Barter System

 The Monetary System

 Three Functions of  Money Medium of Exchange: Exchange: anything that is readily acceptable as payment. y Unit of Account: Account: serves as a unit of account to help us compare the relative values of  goods. z Store of Value: Value: a way to keep some of our wealth in a readily spendable form for future needs. x

The Two Types of Money Commodity Money: something that performs the function of money and has alternative, nonmonetary uses.

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Examples: Gold, silver

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Fiat Money: something that serves as money but has no other important uses.

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Examples: Coins, currency, check deposits

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 The nature of money What is money ? money ?

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It is whatever a given society at a given time agrees to use as a means of exchange Do not confuse money and money and wealth 

In other words, money is what we decide it to be as a society

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It is a social institution Its existence is therefore always based on the level of trust within a society 

 There are several types of currency

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 The nature of money Commodity money

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A situation where a commodity serves as currency Very close to barter , but with the currencycommodity dominating the exchanges Gold, silver, salt, cigarettes, sea shells, marbles. marbl es. 

Not necessarily intrinsically valuable, valuable, but often so: doesn’t require much trust.

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 The commodity is usually rare (limited supply) Has desirable properties: divisible 

 The nature of money  Token money:

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A situation where the currency is officially backed on a commodity.

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 The commodity itself is not exchanged, instead tokens representing units of the commodity are exchanged (ex: bank notes in the Gold Standard) Sta ndard)

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 This requires a higher level of trust, as the intrinsic value of the token is much less than the face value. value.

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 The tokens can always be converted into the commodity on demand.

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 The nature of money 

Fiat money:

Where money exists simply by law (an act of  government): it must be accepted in repayment of  all debts

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Money as a sign, sign, a symbol. It typically has no intrinsic value (except for pennies!) Its face value is backed entirely by the state’s credibility 

 This requires a high level of trust of  trust in the institution that creates it.

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 The nature of money Most countries nowadays use fiat currency, because money supply can be controlled.

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 This is important for financing the economy

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In a commodity/token currency system, the money supply is exogenous

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Restricted money supply during WWI, which caused most countries to temporarily abandon it.

In a fiat system, the supply can be adjusted as necessary.

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Money : function and creation process  The nature of money  The classical and Keynesian functions of money  The creation of money by the banking system

 The classical and Keynesian functions  The classical functions of money

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Also called the Aristotelian the Aristotelian functions.  Aristotle was intrigued by the problem of  commensurability:: how can intrinsically different  commensurability goods have an exchange value?  His conclusion : exchange can only occur if the goods are equal in a given comparable measure 

1st function: Means of exchange

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Simplifies exchange compared to barter: no need for a double coincidence of wants

 The classical and Keynesian functions 2nd function : unit of account

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Money is divisible, so can be used to measure and compare the values of different goods (price system)

3rd function: Reserve of value

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Payments made in money do not lose their value over time, unlike barter or payments in kind  Money allows the conservation of values through time (discounting inflation) 

 The classical and Keynesian functions Keynes’ “General “General theory of employment, interest  and money ” money ” introduced more functions, leading to a debate about the role of money in the economy

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 The central argument is the existence of a  preference for liquidity in liquidity in agents

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With uncertainty, agents will prefer to hold liquidities as away of adapting faster to the risky environment  Money is the most liquid and least risky way of holding assets: it is always accepted in transactions  Money will be demanded for its intrinsic properties 

 The classical and Keynesian functions Keynes identifies 3 “motives” for demanding money   The transaction motive: 

money is required for exchange (similar to the “classical functions”)   This demand is a positive function of income 

 The precaution motive:

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Holding some liquidity is the best option in the presence of  uncertainty .   This is also a positive function of income 

 The classical and Keynesian functions  The speculation motive:

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 This motive embodies the trade-off between holding liquidities and assets.  Liquidity is preferred, but does not pay interest. Assets pay interest, but are not as liquid   Therefore the interest rate is the opportunity cost of  cost of  holding liquidity : as it increases people will hold less liquidity 

 This leads to an overall demand for money of the following form:

