Monetary Economics

Econ 3121
•INTRODUCTION:
• It would certainly be an exaggeration to say that all economic
problems are the result of malfunctions in the monetary system,
but we can for sure say that some of the most important ones are
related to the monetary system.
• Inflation is a monetary problem in the obvious sense that it means
that our monetary unit, which is the birr, is losing value. It is also a
monetary problem if: substantial and sustained inflations have
occurred only when the quantity of money has risen at a fast rate.
Hence, one can say that major inflations are "caused" by a rapid
rise in the supply of money.
• Unemployment, while it has many non-monetary aspects, is also
closely connected with changes in the money supply. If the supply
of money rises at a faster than expected rate, this lowers
unemployment temporarily, while a sharp decrease in the quantity
of money usually increases unemployment temporarily.
• Obviously, ‘monetary theory', the theory that
deals with the relation between changes in
the quantity of money, interest rates, and
changes in money income, is an important
topic, and so is monetary policy, which is
concerned with how the quantity of money
and interest rates should be managed.
• In general it is very important concept that
needs to be studied. In doing so, we start with
introducing ourselves with the basics of
money
ORIGIN OF MONEY:
• Various difficulties and inconsistencies experienced
under the barter system led to the invention of
money. Money may be any commodity chosen by
common consent as a medium or instrument of
exchange.
• All other commodities are thus expressed and valued
in terms of that commodity regarded as money. Such
a commodity should be recognizable and acceptable
by all to use it as a medium of exchange.
• It is a commodity, which is accepted customarily
without any special test of quality and quantity.
MONEY:Definition
 Various economists have defined money differently.
 Walker has defined it in terms of its functions.
According to him “money is what money does”. This
definition is too simple, vague, and extensive in the
sense he did not explain what money actually is or does.
 Robertson on the other hand has defined “money is
anything that is widely accepted in payment for goods or
in discharging other kind of business obligations”. This
definition, although exhaustive it is one sided in the
sense that it stresses only one aspect or basic
characteristics of money, namely its general
acceptability.
 Seligman has also defined money stressing on
the general acceptability as “one thing that
possesses general acceptability”.
 The definitions given by Cole and Kent were “
anything that is habitually and widely used as a
means of payments and generally acceptable in
the settlement of debt” and “ anything that is
commonly used and generally accepted as a
medium of exchange or as a standard of value”
respectively. Relatively the definition of Kent
emphasizes two functions of money, medium of
exchange and standard of value.
 None of these definitions are complete or
satisfactory. A comprehensive definition of
money must emphasis not only the important
functions of money but also its basic
characteristics i.e. general acceptability.
 From this criterion, the definition of Corther is
the most suitable. He defined it as “anything that
is generally acceptable as a means of exchange
(i.e. as a means to settle debt) and that at the
same time acts as a measure and as a store of
value”. This definition covers all the three
important functions of money and also stresses
its basic characteristic, namely general
acceptability.
FUNCTIONS OF MONEY:
• Instead of defining money either so narrowly as just
currency or so broadly as to include all wealth,
economists define money by its functions. Anything that
functions as a medium of exchange, as a standard of
value, or as an extremely liquid store of wealth is
considered money, these functions of money need
explaining
• That is, money acts as (1) a medium of exchange, (2) a
standard of value, (3) a standard of deferred payments,
and (4) a store of wealth. The first two of these functions
are the ones that are unique to money.
I. Money as a medium of Exchange
