2. The nature of mone y - PowerPoint Presentation

1. 2. The nature of moneyGoodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan, 1989a), Chapter 2.Lewis, M.K. and P.D. Mizen, Monetary Economics. (Oxford; New York: Oxford University Press, 2000), Chapters 1 and 2. McCallum, B. Monetary Economics. (New York; Macmillan; London: Collier Macmillan, 1989).1

2. The contentWhat is money?Functions of moneyCharacteristics and shortcomings of barter economy Emergence of commodity moneySignificance of trust, information and uncertainty for the emergence of money (The Wicksell problem) Properties of moneyMoney substitutes2

3. What is money?Usually defined by its functions Anything which is in general use and generally accepted as a means of payment.Functions of moneyUnit of account and a unit of contract (standard for differed payment)Means of exchange or paymentLiquid store of value3

4. 1. Unit of accountWe express and compare the values of goods and services in terms of money Important for economic efficiency, it makes simpler to express the value of goods- common language expresses to the value (like meters or kilograms) In barter economy, with n distinct commodities, there would be n(n-1)/2 prices (1.000x999/2=499.500)Advantages:Money avoids unnecessary calculations Permits rational economic decisionsTransmits economic information, making possible specialization and a division of labour Unit of contractIf purchase is made without paying cash, the price is quoted in terms of money, cause it is a unit of account and buyer agrees to pay later quoted money amount. If payment would be in units of different goods, we would have to estimate the exchange value of each of these goods in the future.Value of money in terms of goods is not fixedInflation makes money poor unit of account4

5. 2. Medium of exchangeWicksell: Object taken in exchange to be exchanged for something elseFacilitates transactions and avoids inefficiencies of barter Direct barter: double coincidence of wants and double coincidence of time of wantsBoth a sale and a purchase: what, how much and on what terms to sell and what, how much and on what term to buyGenerally acceptable medium of exchange – less time and energy for shopping- more time and energy for higher production and leisure Independent on weather that special commodity has intrinsic value- generally acceptable in exchange Money as medium of exchange brakes down barter transaction into separate sales and purchases; enabling people to sell to one person (and in one place) and to buy from another one (and in another place)Money replaces bilateral trading with multilateral, reducing necessary number of transactions Use of money increases competition- increases the number of similar transactions5

6. Means of a paymentMoney is used to pay for goods purchased or to settle debtsFinal payment- seller receives equal value from the buyer and has no further claim on himMeans of payment can be medium of exchange (gold coin used for purchase, seller will accept it for his good and use it later to buy other item, not to produce something else)Means of payment is not medium of exchange when using credit card- payer still has a debt outstanding to the credit card company (credit card is not a means of payment)Credit cards, trade credit between firms, unused overdraft facilities or other credit lines are not included in the definition of moneyMedium of exchange includes assets or claims whose transfer to the seller will allow a sale to proceed 3. Store of valueEnables a person to sell a good without simultaneously having to buy another goodDelay in consuming a part of earnings- buying the goods for the consumption will also be postponedCosts and inconvenience of storing goodsDeterioration and obsolescence of stored goodsStoring general purchasing power instead of specific commodities has advantages in an uncertain worldUse of cash in the case of emergency or when costs are higher than income when the need arises Wait and be prepared for later opportunities of making good buy6

7. Characteristics of money like durability and the fact that it can always be used for the purchase, cause people to hold it as an asset – the part of their stock of wealth.Money is not unique store of value- the function is performed by financial assets and some real assetsMoney has the advantage of liquidity Liquid assets are easy marketable and converted into other assets Cash is the most liquid asset, it is readily and immediately accepted in paymentPredictability of the value of an asset when it will used for payment Reversibility- a value in payment that is little smaller than it was on receipt (real and even financial assets lack reversibility, new car, commission or tax when selling)Divisibility – what is the size of the smallest unit of asset in exchange- determines its flexibility in exchange 7

