Week 2 2. The nature of mone - PowerPoint Presentation

1. Week 22. The nature of money1

2. ContentMonetary standardTypes of moneyCommodity moneyFiat moneyCredit moneyMonetary systemsBimetallismGold standardBretton Woods2

3. Monetary standardDifferent monetary systems have different monetary standardItem that performs the role of measuring valuesvalue behind money in monetary system principal method of regulating quantity & exchange value of standard moneyprice determination and other monetary outcomes differHicks: all monetary economies have a basic credit elementConcepts of credit and payment of debts are important for understanding the role of money in monetary systemsTrade of commodity or financial assets has 3 components:Contractual agreement that specifies the terms of exchange- quantity and quality of a good, its physical characteristics, price, method of payment, location, time of delivery, liability provisionThe delivery- transfer of ownershipThe payment In many auction markets transaction takes place on spot, with no separation of those componentsUsually transaction involves differed or advanced payment, those components are separated in time3

4. Buyer must put down a deposit or give cash in advancemeans of payment is delivered before goods and servicesBuyer uses trade or consumer creditFinal payment comes after the delivery of goods and servicesMoney has 2 roles: In fixing the terms of the original contract (unit of contract or unit of account)Means by which the debt is settled (means of payment, means of exchange)Store of value in the majority of transactions- if purchase decision is later than the sale of goods – there is a need to store a purchasing powerThe essence of monetary exchange is fixing the terms of contract in money and its ultimate settlement in money economic and financial system require a basic monetary item- a standard which defines the measure of value and is basis for ultimate repayment of debt (gold, silver, fiat money)Monetary standard ≠ money Even in one country rarely only one form of money was used In the past: gold, silver, banknotes and deposits coexisted as exchange or payment mediaNow: coins, paper money, central bank money, credit money Monetary system embraces different types of moneySet of policies and arrangements taken by and through monetary institutions Study of monetary mechanism: the ways different elements of the system interact and work – the process which enables achievement of the standard4

5. Types of moneyCommodity moneyFiat moneyCredit money1. Commodity moneyThe simplest and the oldest type of moneyIt derives from the use of commodities as exchange intermediaries in indirect barterDifferent forms: cattle, corn, seashells, salt, leather, weapons, cigarettes… Lack important characteristics of moneyMetallic money- Precious metals –copper, silver, goldHave desirable propertiesAccepted in exchange due to their intrinsic valueValued for non-monetary use (as ornaments an jewellery- even if it wasn’t money it would have value)Value of money is the price, determined by supply and demand of good, whose production is costly 5

6. Commodity money is inefficient Doesn’t have ideal properties of exchange intermediariesUse of goods with intrinsic value for purpose which doesn’t make use of that valueIn less pure commodity money system (forms of gold standard)Given commodity doesn’t circulate as medium of exchange Token claims (paper) to the monetary commodity Countries pegged the value of their currency to a certain amount of the precious metal and promised to exchange their currency for the metal on demand100 dollar bill could have been exchanged for a 100 dollars' worth of gold  Gold was a real thing with real value, the paper money had value only because it was redeemable for goldPrice level was still determined as if gold coins were the actually money6

7. 2. Fiat moneyGovernment issued bank notes and coinsIt is not backed by gold or any other physical commodity of real valueIts intrinsic value is significantly lower than its face value (very low costs of production)It has no real use or value other than its value as a form of currency  It is money because the government says it is It gets its value from a government order (i.e. fiat)Government declares fiat money to be legal tenderall people and firms within the country are required to accept it as a means of paymentWhy people accept it? They know others will accept it in payment for goods and servicesThe value is derived from the relationship between supply and demandLarge seignorageThere is difference between the value of goods fiat money can buy and printing costsProfit of issuing authorityIts supply must be controlled to preserve the purchasing power of a unit of moneyMost modern economies are based on a fiat money system 7

8. Credit moneyDebt of a private person or institutionMoney that is backed by a promise to pay made by someone other than the stateAny form of security or financial instrument that is not repaid immediately coul be treated as credit money (bank deposits, credit card loans, bonds, money market accounts, IOUs, accounts receivable- in business, cheque…)When a commodity is sold & money is not exchanged simultaneously during the transactionThe seller becomes creditor and the buyer- the debtor8TailorFarmerFurniture producerBanks’ IOUBankIOUBanks’IOUTailors’ debt (IOU) is used as means ofpayment- moneyTailors’IOUTailors’ IOUBanks’ debt (IOU) is used as means ofpayment- moneyTrustCertainty!

