MONETARY ECONOMICS

&
EVOLUTION OF MONEY
 Why Take this Class?

 To understand how the financial markets like the bond and stock markets work

 To articulate why these markets react so strongly to actions taken by the central bank

 To evaluate the effectiveness of monetary policy in dealing with economic shocks

and inflation

 To analyze the effects of policy on interest rates and how different interest rates
affect different actors in the economy.

 To explain the role of money in the economy and the process by which banks create
money

 To understand how moral hazard and adverse selection in financial markets led to the
current credit crisis

 To evaluate how domestic policy affects exchange rates and capital flows abroad.
 MONEY
 Money is defined as the set of assets in an
economy that can be readily used to purchase
goods and services.
 Economists define money (also referred to as the
money supply) as anything that is generally
accepted in payment for goods or services or in
the repayment of debts.
MONEY
 According to Friedman money means

“The number of dollars people carrying in their

pockets, the number of dollars they have to their
credits at banks in the form of demand deposits or
time deposits”

 Thus he defines money as the sum of currency

plus all adjusted deposits in commercial banks.
 Before the evolution of money exchange was done on
the basis of direct exchange of goods & services. This
is known as Barter System.
 Barter involves the direct exchange of one good for
some quantity of another good.
Difficulties involved in Barter
 Standard of value (who decides what some thing is
worth).
 Double coincidence of wants

 Indivisibility of certain goods.

 DIFFERENT STAGES OF EVOLUTION OF
MONEY
1. Commodity Money
2. Metallic Money
3. Paper Money
4. Credit Money
5. Electronic Money
COMMODITY MONEY
When different commodities were used as a
medium of exchange (BARTER SYSTEM)
Cow Heads, Goats, Axes, Dried Fishes etc
were used as medium of exchange.
 METALLIC MONEY
The next step in the evolution was the discovery of
precious metals like Gold, Silver, Copper.
“ Metallic Money consist of coins made of Gold,
Silver, Copper or nickel as a mode of payment.”
Coined Metals.
 As a next step, standard coins were created.

 They had a standard weight & value.

 Problem of un coined metals started here as well.

Metallic money can be:
Fully Bodied
Whose Face Value is equal to the value of metal
contained in it.
Token Money
Its Face Value is Higher than Intrinsic Value (Value of
Metal)
PAPER MONEY
PAPER MONEY
 When paper currency was introduced as a mode of
payment.
 Originated as a receipt issued by Goldsmiths.

 These receipts were then later on used for payments.

 Difference in the value of receipts was becoming a

problem then refers to the Notes issued by the State or
by the Bank, usually the Central bank.
 Paper Money can be:
1. Representative Paper Money.
2. Convertible Paper Money.
3. Fait Paper Money.
Representative Paper Money.
It is that money which is fully backed by equivalent
metallic reserves.
Convertible Paper Money
Which is convertible into coins on demand.
Fait Paper Money
Which is not convertible into Gold or Silver on demand.
It is accepted because it is declared legal tender by the
issuing authority and has general acceptance as a
medium of exchange. The intrinsic value of Fait money
is Nil.
 CREDIT MONEY

 Includes Bank money (different instruments offered by

the Banks.)
 Cheques, Drafts, are examples.

 Convenient, Safe and easily convertible into cash.

 Its like Near Money.

ELECTRONIC MONEY
 Electronic money is money which exists only in banking
computer systems and is not held in any physical form.
In the United States, only a small fraction of the
currency in circulation exists in physical form.
 The need for physical currency has declined as more and
more citizens use electronic alternatives to physical
currency.
MONEY DEFINITIONS
 From most liquid (narrow) to the least liquid
(broad).

 M0 = paper currency and coins

 M1 = M0+ Checking Accounts+ Traveler Checks
 M2 = M1 + Savings Accounts
 M3 = M2 + Forex Accounts
FUNCTIONS OF MONEY
 Medium of exchange
 Standard of value

 Store of value

 Standard of deferred payment

MEDIUM OF EXCHANGE
 The
most important job of money is to serve as a
medium of exchange
 When any good or service is purchased, people use
money
 The use of money as a medium of exchange promotes
economic efficiency by minimizing the time spent in
exchanging goods and services.
 The time spent trying to exchange goods or services is
called a transaction cost. In a barter economy,
transaction costs are high because people have to
satisfy a “double coincidence of wants”
MONEY AS A UNIT OF ACCOUNT
 Without money, we would have to measure the
value of goods and services in terms of other
goods and services.
 Money is used to measure value in the economy.
We measure the value of goods and services in
terms of money, just as we measure weight in
terms of pounds or distance in terms of miles.
STORE OF VALUE
 If you could buy 100 units of goods and services with
$100 in 1982, how many units could you buy with $100
in 2000?
 Answer: you could have bought just 51 units
 During this period, inflation robbed the dollar of
almost half of its purchasing power
 Over the long run, particularly since World War II,
money has been a very poor store of value
 However, over relatively short periods of time, say, a
few weeks or months, money does not lose much of
its value
THE CIRCULAR FLOW OF MONEY
 The circular flow of money refers to the process whereby
money payments and receipts of an economy flow in a
circular manner continuously through time.
 The various components of money payments and
receipts are savings, investment, taxation, loans.
Government purchases, exports, imports etc.
The Circular-Flow Diagram
CIRCULAR FLOW OF ECONOMIC
ACTIVITIES
A household is a person or a group of people that share
their income.