8. Is it necessary to use the same object to perform all 3 functions of money?It is convenient to concentrate all functions with a single item, except in the times of serious monetary disorderPrices could be expressed in terms of other commodity (ounces of copper) while domestic currency serves as a medium of exchangeFor each transaction there would be extra calculation- quoted price in terms of copper would have to be converted into domestic currencyThere is a strong tendency for the medium of exchange to be used also as unit of account 8

9. Why do we have money?It helps facilitate trade- without it trade would be direct exchange of goodsIn barter economy trade involves double coincidence of wants and timing of wants- high costsWe must optimally allocate our scarce time on different functions of life, like work, leisure, information gatheringMoney is one of social artifacts that evolved to relax time/ information constrainPotential value of goods in barterIn market transaction both sides in exchange believe they will benefit from getting a good of higher or the same value as the offered oneDouble coincidence of wants and time or one party will be left holding a good that will be exchanged later Money emerged as a response to these need like standardized store of value and means of paymentThe second social artifact that relaxes time/information constraint are organized markets, where buyers and sellers meet at prearranged times and places. 9

10. Money, trust & uncertaintyIf there would be a complete trust in the counterparty’s willingness and ability to fulfill his obligations, (world of certainty, without transaction costs), there would be a little need for moneyExchange could be based on creditA buyer promises to pay in the future equivalent present value Lack of trust in personal honestyRationale for the use a moneyBuyers face liquidity constraint (cash in advance)Sellers of goods and services are often unwilling to extend credit or accept other good as a means of paymentOnly with money they can buy goods10ABCtt+n

11. Wicksell problem gains from trade through bilateral exchange are not possible IndividualProduceConsumption utilityBreadApplesWineAnnBread0.501MarkApples10.50NicoleWine010.5Markapples AnnbreadNicolewinebreadappleswineMarkapples AnnbreadNicolewinebreadappleswineapplesapples Money emerged from the indirect barter, in form of foodstuff11

12. Trust and uncertainty explain the existence of moneyIf IOUs (personal acceptances of indebtedness) would be strictly honored, credit economy could exist even in environment of uncertainty and transaction costsIssuer of IOU must protect himself from risks like sickness or deathThere might be some non-diversifiable risks (war)Bank vs. private IOUsPrivate IOU- Lack of trust and liquidityBank IOU- liquid and functionally equivalent to cashEveryone knows and trusts the bankPaying goods using debit cards Bank debits buyers’ account and credits sellers’Buyer gives IOU to the bank and bank gives its IOU to the seller12

13. Uncertainty is necessary condition for a monetary system with some special means of paymentIt is not sufficientIn a system where the role of participants is defined by agreement or custom (family, commune, religious community), transactions will not have the form of exchange of stores of valuePrice mechanism is not usedAllocation of goods and resources could be by central directionSuch system with complete suppression of price mechanism and centralized allocation would require undesirable authoritarian societyThat could work in small groupsIn large groups, economic transactions as personal benefits of each participant rather than adding to the social welfare of the groupEveryone want to maximize own personal welfareMay gain utility or loss seeing others better off13

14. How can individual asses if a transaction is to his advantage?Uncertainty causes transaction costs- costs of obtaining information Learning the demand and supply schedules for tradable goods and discovering the prices bid and offered Establishing prices and completing transactions at such prices for all goods and services takes timeAdequacy of information about the buyer (behavior, credit standing)Information about creditworthiness of a potential buyerOtherwise high risk he might defaultMinimizing risk- physical exchange of the store of valueRisk is minimized if the payer gives an item of worth (commodity money or another store of values, IOU of a bankCredit and cheque guarantee cards- information augmenting deviceIncrease in personal information reduces the use of money as means of payment Cash is anonymous means of payment- way of hiding information14