9. It can function only if tailor and farmer have complete confidence in willingness and the ability of the intermediary to honor the debtOtherwise, farmer would still have a claim on tailor, tailor might not have the funds to honor that claimCredit money: “inside money”- there is a private liability perfectly balanced the asset acting as a means of payment- money is generated inside the private systemFarmer has a claim on the bank that is matched with the banks claim on tailorThe bank’s liability (what it owes to the farmer) must be matched with bank’s asset (what tailor owes to the bank)- bank’s balance sheet has to be balancedDominant type of money todayBank money- it is not created by the central bank or any other part of governmentCreated by private banks, usually in the process of making loansClaims against financial institutions that can be used to purchase goods or servicesIt is in electronic form, banks create money by simply adding deposits to their balance sheets (multiple deposit creation through fractional reserve banking system)Unlike metallic and paper money, cannot be passed hand to hand for purchasing goods and servicesDeposit money is considered as entries in the ledger of the bank to the credit of the holder. These deposits can be transferred through checks or debit cards9

10. 10CharacteristicsHistorical example1. Only commodity money, no financial institutions, bit occasional credit transactionsEarly antiquity2. Metallic money, bills of exchange and indigenous small-scale financial institutions (money lenders)Classic antiquity: most parts of medieval Europe and large parts of Europe through the 18th century3. Central bank the only or predominant financial institutionFrance, Russia (18 century)4. Deposit banks, no central bank and no paper moneyMedieval Italian cities (from 13th century on)5. Multiplicity of note issuing and deposit banks, beginning of other financial institutionsScotland in first half of 19th century, USA to 19136. Central bank, modern deposit banks, indigenous small-scale financial middlemanColonies in the period around independence (FB 1791)7. Central bank, deposit banks, beginning of other financial institutions (particularly saving banks, mortgage banks, development banks and insurance companies)Western Europe from mid-19th century to First World War8. Full complement of financial institutions and instrumentsUSA from 1970s, Europe from 1980sTypes of money and financial institutions

11. 11No external valueSome external value1 commodityFiat moneyFreely issued inconvertible token paper or credit moneyMonometallism A system based on one metal freely minted into coins which can be melted and exportedGold specie standardGold coins circulate along with banknotes which are convertible into gold coins on demand and for the smallest coin available Limping gold standardConvertibility into metal rather than fiat money is at the authorities 'discretionGold bullion standardGold coins no longer circulate and banknotes can only be exchanged for gold bullion, often only by specified groupsGold exchange standardMaintaining a country's currency convertible into the currency of a country on the gold standard, and so indirectly into gold2 or more commodities BimetallismUse of a monetary unit defined as a specific weight of silver or a gold, both freely minted and standing in a fixed ratio to one another SymmetallismMU- specific weight of silver and gold. Two metals can be exchanged at a fixed price (in monetary unit) when combined in the legally fixed proportions, but their relative prices is free to vary Composite commodity reserve standardMU-consists of or is defined in terms of warehouse receipts of a fixed weighted bundle of commodities held in store or as a reserve assetClassification of monetary standards - according to the nature of monetary standardItem that performes the role of measuring values

12. 12Some external value1 or more currenciesIndex standardExchange standardThe value of the domestic monetary unit is fixed in terms of the value of the monetary unit of a foreign currencyTabular standardMU- a specific combination of a selected group of commodities, and would be adjusted periodically to offset movements in the prices of the selected group relative to all commoditiesCurrency basketFixing the value of domestic money in terms of a composite unit (a number of foreign currencies, usually weighted according to tradeGoods standardThe practice of maintaining stable by monetary management the value of money relative to an index of goods Balance of payment standardUse of monetary policy to maintain a defined equilibrium in the balance of paymentsEarnings standardMaintaining the value of money stable in terms of an index of wage earningsLabour standardExpanding the money supply to accommodate full employment wage outcomes, as under an incomes policyClassification of monetary standards

