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Barter System

Barter System

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The Monetary System

Three Functions of Money
x Medium of Exchange: anything that

is

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

The Two Types of Money
Commodity Money: something that performs

the function of money and has alternative, nonmonetary uses.
Examples: Gold, silver

Fiat Money: something that serves as money

but has no other important uses.
Examples: Coins, currency, check deposits

The nature of money
What is money ?
It is whatever a given society at a given time

agrees to use as a means of exchange Do not confuse money and wealth

In other words, money is what we decide it

to be as a society

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

The nature of money
Commodity money A situation where a commodity serves as currency
Very close to barter, but with the currency-

commodity dominating the exchanges Gold, silver, salt, cigarettes, sea shells, marbles.

Not necessarily intrinsically valuable, but often so:

doesn’t require much trust.
The commodity is usually rare (limited supply) Has desirable properties: divisible

The nature of money
Token money: A situation where the currency is officially backed on a commodity.
The commodity itself is not exchanged, instead tokens

representing units of the commodity are exchanged (ex: bank notes in the Gold Standard)

This requires a higher level of trust, as the intrinsic

value of the token is much less than the face value.
The tokens can always be converted into the

commodity on demand.

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
Money as a 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 in the institution

that creates it.

The nature of money
Most countries nowadays use fiat currency,

because money supply can be controlled.
 This is important for financing the economy

In a commodity/token currency system, the

money supply is exogenous
 Restricted money supply during WWI, which caused

most countries to temporarily abandon it.

In a fiat system, the supply can be adjusted

as necessary.

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
 Also called the Aristotelian functions.  Aristotle was intrigued by the problem of

commensurability: how can intrinsically different 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
 Simplifies exchange compared to barter: no need for

a double coincidence of wants

The classical and Keynesian functions
2nd function : unit of account
 Money is divisible, so can be used to measure and

compare the values of different goods (price system)

3rd function: Reserve of value
 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 theory of employment, interest

and money ” introduced more functions, leading to a debate about the role of money in the economy
The central argument is the existence of a

preference for liquidity in agents
 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:
 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:
 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 holding liquidity : as it increases people will hold less liquidity

This leads to an overall demand for money of the

following form:

M M = = L Y,i + − P
d

( )

The classical and Keynesian functions
This has lead to an important debate on the effect

of money in the economy between:
 Those who believe that money is neutral (i.e. does not

affect real economic variables)

Classical approach, quantity theory approach

 Those who believe that money is not neutral (it can affect

real variables)

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

The debate is not closed yet, but has moved to a

short-term/long-term debate
Money is neutral in the LR, not in the SR

The classical and Keynesian functions
The Keynesian argument for non-neutral money will

be shown in greater detail in the next few weeks (ISLM)
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 only the “classical” functions apply.

The classical and Keynesian functions
Money

M × V

Velocity

= P×
Prices

Transactions

T

QTM states that velocity V (the number of times a

given money is used in a given time period) and the volume of transactions T are exogenous with respect to money M.
 Therefore increases in M lead to proportional increases in P  Inflation is a purely monetary phenomenon

But Keynesians argue this holds only in the LR: in the

SR, increasing M can change real variables because of the liquidity preference

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 :
The agents:  Provide deposits to banks and take out loans The banking system:

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

The central bank:  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 Interbank market
Supplies base money B (interbank liquidity)

 The amount of

Bank A

Bank B

Bank C
Supplies money M to the economy

money M supplied by the banks is larger than the base money B supplied by the central bank M>B

Deposits and loans

 There is a net

creation of money !

Agents

Credit Creation by a Single Bank
Rounds Primary Deposits 1. Person (A) 2. Person (B) 3. Person (C) 4. Person (D) 5. ---- ---6. ---- ------- ------- ---Total Cash Credit Creation Reserves (20%) Rs. 1000Rs. 200 Rs. 800 800 160 640 640 128 512 512 102 410 ------------------------5000 1000 4000

Credit Multiplier
Credit creation depends upon the ratio of cash reserves to 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 K= 1/r = 1/.2 = 5
The higher the cash reserve ratio, the lower would be the credit multiplier

and vice-versa.
Credit creation under multiple banking system.

P
1

Price Level (P)
Value of Money

P
P
2

Money Supply

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

Moneyand M Supply in India M ,M ,M ,
1 2 3 4

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)

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