The Monetary System
Three Functions of
Three Functions of
Money
Money
xx Medium of ExchangeMedium of Exchange: : anything anything that that isis
readily acceptable as payment. readily acceptable as payment.
y
y Unit of AccountUnit of Account: : serves serves as as a a unit unit of of accountaccount
to help us compare the relative values of to help us compare the relative values of goods.
goods.
z
z Store of ValueStore of Value: : a a way way to to keep keep some some of of ourour
wealth in a readily spendable form for future wealth in a readily spendable form for future needs.
The Two Types of Money
The Two Types of Money
Commodity Money:Commodity Money: something that performssomething that performs
the function of money and has alternative, the function of money and has alternative, nonmonetary uses.
nonmonetary uses.
Examples: Examples: Gold, Gold, silversilver
Fiat Money:Fiat Money: something that serves as moneysomething that serves as money
but has no other important uses. but has no other important uses.
The nature of money
The nature of money
What is
What is money
money ?
?
It is whatever a given society at a given timeIt is whatever a given society at a given time agrees to use as a
agrees to use as a means of exchangemeans of exchange
Do not confuse money Do not confuse money andand wealthwealth
In other words, money is what we decide it
In other words, money is what we decide it
to be as a society
to be as a society
It is aIt is a socialsocial institutioninstitution
Its existence is therefore always based on theIts existence is therefore always based on the level of trust within a society
level of trust within a society
The nature of money
The nature of money
Commodity moneyCommodity money
A situation where a commodity serves as A situation where a commodity serves as currencycurrency
Very close toVery close to barter barter , but with the currency-, but with the
currency-commodity dominating the exchanges commodity dominating the exchanges
Gold, silver, salt, cigarettes, sea shells, marblGold, silver, salt, cigarettes, sea shells, marbles.es.
Not necessarily intrinsically valuableNot necessarily intrinsically valuable, but often so:, but often so:
doesn’t require much trust. doesn’t require much trust.
The commodity is usually rare (limited supply) The commodity is usually rare (limited supply)
The nature of money
The nature of money
Token money: Token money:
A situation where the currency is officially backed onA situation where the currency is officially backed on
a commodity. a commodity.
The commodity itself is not exchanged, instead tokens The commodity itself is not exchanged, instead tokens
representing units of the commodity are exchanged representing units of the commodity are exchanged (ex: bank notes in the Gold Sta
(ex: bank notes in the Gold Standard)ndard)
This requires a higher level of trust, This requires a higher level of trust, as the intrinsicas the intrinsic
value of the token is much less than the face value
value of the token is much less than the face value..
The tokens can always be converted into the The tokens can always be converted into the
commodity on demand. commodity on demand.
The nature of money
The nature of money
Fiat money:Fiat money:
Where money exists simply by law (an act of Where money exists simply by law (an act of
government): it must be accepted in
government): it must be accepted in repayment of repayment of
all debts all debts
Money as aMoney as a signsign, a symbol., a symbol.
It typically hasIt typically has nono intrinsic value (except forintrinsic value (except for
pennies!) pennies!)
Its face value is backed entirely by the state’sIts face value is backed entirely by the state’s
credibility credibility
This requires a high level of This requires a high level of trusttrust in the institutionin the institution
that creates it. that creates it.
The nature of money
The nature of money
Most countries nowadays use fiat currency,Most countries nowadays use fiat currency,
because money supply can be controlled. because money supply can be controlled.
This is important for financing the This is important for financing the economyeconomy
In a commodity/token currency system, theIn a commodity/token currency system, the
money supply is
money supply is exogenousexogenous
Restricted money supply during WWI, which causedRestricted money supply during WWI, which caused
most countries to temporarily abandon it. most countries to temporarily abandon it.
In a fiat system, the supply can be adjustedIn a fiat system, the supply can be adjusted
as necessary. as necessary.
Money
Money
:
:
function
function
and
and
creation process
creation process
The nature of money
The nature of money
The classical and Keynesian functions
The classical and Keynesian functions
of money
of money
The creation of money by the banking
The creation of money by the banking
system
The classical and Keynesian
The classical and Keynesian
functions
functions
The classical functions of money The classical functions of money
Also called theAlso called the Aristotelian Aristotelian functions.functions.
