Functions and Definitions of Money

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Functions and Definitions of Money

• LECTURE 2

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BEGINNING TERMS

• BARTER
• SPECIALIZATION
• MONEY
• MEDIUM OF EXCHANGE
• MONETARY STANDARD
• STABLE IN VALUE

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BARTER AND THE NEED FOR MONEY
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FROM ADAM SMITHS WEALTH OF NATIONS BOOK 1 ,
CHAPTER 4 ON MONEY (1776)
But when the division of labour first began to
take place, this power of exchanging must
frequently have been very much clogged and
embarrassed in its operations. One man, we shall
suppose, has more of a certain commodity than he
himself has occasion for, while another has less.
The former consequently would be glad to dispose
of, and the latter to purchase, a part of this
superfluity. But if this latter should chance to
have nothing that the former stands in need of,
no exchange can be made between them. The butcher
has more meat in his shop than he himself can
consume, and the brewer and the baker would each
of them be willing to purchase a part of it. But
they have nothing to offer in exchange, except
the different productions of their respective
trades, and the butcher is already provided with
all the bread and beer which he has immediate
occasion for. No exchange can, in this case, be
made between them. He cannot be their merchant,
nor they his customers and they are all of them
thus mutually less serviceable to one another. In
order to avoid the inconveniency of such
situations,every prudent man in every period of
society, after the first establishment of the
division of labour, must naturally have
endeavoured to manage his affairs in such a
manner as to have at all times by him, besides
the peculiar produce of his own industry, a
certain quantity of some one commodity or other,
such as he imagined few people would be likely to
refuse in exchange for the produce of their
industry. ( LIBRARY OF THE FUTURE 3rd ,1994)
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Characteristics of a Pure Barter System

• HUMAN PROPENSITY TO TRUCK,BARTER, AND EXCHANGE
  ONE COMMODITY FOR ANOTHER.
• EXPANSION OF MARKETS
• SPECIALIZATION AND DIVISION OF LABOR
• PRODUCTIVITY INCREASES

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Characteristics of a Pure Barter System

• EXCHANGE PROCESS
• DOUBLE COINCIDENCE OF WANTS PROBLEM INCREASES
  TRANSACTION COST OF EXCHANGES
• SEARCH COSTS
• DISADVANTAGES OF BARTER
• NO MEDIUM OF EXCHANGE
• NO STORE VALUE
• NO STANDARD OF VALUE

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Characteristics of a Pure Barter System

• BUT REMEMBER THE EXCHANGE PROCESS IS NOT A
  DISADVANTAGE
• MONEY EVOLVED AS A NATURAL OUTCOME OF NATURAL
  ECONOMIC PROCESSES

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FUNCTIONS OF MONEY

• MEDIUM OF EXCHANGE
• GENERALIZED PURCHASING
• POWER
• REDUCTION IN TRANSACTIONS
• COSTS
• FUNCTION ASSOCIATED WITH
• SPECIALIZATION

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FUNCTIONS OF MONEY

• UNIT OF ACCOUNT FUNCTION
• COMMON DENOMINATOR
• VEIL OVER REAL EXCHANGE
• RATIOS
• VARIABLE MEASURE-- KEY ISSUE
• STANDARD OF DEFERRED
• PAYMENT

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FUNCTIONS OF MONEY

• STORE OF VALUE
• MONEY AS AN ASSET
• ONE CHOICE IN YOUR PORTFOLIO
• DECISION
• ONE WAY TO HOLD WEALTH

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Qualities of a Sustainable Money
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MONETARY STANDARDS

• THE PERSISTENT HISTORICAL QUESTION HAS BEEN HOW
  DO YOU MAINTAIN A CONTROLLABLE / STABLE MONETARY
  STANDARD.
• WHAT IS A MONETARY STANDARD ?
• THE STANDARD MONEY OF AN ECONOMY IS THE COMMODITY
  IN TERMS OF WHICH THE MONETARY UNIT IS FIXED.

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TYPES OF STANDARDS

• 1. METALLIC STANDARDS
• A. MONOMETALLIC STANDARDS
• i. GOLD
• ii. SILVER
• B. BIMETALLIC STANDARDS
• 2. INCONVERTIBLE OR FIAT
• STANDARD

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TYPES OF STANDARDS

• FIAT MONEY A PAPER MONEY PUT INTO CIRCULATION BY
  GOVERNMENT DECREE -- THE GOVERNMENT SAYS THIS
  GREEN PAPER IS LEGAL TENDER.

