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Ch02 What Is Money - Canadian-Financial-System
Sciences Economiques et Gestion
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CHAPTER 2: What Is Money?
FOCUS OF THE CHAPTER
This chapter provides a brief analysis of money, and its importance in the economy. The analysis deals with the definition of money, problems in economies without money (barter), what money does in a money economy, types of money used in the historical evolution of money, how to measure the supply of money, types of money used in Canada, the relationship between the money supply and economic activity (price level, GDP, etc.). The impact of inflation on social welfare is also discussed.
Learning Objectives:
Identify why monetary economies are prevalent around the world Understand the functions of money and identify the special features of a monetary standard Trace the monetary standards that have existed through history and their evolution Understand the basic features of and definitions used in measuring Canada’s money supply Determine why a multiplicity of money supply definitions exist Identify what economic factors affect the purchasing power of money
SECTION SUMMARIES
Why Money?
Money is not necessarily legal currency (notes and coins). Money is any asset (or assets) that the public in general accepts as capable of performing certain functions (the functions of money). The social agreement (or acceptance) is the most important requirement. Money is believed to improve economic efficiency and social welfare.
Barter: Barter is the direct exchange of commodities without the use of money (exchanging commodities for commodities). Barter is less efficient than monetary exchange (selling one commodity for money and buying another using that money). The exchange is not possible unless there is a ‘‘double coincidence of wants’’ (i., the wants of the two parties match exactly), a condition not easy to satisfy. Time and other real costs of completing a transaction (transaction cost) are therefore higher with barter. There are other difficulties with barter as well.
The Functions of Money: Money fulfills three basic functions as: 1) a medium of exchange (as payment for goods and services); 2) a unit of account (as a yardstick for measuring value or price); and 3) a store of value (as an asset in terms of which the storage of wealth is possible). As a generally acceptable medium of exchange, money is perfectly liquid and eliminates the need for a double coincidence of wants. The ease with which an asset can be converted into a medium of exchange is called liquidity. The suggestion that money must be designated as legal tender is not appropriate since the confidence of the public, not government enforcement, ultimately decides which assets will be used as money. Transaction costs can be lowered by using media of transaction such as traveller's cheques or credit cards. The medium of exchange function does not imply the store of value function, as there other interest rate-bearing assets than money (or cash) which may function better as stores of value.
A variety of commodities have served as mediums of exchange at various times in history. Why are certain commodities chosen? Who chooses which commodities get used as mediums of exchange? People would begin using an exchange commodity if they found it more convenient to exchange the goods they were selling for an exchange commodity because they could use that exchange commodity to trade for the goods they ultimately wanted. To fulfill this role an exchange commodity should be widely accepted, easy to carry around, durable, divisible and finally, easy to measure and evaluate.
Monetary Standards
A society’s monetary standard is the basis of its monetary arrangements and includes rules, regulations, and customs regarding the issue and use of money. Broadly, two monetary standards are found in history: commodity standards and fiat-money standards. Under a commodity standard the monetary unit is defined as a commodity such as gold (a physical asset) in a specified quantity and often quality. Commodity standards may take one of several forms. Standardized units of the physical commodity itself, or minted coins made from a precious metal can be used in trade. The term “commodity standard” also applies when paper money or token money is convertible into the designated commodity, and is used as circulating media (actually used in transactions). The gold standard, discussed below is an example of a commodity standard. Silver has also been used as the basis of commodity standard money.
Under a fiat-money standard (paper-money standard), the circulating media are the legal tender (notes and coins whose monetary worth is determined and guaranteed by the taxing and borrowing powers of the government), and have virtually no commodity value. Neither monetary standard is perfect, but fiat-money standards have become more popular and widespread.
Types of Banks and Deposits: Banks are a group of deposit-taking financial institutions which include chartered banks (e., Bank of Montreal, Bank of Nova Scotia), and near banks such as trust companies and credit unions. Depositors lend their funds to the banks. Therefore the deposits are assets to the depositor and liabilities to the institution. The deposits are of four types: 1) current accounts and personal chequing accounts; 2) savings deposits; 3) term deposits; and 4) money market mutual funds.
