Money : Money Chapter 4 Money : Money Without Money What is Money? Evolution of Money : Evolution of Money Without exchange, there was little need for money and most of the exchanges involved barter
Refers to the direct trading of one good for another good
Problems with barter
Requires a double coincidence of wants the traders each have products that the other wants
The trades must agree on the exchange rate between the two goods Evolution of Money : Evolution of Money The objects that have served as money have evolved over many centuries.
Four main forms of money are:
fiat paper and coin
deposits Commodity Money : Commodity Money Commodity money is a physical commodity that is valued in its own right and is also used as money.
Examples from the past:
cakes of salt
silver and gold coins
Commodity money has two major problems:
cheating (clipping and debasing)
opportunity cost of resources tied up as money Problems with Commodity Money : Problems with Commodity Money Commodity money refers to the use of some item – gold, silver, wampum – as money
If the commodity money is perishable it must be properly stored or its quality can deteriorate money must be durable
If the commodity used as money is bulky, exchanges for major purchases can become unwieldy money should be portable Problems with Commodity Money : Problems with Commodity Money Some commodity money is not easily divisible into smaller units money should be divisible
If commodity money is valued equally in exchange, regardless of its quality, people will tend to keep the best and trade away the rest
Gresham’s Law: bad money drives out good money
People tend to trade away inferior money and hoard the best
As a result, the supply of money shrinks and the quantity in circulation becomes less acceptable
Therefore, money should be of uniform quality Problems with Commodity Money : Problems with Commodity Money Fifth, commodity money usually ties up otherwise valuable resources it has a relatively high opportunity cost, compared with, say paper money money should have a low opportunity cost
A final problem with commodity money is that its supply and demand determine the prices of all other goods and if either of these fluctuate unpredictably, so will the economy’s price level the value of money should not fluctuate erratically Convertible Paper Money : Convertible Paper Money Convertible paper money is a paper claim to a commodity.
The paper will be converted into the commodity on demand. First known example occurred in China during the Ming dynasty (1368-1399 A.D.).
The goldsmiths of Europe developed convertible paper money and invented modern banking.
The key idea is fractional banking.
Convertible paper money does not require one unit of the commodity for every claim check in circulation. Fiat Money : Fiat Money Fiat money is intrinsically worthless (or almost worthless) paper and tokens that serve as money.
“Fiat” means “let it be done” or “by order of authority.”
The earliest fiat monies were issued during the American and French revolutions and the U.S. civil war. Deposit Money : Deposit Money Deposit money consists of deposits in banks and other institutions (collectively called depository institutions) the ownership of which can be transferred from one person to another either by writing a check or by an electronic transaction. Value of Money : Value of Money Why does money have value?
The commodity feature of money bolstered confidence because of its acceptability
Initially paper money was acceptable because it was redeemable in gold, silver of some other item of value
However, what makes paper money acceptable today is that individuals accept these pieces of paper because they have reason to believe others will do so as well it can be used in exchange Purchasing Power of Money : Purchasing Power of Money The purchasing power of money is the rate at which it exchanges for goods and services
The higher the price level, the less can be purchased with each dollar each each dollar is worth
Specifically, the purchasing power of a dollar over time varies inversely with the price level Functions of Money : Functions of Money Store of value
Unit of account
Medium of exchange The ease with which money is converted into other things--
goods and services-- is sometimes called money’s liquidity. Medium of Exchange : Medium of Exchange Anything that is generally accepted in payment in exchange for goods and services sold
Thus, so long as a number of individuals believe something can be used to purchase whatever is desired, it can serve as money
In early times, money was commodity money like gold and silver Unit of Account : Unit of Account A unit of account is an agreed measure for stating the prices of goods and services.
In the absence of a standardized unit of account, keeping track of prices and comparing prices would be difficult.
Eliminates the necessity of having to determine how much of each good exchanged for every other good Store of Value : Store of Value Money serves as a store of value when it retains purchasing power over time the better it preserves purchasing power, the better money serves as a store of value
Recall the distinction between stock and flow
Stock is an amount measured at a particular point in time
Flow is an amount per unit of time
Money is a stock and income is a flow Slide 18: Monetary Policy Money Supply vs. The money supply is the quantity of money available in an economy.
The control over the money supply is called Monetary Policy.
In the United States, monetary policy is conducted in a partially
independent institution called the Federal Reserve, or the Fed. Slide 19: To expand the Money Supply:
The Federal Reserve buys U.S. Treasury Bonds and pays for them with new money.
To reduce the Money Supply:
The Federal Reserve sells U.S. Treasury Bonds and receives the existing dollars and then destroys them. U.S. Treasury Bonds Slide 20: The Federal Reserve controls the money supply in three ways. 1) Open Market Operations (buying and selling U.S. Treasury bonds).
2) D Reserve requirements (never really used).
3) D Discount rate which member banks (not meeting the reserve requirements) pay to borrow from the Fed.