• The medium of exchange function is obvious; we
use money as an intermediary in exchange. We
exchange goods and services for money, and
then exchange this money for those goods and
we want to acquire. Such a round­about system of
exchange avoids the great disadvantage of
barter, as it needs for double coincidence of
wants. In other words to effect barter we have to
find someone who wants to obtain the goods and
services we have to offer and, at the same time,
can provide the goods and services we want to
obtain in exchange.
II. Money as a standard of value and deferred payment
• The second function of money is to act as a standard of
value, which simply means that we use money as a
way of comparing worth. We think of, and express, the
values of goods and services in terms of money, so
that money is the measuring rod of value the same
way as a mile is a measure of distance.
• Obviously, a modern economy requires continual
comparisons of value; buyers have to compare the
offers of numerous sellers, and this would be hard to
do if different sellers denominated their prices in
different goods; for example, if one shop demands two
birr of butter for a birr of beef, and another shop
demands ten pencils for a birr of beef, which shop is
cheaper?
• A similar problem would arise in deciding
whether to buy, say, beef or fish, if the price of
beef is expressed in terms of butter and the price
of fish in terms of another good. To make rational
decisions we would have to know the ratios at
which any one good exchange for all the others.
• One particular function of a standard of value is
to act as a standard of deferred payment. That is,
a standard in which debts are expressed. This use
of a standard of value creates serious problems
because, as unfortunately we (have all found out,
the value of money varies over time; the dollar
you lent last (year will not buy as much when you
receive it back this year.
III. Money as a store of wealth
• The final function of money is to serve as a store
of wealth. Although this function of money is no
more important than the other ones.
• Money has several peculiarities as a store of
wealth. One is that it has no, or only trivial,
transaction costs.
• People who decide to hold any other asset as a
store of wealth must take the money they
receive as income and buy this asset. Later on,
when they want to obtain goods or other assets
in place of this asset they have to exchange it for
money. Both of these transactions, from money
into this asset and, later on, from this asset back
into money, involve a cost.
• A second characteristic of money as a store of
wealth is that, quite obviously, its value in terms
of money is fixed. This is important because
debts are normally stated in money terms. Hence
money has a fixed value in terms of debts and
certain commitments, such as rental payments .
• Those who want an asset that will allow them to
pay off a debt have a definite incentive to hold
money.
• The absence of significant transactions costs and
the fixity of its value in terms of debts are the two
basic characteristics of money as a store of
wealth.
TABLE 1: SUMMARY OF FUNCTIONS OF
MONEY
 THE EVOLUTION OF MONEY
( MONEY IN HISTORICAL PERSPECTIVE: TYPES OF
MONEY )
A. Commodity money
• In the primitive society, things in common demanded like skins,
salt, corn, utensils, and weapons were used as money.
• The commodity chosen to serve as money was affected by the
factors such as location, climate, culture, and economic
development. For instance, the communities living by the
seashore used shells as a medium of exchange, Salt and cattle
were used as money in ancient Rome, while tobacco was used in
the early American colonies, in Tibet ‘tea’, in Japan ‘rice’, in
ancient Greece ‘ox’, in India ‘cattle’, in ancient Ethiopia ‘salt’, Kent
cigarettes in Rumania, and Horses in new England region (during
the colonial period) were the popular medium of exchange.
• Some of the difficulties in using commodity as money are most of
the commodities do not possess the essential characteristics of
money such as desirability, durability, portability, scarcity,
homogeneity, and variability.
• However, the use of commodity money was preferred to barter.
B. Convertible paper money