Cheques and Cheque Clearing: A cheque is a written order for a bank to transfer a specific amount of funds from the writer’s account to someone else. In a system of many banks, a large number of transactions are done every day using cheques which require the transfer of funds between the banks and changes in the balances of accounts. In Canada this is done by the Canadian Payments Association, which operates an automated cheque- clearing system (a clearing house). Computer technology has increased the speed of cheque clearing, but at all times some cheques are in transit. As a result, the double counting of money held by financial institutions is unavoidable. Therefore, an estimate called private sector float is used to adjust for the amount of double counting.
Definitions of the Money Supply:
Empirical definitions used in Canada, from the narrowest to the broadest, are listed below.
- Currency in Circulation, i., the notes and coins outside the banking system.
- M1. The currency in circulation plus current, demand, and personal chequing accounts at chartered banks, net of the private sector float.
- M2. M1 plus non-personal notice deposits and personal savings deposits at chartered banks.
- M2+. M2 plus notice and term deposits at near banks, generally at trust and mortgage loan companies.
- M3. M2 plus non-personal fixed-term deposits at chartered banks plus the Canadian dollar value of foreign currency deposits of residents booked in Canada.
Some Possible Refinements: Still broader measures of the money supply may be constructed which include some liquid assets such as Canada Savings Bonds, unused portions of credit card balances, and consumer or residential mortgage credit. Each of the money supply definitions measures the aggregate value of many different types of assets. Divisia Indexes have been developed to take into account the degree of liquidity of different assets included in the definitions of money supply.
Why So Many Monetary Aggregates? The link between the money supply and key macro aggregates such as GDP and price level has evolved over time because of financial innovations and deregulation. In response to new developments in the financial sector and the economy, the Bank of Canada has introduced a series of monetary aggregates. These aggregates are crucial variables in the analysis of economic performance and monetary policy effectiveness.
Seasonal Adjustment: Seasonal adjustments, calculated to smooth seasonal variations of money supply aggregates, are less necessary as we move from narrow to broad definitions.
Inflation, Deflation and Social Welfare
Inflation is an increase in the general level of prices. Inflation reduces the purchasing power (real value) of money and decreases social welfare through a redistribution of income and other harmful effects. Social costs result because inflation upsets the debtor- creditor relationship; influences the government revenue motive for inflation; creates a deadweight loss for society; leads to the additional cost of distinguishing nominal from real magnitudes; increases menu costs, poses problems for accounting in historical and current values; and generates uncertainty associated with higher and volatile prices.
MULTIPLE-CHOICE QUESTIONS
For an asset to act as money, the asset must a) be legally accepted as a medium of exchange. b) be commonly accepted by the public as a medium of exchange. c) have a physical existence. d) be made out of or fully backed by a precious metal.
Which of the following is not a function of money? a) Unit of account. b) Medium of exchange. c) Store of value. d) Intermediation.
The exchange of commodities for commodities is called a) barter. b) indirect exchange. c) asset transformation. d) monetary exchange.
A double coincidence of wants is a) a condition easily satisfied in a direct exchange economy. b) a condition not easily satisfied in barter. c) a desirable property of money. d) a function of money.
The two broad classifications of monetary standards found in the history of money are a) gold standard and silver standard. b) bimetallism and trimetallism. c) monometallism and bimetallism. d) commodity standard and paper-money standard.
Legal tender is the circulating medium under
d) Currency in circulation plus demand deposits at chartered banks and near banks
Which of the following is not true of inflation? a) It reduces purchasing power of money. b) It favours lenders and penalizes borrowers. c) It redistributes income in favour of variable income earners. d) It decreases social welfare.
The last year that Canada was on a gold standard was a) 1854 b) 1914 c) 1926 d) 1931
Inflation results in a) more seigniorage profits to governments and central banks. b) less seigniorage profits to governments and central banks. c) no change in the seigniorage profits to governments and central banks. d) a complete loss of all seigniorage profits to governments and central banks.