13. BimetallismThe value of the money is based on two different metals (usually gold and silver)The typical 19th-century bimetallic system: a nation’s monetary unit by law in terms of fixed quantities of gold and silver automatically established a rate of exchange between themThe value of gold and silver is tied to each otherThe U.S. fixed the value of silver to gold as 15:1 (1 ounce of gold was worth 15 ounces of silver)U.S. Mint was established, both silver and gold recognized as legal currency; one could bring silver or gold to a U.S. mint and have it converted into coinsPaper money would also be traded in for the equivalent value of silver or gold Advantages: The combination of two metals can provide greater monetary reserves, more currency could be in circulationGreater price stability will result from the larger monetary baseGreater ease in the determination and stabilization of exchange rates among countries using gold, silver, or bimetallic standards will result13

14. Disadvantages:Impossible for a single nation to use standard without international cooperationDifferent countries set a different value for gold and silverinfluenced the exchange rates between themSystem was wasteful: mining, handling, and coinage of two metals is more costlyPrice stability depends just on the type of monetary base, bimetallism does not provide greater stability of pricesFreezes the ratio of the prices of the two metals, their demand and supply conditions can change → difficult to maintain the double standardGresham's law: bad money drives out goodif coins containing metal of different value have the same value as legal tender, the coins made of the cheaper metal will be used for payment, ones made of more expensive metal will be hoarded or exported -disappear from circulationMarket value depends on supply and demand, people who sold gold to the government received less that selling it to someone else- more silver money in circulation14

15. Gold standardClassical gold standard- in operation 1879-1914 Some countries (Britain, some of its colonies, Portugal 1854) had currencies attached to gold earlier international gold standard: a number of countries provide for convertibility between currency and gold and allow unrestricted export and import of goldBritain, USA and Germany permitted full and automatic convertibility since 1879France, Belgium and Switzerland “limping standards”- legal convertibility was at the option of the authoritiesJapan, the Netherlands, Canada, Australia, Austria-Hungary- had substantial foreign reserves in foreign exchange -“gold exchange standard” To standardize international transactions Guarantee government will redeem paper money- guaranteed value Transactions not only in bullions or coinsIncreased trust needed for ↑ international tradePeriod of high economic growth, free trade in goods, labor and capitalSupporters: period of price stability and economic and personal freedom smoothly operating mechanism which automatically ensured balance of payment equilibrium stable exchange rates 15

16. Country maintains equality between the value of the domestic monetary unit and a specified amount of goldValue of the currency in terms of gold is defined by mint parity Free convertibility: the currency is freely convertible at home or abroad into a fixed amount of gold per unit of currency (1 ounce of gold: 31,1gr = 20,67$ → 1gr Au=0,66$; 1$=1,5gr)Freedom to export and import gold in unlimited amountsFree minting, if coins value would rise relative to their gold content, it would pay an individual to convert gold bars into coins and vice versaDomestic currency was kept equal in value to the established weight of gold on world marketsGold was suitable for Britain (1821)Richest country, largest proportion of its monetary transactions could be conveniently carried out using gold, that has large valueUse of gold provided Britain long term price stabilityOver the period of more than 100 year (1821-1931) prices in absolute terms were almost the same In short periods they fluctuated16

17. Commodity-based money fixes the relationship of the monetary unit to the standardMovements of relative price of the standard commodity to goods in general is the only source of fluctuations in commodity pricesThe value of gold changes by new mines, technical improvements in mining, tastes in jewellery, by hoarding Gold production rises slow relative to trade and income commodity prices will fall- raising relative prices of gold1870s-1890s annual production of gold declined, prices were falling until new discoveries and new technologyDeflation made problems to debtors: real interest rate increased, while nominal interest rate didn’t follow quickly fall in commodity prices Different suggestions for alternative standards (silver, symmetallism, tabular standards)Fractional reserve system undertaken by banks and other financial intermediariesResource costs of commodity money can be lower by reducing the ratio of gold reserves to the domestic money supplyFrom predominantly commodity money- to the increasing use of fiduciary money like banknotes and debt money like deposits17

18. Fractional reserve monetary system: at least two moneys circulate a commodity like gold in the form of currency credit money in form of deposits and banknotes backed by gold Bank’s liabilities > than its gold reserves Quantity of money > the stocks of goldSociety gets monetary services at lower costsIndividuals profit- r or services for their depositsDebt can serve successful like moneyIf bank maintains the trust and confidence of depositors↑debt money on a limited amount of gold can cause instability in times of crisis18