15. How is money established?Direct barter- high transaction costs (double coincidence of wants and timing)Indirect barter Longer transaction chain necessary to complete desired exchangeIndividual still holds a good which he wants to sell, doesn’t have desired good, faces uncertainty whether and on what conditions he can sell new goodEach link in chain involves uncertaintyIn each step it is necessary to asses the quality and value of good offered in exchangeFrom A to e.g. G trader will bear considerable risk or will have to obtain information about characteristics and market prospects of B, C…Has that good satisfactory physical characteristics?Is there a good market for it to be exchanged?Marketability: some goods have broader and more stable markets Tendency to move towards the general use of one or more goods as a common means of payment to avoid inefficiencies of barter If he founds good with all desirable information qualities, why not use it in all trades, reducing length of transaction chain and limit uncertaintyIt is easiest to use as a money a good whose precise physical characteristics don’t require continuous and skilled checking and which acceptance is guaranteed15

16. Jones (1976): medium of exchange will arise even in an economy with barterCommodity that is the most traded (e.g. apples)Better to exchange rare good for such commodity, and use it to obtain the desired good than looking for an exact match Trade in apples increases- rising the probability to find someone to accept apples in trade- more traders will use applesThis process – majority of traders will use apples and they will become the medium of exchangeMenger (1892): assets that will be used as money have superior marketabilityTraders want to hold more marketable goods for use in exchange Others accept them in trade because of their marketability and value in exchangeTheir demand as medium of exchange raises compared to their non-monetary demandThey become more marketable and valuable in exchangeThose assets should have certain characteristicsStability of valueEase of transport and identificationDurabilityDivisibility Easy to storeReadily saleableliquidity16

17. Assets lacking some of these attributes will acquire them if it becomes accepted as a medium of exchangeMacDonald and Milbourne: if a chosen item is difficult to carry around, there is an incentive for individual to accept it and issue paper claims against themGold and silver were accepted as a medium of exchange, but difficult to carry in larger amountsIncentive for banks to accept them and issue banknotes against them Kiyotaki and Wright: the good with lowest storage cost will be chosen as a medium of exchangeFiat money will not be selected for these purpose unless people believe others will accept itAcceptability is of essential importance!People accept payment in money because they expect others to accept it in payment from him Whatever it is considered as money becomes money 17

18. How we come to the point that something is considered as money? A social convention must be establishedScitovsky: All members of a group can formally promise to accept certain object as a medium of exchange (euro)Authority can enforce acceptance of money as paymentmoney is a legal tenderlimitations- no obligation for private bodies to accept the money Important member of a group can unilaterally accepts in payment a certain form of money If he is important enough and that money convenient enough, other members will probably follow (e.g. using one country’s currency as external reserve by other countries, payment of taxes in domestic currency)Commodity that is valuable in consumption and especially suitable as a medium of exchange can gradually acquire the status of moneyWhen social convention is established its use as money is independent of its value or continued use in consumption (gold)Object can get moneyness if there is a guarantee of its convertibility into object that already has a status of money (evolution of paper money, bank deposits, traveler’s cheques…)18

19. If an object has some esteemed abstract value (prestige, power) and status in that group is determined by amount of that object (cows, pigs, shells…), that object can be accepted in paymentWhat gives value to the object used as money?Long debate between Cartalists and Metallists Cartalists: currency is money because it has an insignia of majesty- power of issuing authority, not because it is made of gold or silver Metallists: Value of currency depends on the intrinsic value of the metalArguments in favor of both viewsSubstitution of metallic coins for fiat-paper money: Cartallists viewWhy early kings minted money from precious metals, reducing seignorage (difference between the value of resources that could be obtained for the coin and the cost of its production)?Discouraging forgery (lowering profit by reducing seignorage)Gresham’s law (coins of low intrinsic value would be used for paying taxes, and people will tend to hold and hoard foreign coins of greater intrinsic value)Need to increase the attraction and lower the risks of money holdingEarly kings could not get much seignorage because they didn’t have much powerWhat percentage of seignorage should be incorporated in the currency Higher percentage (debasing the currency)- higher profit, but increasing unwillingness to hold a currency and preference to substitutes 19

