Money and the Financial

System

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© 2006 Thomson/South-Western
 Evolution of Money

Barter is the direct trading of one good

for another good

Problems with barter

 Requires a double coincidence of wants:
traders have products that other traders
want
 The traders must agree on the exchange rate
between the two goods

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 Medium of Exchange

Anything that is generally accepted by all

parties in payment for goods and services
Money is anything generally accepted in
exchange for goods/services – making it a
medium of exchange
Commodity money: anything that serves
both as money and as a commodity;
money that has intrinsic value, such as
gold and silver

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 Unit of Account

 A common unit for measuring the value of each

good and service
 Eliminates the necessity of having to determine
how much of each good exchanged for every
other good

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 Store of Value
 Money serves as a store of value when it retains
purchasing power over time: the better it
preserves purchasing power, the better money
serves as a store of value

 Recall the distinction between stock and flow

 Stock is an amount measured at a particular point
in time
 Flow is an amount per unit of time
 Money is a stock, and income is a flow

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 Desirable Qualities of Money
 Durable
 Portable or easily carried
 Divisible
 Acceptable
 Gresham’s Law:People tend to trade away
inferior money and hoard the best.
 Uniform Quality: Over time, the quality of
money in circulation becomes less acceptable,
so money should be of uniform quality.
 Low opportunity cost
 Relatively stable value

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Exhibit 1: Six Desirable Qualities of Money

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 Coins
 Quality and quantity of commodity was
questionable
 Precious metals could be debased with cheaper
metals: the quantity and quality of the metal
had to be determined with each exchange
 This quality-control problem was addressed by
coining the metal where coinage determined
both the amount and quality of the metal
 However, because of the possibility of clipping
or shaving some of the metal from the coin,
coins had to be bordered with a well-defined
rim and were milled around the edges

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 Coins

Seigniorage: The difference between

the face value of money and the cost
of supplying it; the “profit” from
issuing money
Token money: Money whose face
value exceeds its cost of production

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 Money and Banking
 Goldsmiths offered the community
“safekeeping” for money and other valuables

 In return, they gave depositors their money

back on request

 However, since deposits by some people tended

to offset withdrawals by others, the amount of
idle cash, or gold, in the vault remained
relatively constant over time

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 Money and Banking
 For this reason, the goldsmiths found they
could earn interest by making loans from this
pool of idle cash

 However, visiting the goldsmith every time

money was needed created a problem

 As a result, goldsmiths devised written

instruments that could be used in payment: the
first checks
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 Money and Banking

The goldsmith soon discovered how to make

loans against which the borrower could write
checks, written orders instructing the goldsmith
(now, a bank) to pay someone from an amount
deposited: they were able to create money

 This money, based only on an entry in the

goldsmith’s ledger, was accepted because of the
public’s confidence that these claims would be
honored

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 Fractional Reserve Banking

 The total claims against the goldsmith consisted

of
 Claims by those who had deposited their money,
plus
 Claims by people to whom the goldsmith had
extended loans

 Because these claims exceeded the value of gold

on reserve, this was the beginning of a
fractional reserve banking system

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 Fractional Reserve Banking

 System in which the goldsmith’s reserves

amounted to just a fraction of total deposits

 The reserve ratio measures reserves as a share

of total claims against the goldsmith, or total
deposits
 For example, if the goldsmith had gold reserves
valued at $5,000 but deposits totaling $10,000, the
reserve ratio would be 50%

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 Paper Money
 Another way a bank could create money was by
issuing bank notes, pieces of paper promising the
bearer specific amounts of gold or silver when the
notes were presented to the issuing bank for
redemption
 Banks in London introduced checks
 Principal difference between checks and bank
notes
 Checks could be redeemed only if endorsed by the payee
 Notes could be redeemed by anyone who presented them
 Representative money
 Bank notes that exchange for a specific commodity
 Paper money was often as good as gold since the bearer
could redeem it for gold
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 Fiat Money
 Fiat money derives its status as money from the
power of the state: is money because the
government says so
 Not redeemable for anything other than more fiat
money, nor is it backed by anything of intrinsic
value

 Fiat money is declared legal tender by the

government: person has made a valid and legal
offer of payment when payment is made with
this money

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 Value of Money

 Why does money have value?

 The commodity feature of money bolstered
confidence because of its acceptability
 Initially paper money was acceptable because it
was redeemable in gold, silver of some other
item of value
 However, what makes paper money acceptable
today is that individuals accept these pieces of
paper because they have reason to believe others
will do so as well: it can be used for exchange

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 Purchasing Power of Money
 The purchasing power of money is the rate at
which it exchanges for goods and services

 The higher the price level, the less can be

purchased with each dollar  each dollar is
worth less

 Specifically, the purchasing power of a dollar

over time varies inversely with the price level

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