19. Paper and deposit money had to be interconvertible with gold at a fixed mint parityERs were anchored to the mint par of exchange (ratio of gold content of one currency to that of another)1 oz.tr. Au = 20.67$1 oz.tr. Au = 4.87£  1 £ = 4.24$ER fluctuations were within strict limitsVariations of exchange rate from mint par were limited by the cost of gold transportation in either direction between countries(freight, insurance, agency fees, interest during the time of transit)Self regulating mechanismThe international monetary system based on the Gold Standard was self-correctingBalance of payments deficit:Balance of payments surplus:David Hume: “price-specie flow mechanism”19Exchange rates under gold standardDeficitOutflow of gold↓ Money supply↓ Domestic prices↑Competitiveness↓ DeficitSurplusInflow of gold↑ Money supply↑ Domestic prices↓Competitiveness↓ Surplus

20. It caused price levels around the world to move togetherTechnological innovation in US- faster real economic growth and lower pricesUS export prices relatively < prices of importBritish would demand more US goods, and Americans will demand less importUS would have payment surplusgold flow from UK to US↑US money supply & ↑ prices In UK gold outflow↓money supply & ↓price levelbalanced prices among countriesMonetary and real shocks are transmitted via flows of gold and capital between countriesA shock in one country affected the domestic money supply, expenditure, price level, and real income in another countryThe California gold discovery: monetary shock ↑ US money supply  ↑domestic expenditures, nominal income, price level  US export became more expensive  balance of payment deficit, financed by gold outflow ↓ monetary stockIn trading partners: ↑ money supply  ↑domestic expenditures, nominal income & price level 20

21. Central banks had 2 important functionsMaintaining convertibility of currency into gold at fixed price and defending ER Speeding up the adjustment process to a balance of payments imbalancesCentral banks were supposed to play by the “rules of game”Tools: interventions in the gold market, adjustments to the gold reserve, changes in the regulations about convertibility, discount ratesDiscount rate: interest rate at which the central bank lends money to member banksBalance of payment deficit- gold outflow and ↑discount rateInterest rates ↑→↓investment → domestic spending ↓→↓price level → attract short-term capital flows Changes in interest rates became powerful tool of monetary policydebt money presents large part of the money supply Interest rates and conditions on credit market are important for monetary policyCapital flows induced by changes in discount rate- offset the initial gold flows  reliance - on credit and money supply by banksto bring out adjustments to income and prices needed for long-term stabilization of trade and exchange rate position Stable exchange rates - the criterion of monetary stability21

22. Some central banks didn’t fully follow the rules of the gameFrance, BelgiumDidn’t allow sufficient rise in interest rates Gold flows were sterilized: buying and selling domestic securities Inflow of gold will not increase money supply if CB would sell securities for gold, reducing the amount of gold circulatingCB could manipulate the gold points to increase or decrease the profitability of exporting goldTo slow an outflow of gold: ↑costs of financing for gold exporters↑price at which it sold goldRefuse to sell gold completely or ∆ the location where the gold could be picked up- to ↑ the transportation costsThese violation of rules were limited22

23. Advantages of gold standardSimplicity: It avoids the complexity of other standards and can be easily understood by the general public2. Public confidence in money:gold is universally desired because of its intrinsic value no-gold money (paper money, token coins, etc.) are convertible into goldtotal volume of domestic currency directly linked to the amount of gold and there is no danger of over-issue currency3. Automatic Working: the monetary system functions automatically, changes in gold reserves automatically cause changes in the supply of money 4. Long term price stability: gold is the currency base and the prices of gold do not fluctuate much in long run because of the stability in the monetary gold stock of the world and the annual production of gold is only a small fraction of world’s total existing stock of monetary gold5. Exchange rate stability: depend on mint par, facilitate development of international trade and the smooth flow of capital movements among countries 23