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METALLIC STANDARDS

• IN THE QUEST FOR A STABLE MONETARY SYSTEM ,
  METALLIC STANDARDS WERE THOUGHT TO BE
  SELF-ADJUSTING MECHANISMS. THAT IS , THEY
  STABILIZED THEMSELVES WITHOUT A CENTRAL BANK OR
  GOVERNMENT INTERVENTION.

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REQUIREMENTS FOR A GOLD COIN STANDARD

• THE MONETARY UNIT MUST BE DEFINED IN TERMS OF
  GOLD
• GOLD CAN BE COINED WITHOUT LIMIT AT LITTLE OR NO
  COST TO THE SUPPLIERS OF GOLD AND LIKEWISE
  UNLIMITED MELTING OF GOLD IS PERMITTED.

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REQUIREMENTS FOR A GOLD COIN STANDARD

• THE IMPORT AND EXPORT OF GOLD IS UNRESTRICTED
• IF PAPER MONEY EXISTS--ALL LEGAL TENDER PAPER
  MONEY IS REDEEMABLE AT PAR VALUE IN GOLD COINS ON
  DEMAND

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MONEY SUPPLY DETERMINATION UNDER A METALLIC
STANDARD
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Market Forces

• UNDER A GOLD STANDARD THE MONEY SUPPLY IS
  DETERMINED IN THE GOLD MARKET-- BY MARKET FORCES

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MONEY SUPPLY DETERMINATION UNDER A METALLIC
STANDARD
GOLD MARKET BEFORE THE GOVERNMENT SETS A MINT
PRICE FOR GOLD
Price of Gold
Supply of Gold
S
P
Nonmonetary Demand for Gold
DN
Quantity of Gold
Q
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MONEY SUPPLY DETERMINATION UNDER A METALLIC
STANDARD
GOLD MARKET AFTER THE GOVERNMENT SETS A MINT
PRICE FOR GOLD
Price of Gold
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MONEY SUPPLY DETERMINATION UNDER A METALLIC
STANDARD
GOLD MARKET AFTER THE GOVERNMENT SETS A MINT
PRICE FOR GOLD
Price of Gold
Supply of Gold
S
C
D
E
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MONEY SUPPLY
P
Nonmonetary Demand for Gold
DN
Quantity of Gold
Q
A
B
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MONEY SUPPLY DETERMINATION UNDER A METALLIC
STANDARD
GOLD MARKET AFTER THE GOVERNMENT SETS A MINT
PRICE FOR GOLD
Price of Gold
Supply of Gold
S
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P
DN
Nonmonetary Demand for Gold
DN
Quantity of Gold
Q
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MONEY SUPPLY DETERMINATION UNDER A METALLIC
STANDARD
GOLD MARKET AFTER THE GOVERNMENT SETS A MINT
PRICE FOR GOLD
Price of Gold
Supply of Gold
S
C
D
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P
DN
Nonmonetary Demand for Gold
DN
0
Q
Quantity of Gold
A
B
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MONEY SUPPLY DETERMINATION UNDER A METALLIC
STANDARD
GOLD MARKET AFTER THE GOVERNMENT SETS A MINT
PRICE FOR GOLD
Price of Gold
Supply of Gold
S
S
35
P
Nonmonetary Demand for Gold
DN
0
Quantity of Gold
Q
27
MONEY SUPPLY DETERMINATION UNDER A METALLIC
STANDARD
GOLD MARKET AFTER THE GOVERNMENT SETS A MINT
PRICE FOR GOLD
Price of Gold
Supply of Gold
S
S
D
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C
P
MONEY SUPPLY
Nonmonetary Demand for Gold
DN
0
A
B
Quantity of Gold
Q
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HISTORY OF THE MONETARY STANDARD

• CONTINENTAL BILLS OF CREDIT 1775-1779 -- FIAT
  MONEY STANDARD
• COINAGE ACT OF 1792--BIMETALLIC STANDARD
• PROBLEM WITH THE MINT RATIO
• DEFACTO SILVER STANDARD

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GRESHAMS LAW

• THERE IS A TENDENCY FOR OVERVALUED MONEY TO DRIVE
  UNDERVALUED MONEY OUT OF CIRCULATION.
• BAD MONEY TENDS TO DRIVE GOOD MONEY OUT OF
  CIRCULATION.