A firm is an organization that produces goods and

services for sale.

Firms sell goods and services that they produce to

households in markets for goods and services.

Firmsbuy the resources they need to produce—factors of

production—in factor markets.
The circular flow of money with saving and investment
 Saving is one of the leakages and investment is an injection.

 Infect household and business sector do not spend their

whole income rather, they save a part of income for several
motives.
 Such savings are invested in capital markets.

 On the other hand business firms borrow funds from the

capital markets for making investment.
 The capital markets maintains the inflow of savings from
the household and business sector to the capital market, and
the outflow of investment into the business sector from the
capital market.
Circular Flow of Money with Government Sector
 Taxation is a leakage and Government purchases or
expenditures are the injections into the income in this
circular flow model.
 First, take the circular flow between household and
government sector. Taxes in the form of personal income
tax, and commodity taxation by the household sector are
outflows from the circular flow.
 Government purchases the services of the householders,
makes transfer payments in the form of salaries, old age
pensions, unemployment relief, sickness benefits etc.,
and also spends on them to provide certain social
services like education, health, infrastructure and other
facilities.
 The Circular Flow of Money

Wages, rents,
interest, profits

Factor services

Goods
Household nt Firms
r nm e (production)
Government ov e
G nding
Taxes
Savin Spe tment
gs Financial markets Inves
Im p
orts Personal consumption rt s
Ex po
Other countries

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

 Circular Flow of Money with the Foreign Sector
 Foreign trade plays an important role in economy.

 Exports are the injections or inflows into the circular

flow of money. They create incomes for the domestic
firms.
 Imports are the leakages or outflow from the circular
flow. They are expenditures incurred by the household
sector to purchase goods from foreign countries.
 The household sector buys goods imported from abroad
and make payments for them which is a leakage from
circular flow of money. The household may receive
transfer payments from the foreign sector for the services
rendered by them in forign countries.
CLASSICAL ECONOMICS SCHOOL OF
THOUGHT
 David Hume
 Adam Smith
 Thomas Malthus
 David Ricardo
 The main idea is “invisible hand”. The most
effective market system is the market without
government intervention. The outcome will be
efficient.
 Implications of Classical Economics
 Money supply changes has not effect on current
output, only affect price.
 Changes in government expenditure has no effect on
current output.
 Changes in the overall level of taxation do not affect
current output.
 Changes in marginal tax rates can cause current
output to change.
 Policy tools will not affect output and employment
but add instability.
 Let market work properly is the best thing the
government can do.
 Aggregate supply
 Pricesand wages can adjust quickly and fully.
 Households and firms learn reasonably and quickly about
economic environment.
 The economy is always fully-employed.
 The position of AS changes because of capital stock,
technology, or skill of labor.
Aggregate demand
Output is fixed at full employment level

A change in money supply only affects the price level.

MARKET EQUILIBRIUM

 Changes in AD will only

bring about changes in
the price level, not the
level of real output.
NEOCLASSICAL ECONOMICS
 The main decision problem is resource allocation, not
economic growth.
 Price is determined by preference of consumers, not
purely on production cost (which is claimed by
traditional classical economists).
KEYNESIAN ECONOMICS
 Motivated by the great depression
 Keynes published “The General theory of Employment,
Income, and Money” in 1936.
 The classical economics cannot explain the great
depression since it considers only LR equilibrium and
expects a temporary disequilibrium to be adjust quickly.
 Keynesians believed that the cause of the great depression
was due to a combination of events that led to great
uncertainty, huge decreases in investment, and economies
being stuck in an unemployment trap.
 “In the long run, we are all dead”

 Government intervention is needed to help an economy to

go back to the steady state.
Implications Of The Keynesian Model

 Wages and quantities do not adjust immediately (wage/price

rigidities in the short run).
 Involuntary unemployment could occur.
 When prices are rigid,
 The economy is unstable.
 The economy takes a long time to adjust to shocks and go
back to the steady state.
 AD is the main determinant of output and employment.
 Fiscal policy is preferred to monetary policy.
 The Keynesian AS curve
assumes that prices and
wages are fixed until full
employment is reached.
Over the ‘Keynesian
range’ there is spare
capacity in the economy,
the price level is stable,
and real output can
expand as a result of
increases in AD without
any inflationary pressure.
 The short run is assumed to begin
immediately after an increase in
the price level (for example, as a
result of an increase in AD), and
ends when input prices (costs of
production) have increased.
Hence, during the short run
producers are experiencing an
increase in their ‘real’ prices and
produce more output – and the
supply curve slopes upwards.
MONETARIST
 Friedman (1912)
 Brunner (1916)
 Meltzer (1928)

 Friedman did not believe the Keynesian view that money

had little or no impact.
 Monetarists believe that money is a substitute for a wide
range of real and financial assets, but not single asset
could be a close substitute for money. So interest rate
affect money demand.