24. Disadvantages of gold standard1. Lack of elasticity: money supply depends upon the gold reserves which cannot be easily increased. So it is not flexible enough to meet the changing requirements of the country (need to support consumption and investments to fight crisis), causes higher level of unemployment2. Costly and wasteful: the medium of exchange consists of expensive metal, there is a great wear and tear of the precious metal when gold coins are in circulation 3. Fair-weather standard: it works properly in normal, but during the periods of war or economic crisis, it invariably fails, those who have gold try to hoard it. To protect the falling gold reserves, the monetary authority prefers to suspend the gold standard 4. Sacrifice of internal stability: The gold standard sacrifices domestic price stability in order to ensure international exchange rate stability5. Deflationary: the gold losing country must contract money supply. But the gold gaining country, may not increase its money supply in proportion to the increase in gold reserves. It produces deflation in the gold losing country, may not generate inflation in gold receiving country6. Economic dependence: Under gold standard, the problems of one country are passed on to the other countries and it is difficult for an individual country to follow independent economic policy 7. Unsuitable for developing countries: need economic development policy with an objective to secure self-sufficiency8. Not fair: countries without gold reserves or gold mines, have to be more productive than competitors to maintain the same level of living standard for citizens 24

25. Gold exchange standard 1925-1931During the first World war countries needed more money (weapons, munitions, soldiers, uniforms…), and abandoned the rules of pure gold standardDidn’t allow the export of gold in the case of current account deficitThey issued significant amounts of money, without backing in goldAfter war there were incentives to restore gold standardCurrencies fluctuated significantly, prohibiting development of international tradeGold reserves were insufficient to guarantee the convertibility of all paper moneyGold bullion and gold exchange standard Gold bullion standard: UK in 1925modified version of gold standard in which there was no gold coinage and the currency is convertible into gold bullion currency value is expressed in terms of gold gold does not act as a medium of exchange, but is measure of valueGold exchange standard: currency is not pegged to gold, but to another international currency (₤, $- pegged to gold) Keep currency at parity with gold without large gold reserves Maintain sufficient amount of foreign exchange reserves for international paymentsGold rarely used for the settlement of international transactionsCheaper form of gold standard, suitable for the underdeveloped or gold-scarce countries25

26. Bretton Woods system“Gold parity standard”- the modern version of the gold standardInternational Monetary Fund (IMF) established in 1946member countries defined the par value of currency in terms of gold- to determine the exchange rateGoal: maintain stable ERs & take care about domestic economic situationKey currency: US dollar, convertible for external purposes into gold at the parity $35 per ounceExchange rates had to be maintained within ±1% of parity (like gold points)Indirect convertibility into gold (like under gold exchange standard)Interventions in the London gold market ensured that private market price of gold did not differ from $35 per ounce much more than costs of shipping gold from New York to London Key features of a commodity currency standard: parity and convertibility26

27. Idea: to combine the best features of gold and fiat money through fixed- but adjustable exchange rate mechanismGold standard: exchange rate stability, free trade and capital movementsContributed to depression, sacrifice of internal goalsFiat money: Enables countries to recover from unemployment, without deflation Inflation and unstable exchange rates Trade-off of external for internal stability If countries supported stabile growth of employment- “employment standard” If countries sticked to their commitments to IMF- “balance of payment standard”System of rigid but adjustable parities IMF lending resources to solve problems with minor fluctuations in the demand and supply of foreign exchangeParity changes were possible in the case of fundamental disequilibrium System transformed into a fixed exchange rate standard maintenance of the existing parity was key to policy formulation Countries were reluctant to change paritiesRevaluations were unpopular Devaluation called into question the competence of economic policy makersUSA felt obliged to maintain the same value of dollar27

28. Countries were less ready to sacrifice internal balance Support economic growthSurplus countries tried to sterilize the money supply from rise in international reservesDeficit countries applied import quotas and export subsidies, two-tired exchange rates and exchange controls US large balance of payment deficit-↓ confidence of foreign governmentsCB redeemed $ with goldVietnam war, inflationSwiss & France withdrew gold reserves, Germany abandoned BW1971: $ not redeemable for gold, gold P↑ major currencies- floating exchange rates28

29. Fixed ratesDomestic currency is not pegged to commodities but some foreign currency (or basket of currencies) at a fixed rate of exchangeFrom exchange rate targeting to monetary unionBegan under gold exchange standard when smaller countries fixed their exchange rate to larger currency convertible in gold Central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is peggedIt must have high level of foreign reservesMain advantages: Avoids currency fluctuations, reduces uncertainty and gives greater confidence for firms to investKeeps inflation low Main disadvantages:Focus of monetary policy to exchange rate, conflict with other goalsLess flexibility to respond to temporary shocks Encourages speculative attacks 29