20. With the increase of the power of state and development of minting techniques it was possible to increase seignorageState imposes taxes and can insist that they be paid in state-issued money, that gives fiat money a value- reason to use that money in private transactionsState-issued fiat money has advantages (risk) to the notes of small, private institutionsAuthorities can place legal barriers against the use of currency substitutes (like foreign currency or gold)Why government doesn’t use power to buy up everything in sight for their own benefit?it would raise prices, causing expectations of further inflation people would wish to hold less currency and turn to other forms of means of payment (foreign currencies)There is some rate of monetary expansion which would maximize government revenueInflation has high political costsIn the case of war or civil unrest they are lower, authorities can benefit from higher control over resourcesGovernment restricts the issue of fiat money at a point where the market value of assets, which could be bought with the currency, still far exceeds the marginal cost of producing that money 20

21. Money substitute Asset that could be transformed easily, at known constant exchange ratio, on demand, without much cost into legal tender currencyForerunners of today’s bankers (gold-smiths): holding small proportion of currency reserves they were able to guarantee convertibility of their own note and deposit liabilitiesSmall proportion of their clients would want to withdraw deposits or redeem their notes on any one day (confidence The rest of the currency could be lent out to clients-earning the margin between yield on the assets purchased and costs of holding deposits Beginning of XIX century US and UK banks had significant part of liabilities in note formAt the end of XIX century: rise of deposit liabilitiesConstraints on private sector note issueTo increase the power of central bank in controlling monetary conditionsPrudential reserves against bank deposits in with the central bankConvenience and safety of deposit/cheque payment system Deposit with a bank can be readily converted back into currencySafe-keeping, convenience, book-keeping service, interest payment, financial advicesPayments transmission service- people accepted transfer to their current account as satisfactory final payment- current account is a means of payment21

22. Sometimes transfer of assets through the banking system is not acceptable as a method of paymentWhen paying with a chequeMeans of payment is transfer on the bank’s bookMeans of exchange in the transaction is writing a cheque Giving a cheque to seller doesn’t complete the payment (like currency)It is order to bank to complete the final payment to creditorCredit relationshipSeller (payee) extends credit to the buyer (payer) untill the cheque has been cleared Cheque like trade credit- final payment is not completedSeller (creditor) has to trust that the buyer (debtor) has sufficient credit in the bank for the cheque to be honoredCredit and cheque guarantee card increase information for sellerInformation whether the bank will honor the payment orderPayment: by reducing credit account balance or by increasing overdraft Both seller and buyer have to trust to the bank – involves some risk 22

23. Properties of moneyPORTABILITY it must be easily and economically transported for purchases at different locationsDURABILITY in a physical sense, something that can’t deteriorate, perish, decay, rustDIVISIBILITY that it can be divided into equal parts for the purchase of smaller units or for change, and the aggregate value of the mass after division should be almost exactly the same as beforeHOMOGENEITY each monetary unit is the same as every other unit in all respects. They are interchangeable, have the same quality, no physical differencesRECOGNISIBILITY material for being easily recognized and distinguished from all other materials. It will cause great inconvenience if every person receiving money has to inspect, weigh and test it.GENERAL ACCEPTABILITYWe use money because we believe that everyone else will use itSTABILITY OF VALUEMoney should not be subject to fluctuations in value -like a changing kilogram23

24. Trade originated with human communication in prehistoric times History of long-distance commerce started 150.000 years ago People bartered goods and services from eachThere was no common measure of value among the items bartered Some commodities, for their utility, came to be more wanted than others: 9000-6000 B.C. cattle, crops Early development of writing related to accounting and money: in Mesopotamia (5000 B.C.) In the ruins of ancient Babylon, Assyria and Sumeria, were found early accounting records that date back more than 7,000 years- to record the growth of crops and herds and determine if there is a surplus1200-200 B.C. in China cowrie shells, Asia, Africa, and Oceania. In some parts of the world shell money served as currency up until the 19th/20th century. When man discovered metal, it was used to make pottery and weapons previously made of stone; that was used for exchange24