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M 

d 

M 

=

 P 

=  L

(Y , i ) +

−

 The classical and Keynesian functions  This has lead to an important debate on the effect of money in the economy between:

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 Those who believe that money is neutral (i.e. does not affect real economic variables)

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Classical approach, quantity theory approach

 Those who believe that money is not neutral (it can affect real variables)

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 This is due to the role of the interest rate on money demand

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 The debate is not closed yet, but has moved to a short-term/long-term debate

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Money is neutral in the LR, not in the SR

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 The classical and Keynesian functions  The Keynesian argument for non-neutral money will be shown in greater detail in the next few weeks (ISLM)

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What about the “classical” approach? It is grounded in the Quantity Theory of Money (QTM) Classical dichotomy : nominal variables and real variables are independent  Money is only used for transactions, therefore t herefore only the “classical” functions apply. 

 The classical and Keynesian functions M 

T  × V  =  P  × Money Velocity Prices Transactions

QTM states that velocity V (the number of times a given money is used in a given time period) and the volume of transactions of transactions T are exogenous with respect to money M.

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 Therefore increases in M lead to proportional increases in P  Inflation is a purely monetary  monetary phenomenon phenomenon 

But Keynesians argue this holds only in the LR: in the SR, increasing M can change real variables because of the liquidity preference

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Money : function and creation process  The nature of money  The classical and Keynesian functions of money  The creation of money by the banking system

 The creation of money Most of the money is created by banks through the process of credit (lending) What is the purpose of a bank? 

 To hold the short term deposits of money by agents And make them available as long term loans to other economic agents (which earn interest)   This funds economic activity (investment projects, consumer durable purchases) In the process, this also creates money for transactions in the economy 

 The creation of money  The actors in this process are :

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 The agents:

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Provide deposits to banks and take out loans

 The banking system:

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Which take the deposits from agents and make the loans to agents

 The central bank:

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Regulates the banking system (prudential regulations)  Provides “base money” to the banking system  Acts as the lender of last resort to banks 

 The creation of money Central Bank

Supplies base money B (interbank liquidity)

Interbank market

Bank A

Bank B

 The amount of  money M supplied by the banks is larger than the base money B supplied by the central bank

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Bank C

M>B

Deposits and loans

Agents

Supplies money M to the economy

 There is a net creation of  money !

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Credit Creation by a Single Bank Rounds Primary Cash Deposits

Credit Creation

Reserves (20%)

1. Person (A)

Rs. 1000Rs 0Rs. 200 Rs. 800

2. Person (B)

800

160

640

3. Person (C)

640

128

512

4. Person (D)

512

102

410

5. ---- ----

----

-- --

6. ---- ----

----

-- --

-- -- - -- -

----

-- --

-- -- - -- -

----

-- --

5000

1000

Total

4000

Credit Multiplier Credit creation creation depends upon the ratio of cash reserves to deposits. deposits. The credit or the deposit multiplier is K= 1/r ; where K is the credit multiplier  and r is the cash reserve ratio. If cash reserve ratio is 20% then

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K= 1/r = 1/.2 = 5 The higher the cash reserve ratio, the lower would be the credit multiplier  multiplier  and vice-versa.

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Credit creation under multiple banking system.

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P

P

r

ic e L

(

P )

1

l

e v e

M o n e y

V a lu e o

P P 2

Money Supply

f

1/p2 1/p 1/p1 M 2

M

M 1

Money Supply

Demand and Supply of  Money 1.   Transactions Theory of Money 2. Precautionary Motive Theory of Money 3. Speculative Motive Theory of Money

Supply of Money Central Bank of the Country Money Supply during recession/depression Money Supply during inflation Equilibrium between demand and supply and rate of interest. Liquidity trap 

Money Supply in India M1, M2, M3, and M4 M or M1 = C + DD + OD

( C= currency held by the public, DD= Net Demand Deposits of Banks, OD= Other Deposits of RBI )

M2 = M1 + Saving Deposits with Post Office Saving Banks. M3 = M1 + Net Time Deposits of Banks M4 = M3 + Total Deposits with the Post Office Savings Organization ( excluding National Saving Certificates)