PROBLEMS
- Consider the following data (all in millions of dollars): Currency in circulation 100 Demand deposits at chartered banks (personal chequing accounts) 200 Notice deposits at chartered banks (current accounts) 500 Non-personal notice and personal savings deposits at chartered banks 600 Notice and term deposits at near banks 300 Non-personal term and foreign currency deposits 400
Compute the magnitude of a) M b) M c) M2+ and d) M
What are the problems of a barter economy compared to those of a monetary-exchange economy? Explain how a substantial increase in transaction costs would affect the volume of trade in a particular market.
State Gresham’s law and describe a situation in which the law might operate.
Describe some of the advantages and disadvantages of using commodity money in an economy.
d (see page 17)
a (see page 20,21)
c (see page 21)
b (see page 25)
b (see page 31)
d (see page 20)
a ( see page 31)
Answers to problems:
a) M1 = 100 + 200 + 500 = 800 million dollars b) M2 = 800 + 600 = 1400 million dollars c) M2+ =1400 + 300 = 1700 million dollars d) M3 = 1400 + 400 = 1800 million dollars
The problem of satisfying a double coincidence of wants for successful completion of an exchange is the most widely encountered problem under the barter system. This difficulty leads to higher transaction costs and to lower volume of exchanges. When the goods to be traded are of unequal value, the difficulty of dividing the goods for exchange without a considerable loss to one party (problem of divisibility) is another problem. Moreover, the absence of a satisfactory unit of measurement and a store of value (such as money) also creates problems. For instance, in barter there is no standard unit of measurement like the Canadian dollar to express the price or value of commodities or other objects. Although commodities other than money can also function as a store of value (for accumulation of wealth), money provides a more liquid and less costly store of value. Transaction costs have the same effect as direct taxes levied on both buyers and sellers. The transaction cost reduces demand (shifting the demand curve to the left) and reduces supply (also shifting the supply curve to the left). The intersection occurs at a much lower level for quantity traded. In fact, if transaction costs are high enough there may be no trade at all: people revert to being totally self-sufficient thereby losing all the gains from specialization and trade.
Gresham’s law states that bad (cheap) money drives good (dear) money out of circulation. Suppose that under bimetallism, gold and silver coins are used as circulating media in a country. Also, suppose for some reason that the supply of silver has increased greatly, making silver less scarce, and hence that the relative price of silver has dropped. Now, people would prefer to use more silver coins in transactions and to hoard gold coins. As a result, the gold coins eventually would be driven out of circulation.
Commodity money such as gold and silver has intrinsic value. Therefore, it can also be used as commodities (e., to make jewelry ), in addition to being using as money. The supply of such money cannot easily be changed by the authorities, and, therefore, price stability can be easily maintained. However, the supply of money depends on the production of the commodity (e., the discovery of new gold deposits) and the quantity of the commodity used for other purposes. Therefore, the supply is not related directly to the level of economic activity, and cannot be increased as required by increased economic activity.
This answer will depend on the specific reasons chosen but the general idea is that inflation induces a great number of distortions into the economy. Inflation transfers income and wealth from lenders to borrowers, lenders are likely to reduce their supply of funds into financial markets which is likely to impede economic growth. Companies using historical costs as the basis for depreciation expense are likely to overstate their income and not provide adequately for capital replacement.
In a world of nominal rigidities, meaning that wages and prices denominated in money terms are not easily reduced, it is easier to achieve a relative reduction in wages and prices than an absolute reduction in wages and prices.
Wine might be universally desirable, but it isn’t easy to carry around and it can’t be easily evaluated without consuming it. Salt at one time was relatively valuable. It is divisible and easily evaluated. Diamonds are easy to carry around, durable but neither divisible nor easily evaluated. Gold has basically all the desirable properties to be an exchange commodity.
Ch02 What Is Money - Canadian-Financial-System
Course: Sciences Economiques et Gestion
University: Université Sidi Mohamed Ben Abdellah de Fès
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