Now let’s move from a barter to a money economy. Instead of direct exchange of goods, a medium of exchange is used for transactions. Saving and borrowing take place. Is this system more likely to break down and require the help of experts? Money has its own supply and demand, its own objective value based on how many other goods it can exchange for, and each actor in the system places a subjective valuation on money. Like all other goods in which he deals, each person chooses to hold some money in his inventory or to trade it for other goods. This could be due to his expectation of the future value of money, his desire for other goods than money at the moment, or because he prefers the increased optionality that holding money gives him and which holding other goods does not. Regardless of the reason, as more people hold money, the scarcer and more valuable it becomes, and the more people are willing to pay in interest to borrow it. The interest rate is always moving to coordinate the supply and demand of money loans.
How is the money interest rate set? It is based on the natural rate of interest, which is the difference in the price of a good today versus its price at some time in the future. If someone can borrow $100, buy raw materials, convert them into a finished good which can be sold in one year for $110, he will pay up to 10% interest for that loan. The market for money and the information it conveys allows for the supply and demand of other goods to tend toward equilibrium. The existence of money in an economy allows for an increase in the division of labor, as some people will choose to exchange their labor for money instead of producing an entire good on their own. This allows for greater specialization and it increases efficiency, so this would not seem to be a destabilizing force necessitating the benevolent wisdom of our deus ex machina.
It is at this point, where some people exchange their labor for money, when they become employees of other people, that some say that breakdowns can occur and intervention can become necessary. It is widely agreed that the money paid to the person in exchange for his work is equal to the marginal product of his labor. It is also contended that people, specifically workers, will supply their labor until the disutility of one more unit of labor equals the utility of the money received, the wage.
Keynes’ General Theory
John Maynard Keynes disagreed with the second contention, and said that if this were so there would be no involuntary unemployment. Keynes’ opponents said large scale involuntary unemployment would only exist if real wages were kept artificially high by unions of workers or by governments. Keynes responded that workers suffered from a “money illusion”, meaning that they did not care much about real wages and instead focused on nominal wages. So even if prices of consumer goods were falling, and real wages were rising, workers would only see the stagnant or falling nominal wages. Keynes also argued that workers would not be able to affect their real wages much anyway, since their agreed to lower nominal wages would lead to a fall in prices and thus unchanged real wages (although the fact exists that wages make up only a part of production costs). Involuntary unemployment would exist, said Keynes, if consumer goods rose relative to nominal wages, in other words if real wages fell, and the supply of and demand for labor increased.