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Thomas Gresham
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HISTORY OF THE MONETARY STANDARD

• COINAGE ACT OF 1834--CHANGED THE MINT RATIO
• COINAGE ACT OF 1853--REDUCED THE MINTING OF
  SILVER COINS
• GREENBACK ERA 1862-1879 -- LEGAL TENDER
  NOTES--FIAT PAPER CURRENCY
• COINAGE ACT OF 1873-- CRIME OF 73
• BLAND-ALLISON ACT OF 1878--REQUIRED TREASURY TO
  PURCHASE SILVER AT OLD MINT RATIO

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Bland-Allison Act
Bland-Allison Act, 1878, passed by the U.S.
Congress to provide for freer coinage of silver.
The original bill offered by Representative
Richard P. Bland incorporated the demands of the
Western radicals for free and unlimited coinage
of silver. This was passed by the House but was
unacceptable to the conservative Senate. Senator
William B. Allison then offered an amended
version. The act as adopted required the U.S.
Treasury to purchase between 2 million and 4
million worth of silver bullion each month at
market prices this was to be coined into silver
dollars, which were made legal tender for all
debts. Attempts of the free-silver forces to
replace the act with provision for unlimited
coinage were defeated, as were attempts of the
gold-standard forces to repeal it altogether.
President Hayes and his successors weakened the
act's effect by purchasing only the minimum
amount of bullion. It remained law until replaced
by the Sherman Silver Purchase Act of 1890.
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HISTORY OF THE MONETARY STANDARD

• SHERMAN SILVER PURCHASE ACT 1890--- INCREASED
  SILVER PURCHASES BY TREASURY
• PANIC OF 1893--REPEAL OF SHERMAN SILVER PURCHASE
  ACT
• GOLD STANDARD ACT OF 1900--ESTABLISHED A FULL
  GOLD STANDARD
• GOLD RESERVE ACT OF 1934--ESTABLISHED A GOLD
  BULLION STANDARD

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Sherman Silver Purchase Act
Sherman Silver Purchase Act, 1890, passed by the
U.S. Congress to supplant the Bland-Allison Act
of 1878. It not only required the U.S. government
to purchase nearly twice as much silver as
before, but also added substantially to the
amount of money already in circulation. The
Sherman Silver Purchase Act (supported by John
Sherman only as a compromise with the advocates
of free silver) threatened, when put into
operation, to undermine the U.S. Treasury's gold
reserves. After the panic of 1893 broke,
President Cleveland called a special session of
Congress and secured (1893) the repeal of the
act.
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HISTORY OF THE MONETARY STANDARD

• COINAGE ACT OF 1965--ELIMINATED SILVER FROM TOKEN
  COINS
• NIXON SUSPENDS CONVERTIBILITY OF DOLLAR IN
  INTERNATIONAL TRANSACTIONS 1971
• SMITHSONIAN AGREEMENT 1973--FLOATING EXCHANGE
  RATE
• DEC.31,1974--PROHIBITION AGAINST PRIVATE BUY ,
  SELLING , AND OWNERSHIP OF GOLD ENDED

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Stabilizing The Value Of Money
Too Little Money
Too Much Money
Too Much Money
Central Theme
Stable Value
Inflation
Deflation
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Types of Money

• COMMODITY MONEY
• FULL-BODIED MONEY
• REPRESENTATIVE FULL-BODIED
• CREDIT MONEY -FIAT MONEY
• ISSUED GOVTS AND CENTRAL BANKS
• TOKEN COINS
• PAPER -- BY TREASURIES OR BY CENTRAL
  BANKS

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Types of Money

• ISSUED BY DEPOSITORY INSTITUTIONS
• BANKS NOTES
• TRANSACTION ACCOUNTS
• CHECKABLE DEPOSITS
• WHO ISSUES OUR MONEY TODAY ??
• IT DEPENDS ON HOW YOU DEFINE MONEY

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CRITERIA FOR DEFINING MONEY

• THE EFFECTIVE IMPLEMENTATION OF MONETARY POLICY
  REQUIRES A MEANINGFUL DEFINITION OF THE MONEY
  SUPPLY.

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CRITERIA FOR DEFINING MONEY

• 1. A CLOSE CORRESPONDENCE MUST EXIST BETWEEN THE
  THEORETICAL OR CONCEPTUAL DEFINITION OF MONEY AND
  THE EMPIRICAL, MEASURABLE , OR STATISTICAL
  DEFINITION OF MONEY.

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CRITERIA FOR DEFINING MONEY

• 2. THE FED MUST BE ABLE TO CONTROL THE
  EMPIRICALLY DEFINED MONEY SUPPLY AND TO MEET THE
  TARGETS THAT IT SETS FOR THE MONEY SUPPLY WITH
  THE TOOLS AT ITS DISPOSAL.

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CRITERIA FOR DEFINING MONEY

• 3.THE EMPIRICAL DEFINITION OF MONEY MUST BE
  CLOSELY RELATED AND PREDICTABLY RELATED TO THE
  ULTIMATE NATIONAL GOALS OF MONETARY POLICY
  PARTICULARLY PRICE STABILITY.

