changing prices proves that the economic growth without the virtual money is sometimes possible, and the reasons for virtual money are more sophisticated than I stated here.

Remember: the virtual money are not the reason for economic growth, and creating a stream of “unreal money” will not start the economic prosperity. Virtual money are only a tool that makes possible to consume (or to be precise to consume faster) the increase of productivity, which is an effect of some real factor like discovering new technologies, new mineral resources, or new countries to conquer, etc.

Warsaw, 5 February 2004.
Cosmetic corrections: March 2006.
Slawomir Dzieniszewski



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