30. Fiat money systemBased on claims- paper money, coinage, deposits at the central bankNot convertible by law or custom into anything other than themselvesDon’t have fixed value on terms of any objective standard or monetary substanceNot linked with some external object, directly or indirectlyDoes not have intrinsic valueIt has a value in exchange – ability to purchase other goodsIt depends on its demand and supplyRole of governmentstrong influence in the acceptance of a certain object as money (legal-tender laws)Government produces paper currency and declares it to be moneyIf it mismanages that currency- people will abandon itThe costs to society are largeProblems with economic decision making high and unstable prices and price level uncertainty unstable exchange ratesresources are diverted into hedging against price level uncertaintyAdvantage: its supply is more elasticcan flexibly adjust to the needs of economy, with low resource costsPresent international monetary system: national monetary authorities monopolize the supply of inconvertible paper moneyNo major currency has any link to a commodity30

31. SummaryMonetary system: all types of money, financial institutions and arrangements- enable achievement of standardStandard of value: any good (intangible) measures the value and is basis for final payment of debtsTypes of money: commodity, fiat, credit moneyMonetary standardsBimettalism: gold and silver are legal tender, value of currency – in terms of both More currency in circulationMain problem: market variations of metal prices & legally fixed ratio between them → disappearing one metal from circulation Classical gold standard 1879-1914 free convertibility in fixed amount of gold per unit of currency (paper & deposit money)free mintingfreedom to export and import goldMain tasks of CB: maintain convertibility of currency and defend the exchange rate & speed up the adjustment process to a balance of payments imbalancesER fixed (mint parity), gold specie points31

32. System functioned automatically:∆balance of payment → ∆gold reserves → ∆supply of money → ∆P → ∆balance of paymentInflation-deflation adjustment mechanismMonetary and real shocks transmitted via gold flowsTool of MP: rSome CB didn’t follow the rules Long term P & ER stabilityNot elastic, “fair-weather”, deflation, sacrifices domestic stabilityGold bullion standard 1925Gold exchange standard (1925-1931)Bretton Woods system- “Gold parity standard”Exchange rates: within ±1% of parity Indirect convertibility into gold ($- in gold)IMF loans – minor problems∆parity in case of fundamental disequilibrium Focus on fixed ER & internal goals: direct controls (import quotas, export subsidies)- not stabile32

33. Fiat money has no commodity backing but it does have high intrinsic value.In most countries fiat money is quantitatively larger than credit money.Commodity money is inefficient compared to fiat money.Fiat money can be seen as an evolution of commodity money.The use of commodity money will always generate seignorage profit’s. An advantage of indirect barter over fiat money is that indirect barter does not require trust between individuals.The advantage of using fiat money vs. a barter economy is that fiat money no longer requires trust between transaction partners. Show how exchange rates are determined under a gold standard. Explain how a gold standard would, in theory, stabilize balance of payment imbalances.33Homework- Answer and comment following questions

34. For a significant part of economic history, countries have used commodity moneys, in particular metallic standards. The most notable of these was the gold standard, prevalent in the 19th and 20th century, under which the supply of money was backed by gold. To this day, there is a small but vocal group of people who advocate for a return to the gold standard.Explain how prices were determined under the gold standard. Discuss what the implications were for price stability under the gold standard.Discuss and explain one advantage and one disadvantage of fiat money over the gold standard.The Bretton Woods exchange rate mechanism can be thought of as a gold exchange standard.The Gold Standard and the Bretton Woods system were both international monetary arrangements that relied on a system of fixed exchange rates.Explain the advantages and disadvantages of having a system of fixed exchange rates in practice.Explain the reasons why (1) the Gold Standard and (2) the Bretton Woods system ultimately collapsed Under the gold standard, a country that had a deficit on the current account of its balance of payments automatically experienced a tightening of monetary policy.34

35. The Gold Standard is often claimed to have provided the world economy with a self regulating mechanism, controlling each country’s balance of payment and inflation. How does this self-regulating mechanism work? Why have most countries found the discipline of the Gold Standard too strict, and abandoned it in favour of other monetary arrangements? The Bretton Woods regime collapsed between 1971 and 1973 because European countries were unwilling to import inflation from US.35