25. Around 1100 B.C. the Chinese moved from using actual tools and weapons as a medium of exchange to using miniature replicas of the same tools casted in bronze These tiny daggers, spades, and hoes were abandoned for the less spiky shape of a circle, which became some of the first coins25Although China was the first country to use recognizable coins, the first minted coins were created in Lydia, from alloys of silver and gold (electrum-stater -14,1gr). It was the worlds’ first coin, officially issued by a government and was the model for virtually all subsequent coinage.Paper bills were first used by the Chinese, during the Tang Dynasty (A.D. 618-907) — mostly in the form of privately issued bills of credit or exchange notes It eliminated paper money entirely in 1455, due to financial crisis: the production of paper notes was high causing inflation, and wouldn't adopt it again for several hundred years. The first legal tender: in 118 B.C. Emperor Wu issued leather money – pieces of white deer skin, decorated with designs of water plants. The first bank note!

26. Stockholms Banco, Sweden's first bank, issued the first real banknotes in Europe in 1661 as deposit certificatesConvenient to carry –copper coinsHanded out as loans from bank, used to purchase anything, not linked to D- based on confidence they could be exchanged for coins at printed valueOverprinting – inflation-bank failure 26

27. SummaryMoney is defined by its functions (usually means of payment):Unit of account (contract)Means of exchange (payment)Store of valueConvenient – 1 object performs all functions, not necessaryMoney is evolved to relax time/ information constrainPotential value of goods in barter, supply and demand shedule, creditworthinessUncertainty, lack of trust → emergence of moneyWicksell: money emerged from the indirect barter- no gains through bilateral exchange Private IOUs not liquid like bank IOUsInefficiencies of barter economyDouble coincidence of wantsLonger transaction chain involves uncertaintynecessary to asses the quality and value of goodMoney must have adequate properties: portability, durability, divisibility, homogeneity, recognisibility, general acceptability and stability of value27

28. Homework-QuestionsExplain why some economists argues that payments by cheque is the same as giving trade credit. If this is the case and considering that cheques are drawn on bank current accounts (as are payments by bank debit cards), do cheque payment count as money?In a monetary economy, money usually performs the three roles of medium of exchange, unit of account and store of value. Why are these three roles typically combined in one entity? Is it possible to conceive of an economy in which they are performed by three separate entities?In indirect barter goods are exchanged for immediate consumption? True/false/uncertainMoney should essentially be perceived as an instruments that allows an increasingly widespread and anonymous economic society to deal with the inevitable resulting shortcomings in information and trust of each of the members on the others, explainThe evolution of commodity money from indirect barter, as the solution to the Wicksell problem, arises because of a lack of trust between the relevant parties. True/false/uncertain28

29. The Wicksell problem can be solved with the introduction of commodity money. True/false/uncertainExplain how commodity money is a natural evolution from barter. Dis-cuss in the context of the Wicksell problem.In the Wicksell problem, even if goods offered for trade are readilly available, it may still be the case that no trade occures. The only purpose of money is as a means of payment. True/false/uncertainMoney is the best store of value. True/false/uncertainMoney is typically a good store of value.By using money as the means of exchange, the economy avoids need for the double coincidence of wants that characterizes a barter economy. Outline and define the three main characteristics of a good money. Explainto what extent bitcoin meets these criteria and discuss whether you believe bitcoin is likely to become an important form of money.The existence of uncertainty is a key reason for the existence of money as a means of exchange.29

30. 15. Credit cards perform all of the theoretical functions of money.16. There is no strict necessity for the same commodity to serve as the medium of exchange and as the unit of account.30