• Convertible paper money is paper money that can be

redeemed for a specific commodity at a rate specified
on the money. While convertible paper money isn’t
common today, it was once the primary form of
money.
• In many countries, for example, private banks
accepted a specified ounce of gold and issued bank
notes in exchange. A bank note was a piece of paper
printed in a specific denomination ($1, $10 etc) that
had a promise by the bank to pay to the bearer a
specific amount of gold on demand. Put differently,
these convertible paper money or bank notes were like
the current Treasury-Bills form though a specific
denomination T-bills is exchanged for money today.
• Currency, on the other hand, is paper money and
coin issued by the government on regular basis.
The first U.S currency issued in 1879 was a form
of convertible paper money. Until 1933,
exchange of gold for currency was at a rate of
one ounce (approximately 28 g) for $21.
• The U.S government eliminated the practice of
dollar for currency exchange in 1933 when the
official rate was raised to $35 per ounce of gold.
The U.S government, however, continued to
redeem U.S currency to foreign central banks or
governments at a rate of $35 per ounce of gold.
C. Fiat money

• Fiat is Latin for “by order of authority”. Fiat

money is money that some authority, generally a
government, has ordered to be accepted as a
medium of exchange.
• The money itself has virtually no intrinsic value.
That is the specific denomination of a bill (Birr 1
to Birr 100) is determined legally not because it
has something that worth that much in it. Our
currency Birr is fiat money. You will notice the
order on each bill: “Payable to the bearer on
demand”. The problem with fiat money is that it
can be printed so fast that it causes inflation.
D. Debt money
• Private debt money is a loan that the borrower
promises to repay on demand. A checking account, for
example, is private debt money. The owner of a check
account has in effect loaned the money he or she
deposit to the bank. The bank can use the proceeds in
any time it wishes. But, the bank promises to pay the
depositor, in currency on demand-whenever the
depositor decides to cash a check.
• Another form of private debt money is traveler’s
check. When you have travelers check, you are lending
money to the issuer of the check. The issuer agrees to
pay upon demand the amount designated on the
check to you or to anyone to whom you give the
amount. In the mean time the issuer is free to use the
fund.
DEPOSITS, CHECK PAYMENTS,
• Deposits and check payments
• Deposits are fiat money put aside in banks for use
sometimes in future. Except checkable deposits all other
forms of deposits such as saving deposit and time deposits
do bear interest to the depositors.
• Balances in the checking account are called checking
deposits. Checking deposits are deposits whose ownerships
are transferred with a check. Check is a written order to a
bank to transfer ownership of a checkable deposit. Suppose,
for example, that you have $100 in your checking account
and you write a check to your campus bookstore for $30 for
you lost the book you have borrowed from the university.
Therefore, the $30 will be either transferred from your
account to the university bookstore’s checking or saving
account or paid in cash.
• It is thus clear that the use of money arose out
of the inconveniences of barter: although in
the international sphere barter continued to
be practiced for a long time. A feature of a
transaction involving money is that direct
exchange gives way to indirect exchange. In a
barter transaction giving and taking are both
comprised in a single act; the use of money
separates these two processes, since first a
com­modity is sold out for money, and then
subsequently, at a later time the money so
obtained is used to make the desired
purchase.
• In the earliest stage, as already stated,
commodities were used as standard of value
and unit of account; in the second stage
metallic money was used and in the final stage
the paper money is in use. Now with the help
of this unit of account, values of .different
goods and services could be expressed and
compared.
• This led to :
- the extension of area of exchange and to the emergence of
the pricing system.
- Economic calculations became more rational and individual
choice-making became easier.
- This also extended the scope of markets, and provided
ample opportunities for specialization and division of labor.
Now goods came to be brought and sold independently.
- At the same time the dependence of one person on the
other was completely done away with.
- The use of time and efforts was substantially economized.
- When money came to be accepted as a common measure
of value and a medium of exchange, its storage became
easier and hence, money also started functioning as a store
of value. This was the final stage in the invention of money.
• As Crowther has pointed out "Money is one of
the most fundamental of all man's inventions,
every branch of knowledge has its
fundamental discovery. In mechanics it is the
wheel, in science it is the fire, in politics it is
the vote. Similarly, in economics, in the whole
commercial side of man's social existence,
money is the essential invention on which all
the rest is based.
• But, to say that the barter system has been
completely eliminated is wrong. In less
developed countries it still reigns supreme in
the rural areas. Even today, in the field of
international trade, owing to the problem of
international liquidity and scarcity of foreign
exchange more and more countries are
resorting to bilateral trade agreements which
are nothing but a modified form of the old
barter system
MEASURING MONEY
• The total quantity of money at any time is called
money supply. Economists measure money supply
because they know that it affects the level of economic
activity. Money stock/supply or simply money is
measured as the sum of currency in circulation and the
checkable deposits held by non-bank sectors at
commercial banks. This is because other forms of
deposits are NOW “negotiable orders of withdrawal”
that are paid interest. Because, NOW are not easily
convertible or liquid to currency. Economists refer to
the case with which an asset can be converted into
currency as assets liquidity. Checkable deposits are
almost perfectly liquid. An office building, however, is
highly illiquid . It can be converted to money only by
selling it, a time consuming and costly process.
• . As we have seen, many different assets have
performed this role over the centuries, ranging
from gold to paper currency to checking
accounts. For that reason this behavioral
definition does not tell us exactly what assets in
our economy should be considered money.
• Therefore, since it is difficult to determine what
(and what not) to measure as money, the Fed
(Central or National Bank in our case) uses three
different measures of money called M1 (Narrow
money), M2 (Broad money), and M3.
• M1, includes currency, demand deposits,
checking account deposits, and traveler's checks.
• M2 adds to Ml other assets that have check-
writing and other assets such as small
denomination time deposits and repurchase
agreements, savings deposits and money market
deposit accounts, and money market mutual
funds shares(non institutional).
• M3 adds to M2 assets such as large-
denomination time deposits, long-term
repurchase agreements, and institutional money
market mutual fund shares.