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CONCEPTUAL DEFINITIONS OF MONEY

• TRANSACTION APPROACH MONEY AS A MEDIUM OF
  EXCHANGE
• LIQUIDITY APPROACHMONEY AS A LIQUID STORE OF
  VALUE--LIQUIDITY IMPLIES MARKETABILITY AND
  RECOVERY OF COST OR FACE VALUE
• SCIENTIFIC CONSTRUCT APPROACHMONEY AS A TENATIVE
  SCIENTIFIC CONSTRUCT TO BE INVENTED LIKE LENGTH
  OR TEMPERATURE IN PHYSICS

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EMPIRICAL DEFINITIONS OF MONEY

• M1 is calculated by summing currency, travelers
  checks, demand deposits, and OCDs.
• M2 consists of M1 plus savings deposits
  (including money market deposit accounts),
  small-denomination time deposits (time
  deposits-including retail RPs-in amounts of less
  than 100,000), and balances in retail money
  market funds.

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EMPIRICAL DEFINITIONS OF MONEY

• M3 consists of M2 plus large-denomination time
  deposits (in amounts of 100,000 or more),
  balances in institutional money funds, RP
  liabilities (overnight and term) issued by all
  depository institutions, and Eurodollars
  (overnight and term) held by U.S. residents at
  foreign branches of U.S. banks.

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EMPIRICAL DEFINITIONS OF ONEY

• Debt The debt aggregate is the outstanding
  credit market debt of the domestic nonfinancial
  sectors--the federal sector (U.S. government, not
  including government-sponsored enterprises or
  federally related mortgage pools) and the
  nonfederal sectors (state and local governments,
  households and nonprofit organizations,
  nonfinancial corporate and nonfarm noncorporate
  businesses, and farms). Nonfederal debt consists
  of mortgages, tax-exempt and corporate bonds,
  consumer credit, bank loans, commercial paper,
  and other loans.

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MOTIVES FOR DEMANDING MONEY

• Transactions Demand is the demand (desire) for
  money (holding money as a balance) to facilitate
  ordinary transactions.
• Precautionary Demand is the demand for holding
  money as a precaution against unforeseen
  contingencies and as a means of taking advantage
  of unforeseen opportunities.

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MOTIVES FOR DEMANDING MONEY

• Speculative Demand is the demand for money
  holdings to avoid possible losses or realize
  possible gains from changes in the value of bonds
  (or other assets).
• Total Demand is the sum of the
• Transactions demand
• Precautionary demand
• Speculative demand

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VELOCITY AND THE DEMAND FOR MONEY
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TRANSITION TO THE NEXT SECTION

• PREMISE
• THE OVERRIDING GOAL OF MONETARY POLICY IS TO
  STABILIZE THE VALUE OF MONEY --
• OR ,MORE COLLOQUIALLY,TO PROVIDE A SOUND
  FINANCIAL SYSTEM

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BASIS QUESTIONS

• 1. HOW DO YOU CONTROL THE VALUE
• OF MONEY ?
• BY CONTROLLING THE PRICE
• LEVEL --- IF YOU CAN ---
• 2. HOW DO YOU CONTROL THE PRICE
• LEVEL ?
• BY CONTROLLING THE AMOUNT
• OF MONEY IN CIRCULATION---
• IF YOU CAN---

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BASIS QUESTIONS

• 3. BUT WHAT IS MONEY ?
• M1 M2 M3 L
• 4. HOW DO YOU CONTROL M1 , M2 ,
• M3 , AND L .
• BY CONTROLLING THE FINANCIAL
• INSTRUMENTS THAT MAKE-UP THE
• FOUR MONETARY AGGREGATES
• --- IF YOU CAN---
• 5. BUT WHERE DO THESE FINANCIAL
• INSTRUMENTS COME FROM ?
• FROM CORPORATIONS , BANKS , SLs.
• .

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BASIS QUESTIONS

• 6. SO IF YOU WANT TO CONTROL
• THE VALUE OF MONEY, YOU HAVE
• TO UNDERSTAND FINANCIAL
• INSTITUTIONS AND FINANCIAL
• MARKETS. BOTH DOMESTIC
• MARKETS AND INTERNATIONAL
• MARKETS.
• 7. ONCE WE UNDERSTAND THE
• BASICS ABOUT FINANCIAL
• MARKETS AND INSTITUTIONS,
• WE CAN DISCUSS THE FEDS

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BASIS QUESTIONS

• STRATEGIC ROLE AS THE ULTIMATE
• PROVIDER OF LIQUIDITY AND HOW
• MONEY IS PRODUCED.
• 8. BY INCREASING AND DECREASING
• THE PRODUCTION OF MONEY,
• THE FED ATTEMPTS TO CONTROL
• THE VALUE OF MONEY.