Descriptive and Prescriptive Definitions of Money
- Article photo, courtesy of CEPR
Money has traditionally been defined descriptively based on the functions it performs within an economy. The most common roles of money include its use as a medium of exchange, a store of value, and a unit of account. These roles are widely recognized as essential to understanding the broader concept of money in economic systems. However, as economies evolve and financial systems grow in complexity, defining money solely through these functions can be challenging. Assets such as bank deposits, cryptocurrency, or other financial instruments may or may not fit neatly into the descriptive definition, yet they perform similar monetary roles.
Descriptive Definitions of Money
The descriptive definition of money revolves around the physical and operational characteristics that enable it to serve as money. Traditionally, cash and bank deposits were considered the core elements of money supply, but today, the evolving nature of financial assets necessitates expanding this view.
Narrow definitions like M1 focus on the most liquid forms of money, such as coins, banknotes, and sight deposits, while broader measures like M2 or M3 include less liquid assets. As a result, defining money through these descriptive lenses becomes a nuanced process requiring careful consideration of the specific roles that different assets play in the economy.
Prescriptive Definitions of Money
An entirely different approach, known as the prescriptive definition of money, focuses not on its practical functions but on its relationship with other important variables in the economy. This approach begins with a theoretical model of the economy in which money plays a distinct role. For instance, money might be considered neutral, meaning changes in the value of money do not directly impact real variables such as output and employment.
In this prescriptive approach, the goal is to define money in such a way that the theoretical model can be empirically validated. If we assume that money is neutral, we would seek a definition of money that, when tested empirically, supports this neutrality. Alternatively, the prescriptive approach may be driven by the belief that inflation results from rapid growth in the money supply. In such a case, we might start with the view that there is a stable relationship between money supply and real income, and define money accordingly to reflect that relationship.
Economists following this method, such as Milton Friedman, adopt a pragmatic stance, asserting that "money is what money does." In essence, the definition of money is shaped by the predictive power of the model. If a particular definition of money leads to the most accurate predictions regarding inflation or other economic phenomena, it is considered valid. The only challenge, however, lies in finding the empirical counterpart to the theoretical concept of money.
Empirical Challenges in Prescriptive Definitions
One of the key difficulties with the prescriptive approach is that no simple combination of assets may yield the desired empirical results. For example, a particular definition of money may seem to work well in one period but break down in later periods. This could be due to changes in the composition of assets classified as money, each with different relationships to economic variables such as income.
For instance, notes and coins, sight bank deposits, and other bank deposits may each have a stable relationship with nominal income, but these relationships could differ across each type of asset. If the composition of the money supply shifts over time, the relationship between money as a whole and nominal income can fluctuate.
To account for such variations, economists have developed techniques such as weighted measures of deposits, where different types of assets are weighted according to their relative stability or velocity of circulation. Additionally, the use of Divisia indexes attempts to account for different degrees of liquidity by measuring the interest rates of various assets—an asset with a lower interest rate is generally considered more liquid.
This pragmatic, yet complex approach to defining money can sometimes lead to frequent ad hoc adjustments to the definition in an attempt to produce accurate predictions. Critics argue that this approach can become more focused on the econometric techniques employed than on providing meaningful insights into the actual economic relationships at play.
Moreover, economists who do not subscribe to the theory that inflation results from excessive growth in an exogenous money supply may view this empirical method with skepticism. Nonetheless, the prescriptive approach continues to be influential in the field of monetary economics, as it prioritizes predictive accuracy over theoretical purity.