Aristotle was intrigued by the problem of Aristotle was intrigued by the problem of
commensurability
commensurability: how can intrinsically: how can intrinsically different different goods have an exchange value?
goods have an exchange value?
His conclusion : exchange can only occur if theHis conclusion : exchange can only occur if the
goods are equal in a given comparable measure goods are equal in a given comparable measure
11sstt function: Means of exchangefunction: Means of exchange
Simplifies exchange compared to barter: no need forSimplifies exchange compared to barter: no need for
a double coincidence of
The classical and
The classical and
Keynesian functions
Keynesian functions
22ndnd function : unit of accountfunction : unit of account
Money is divisible, so can be Money is divisible, so can be used to measure andused to measure and
compare the values of different goods (price compare the values of different goods (price system)
system)
33rdrd function: Reserve of valuefunction: Reserve of value
Payments made in money do not lose their valuePayments made in money do not lose their value
over time, unlike barter or payments in kind over time, unlike barter or payments in kind
Money allows the conservation of values Money allows the conservation of values throughthrough
time (discounting inflation) time (discounting inflation)
The classical and
The classical and
Keynesian functions
Keynesian functions
Keynes’ “General theory of employment, interest Keynes’ “General theory of employment, interest
and money
and money ” introduced more functions, leading to” introduced more functions, leading to a debate about the role of money in the economy a debate about the role of money in the economy
The central argument is the existence of a The central argument is the existence of a
preference for liquidity
preference for liquidity in agentsin agents
With uncertainty, agents will prefer to hold liquidities asWith uncertainty, agents will prefer to hold liquidities as
away of adapting faster to the
away of adapting faster to the risky environmentrisky environment
Money is the most liquid and least risky way of Money is the most liquid and least risky way of holdingholding
assets: it is always accepted in transactions assets: it is always accepted in transactions
The classical and
The classical and
Keynesian functions
Keynesian functions
Keynes identifies 3 “motives” for Keynes identifies 3 “motives” for demanding moneydemanding money
The transaction motive: The transaction motive:
money is required for exchange (similar to the “classicalmoney is required for exchange (similar to the “classical
functions”) functions”)
This demand is a positive function of income This demand is a positive function of income
The precaution motive: The precaution motive:
Holding some liquidity is theHolding some liquidity is the best option in the presence of best option in the presence of
uncertainty uncertainty ..
The classical and
The classical and
Keynesian functions
Keynesian functions
The speculation motive: The speculation motive:
This motive embodies the trade-off between holding This motive embodies the trade-off between holding
liquidities and assets. liquidities and assets.
Liquidity is preferred, but does not pay interest. AssetsLiquidity is preferred, but does not pay interest. Assets
pay interest, but are not as liquid pay interest, but are not as liquid
Therefore the interest rate is the Therefore the interest rate is the opportunity cost opportunity cost of of
holding liquidity : as it
holding liquidity : as it increases people will hold lessincreases people will hold less
liquidity liquidity
This leads to an overall demand for money of the This leads to an overall demand for money of the
following form: following form:
( ( ))
− − + + = = = = L L Y Y ii P P M M M M d d,,
The classical and
The classical and
Keynesian functions
Keynesian functions
This has lead to an important debate on the effect This has lead to an important debate on the effect
of money in the economy between: of money in the economy between:
Those who believe that money is Those who believe that money is neutralneutral (i.e. does not(i.e. does not
affect real economic variables) affect real economic variables)
Classical approach, quantity theory approachClassical approach, quantity theory approach
Those who believe that money is Those who believe that money is not neutralnot neutral (it can affect(it can affect
real variables) real variables)
This is due to the role of the This is due to the role of the interest rateinterest rate on money demandon money demand
The debate is not closed yet, but has moved to a The debate is not closed yet, but has moved to a
short-term/long-term debate short-term/long-term debate
The classical and
The classical and
Keynesian functions
Keynesian functions
The Keynesian argument for non-neutral money will The Keynesian argument for non-neutral money will
be shown in greater detail in the next few weeks be shown in greater detail in the next few weeks (IS-LM)
LM)
What about the “classical” approach?What about the “classical” approach?
It is grounded in the Quantity Theory of Money (QTM)It is grounded in the Quantity Theory of Money (QTM)
Classical dichotomyClassical dichotomy : nominal variables and real: nominal variables and real
variables are
variables are independent independent
Money is only used for transactions, tMoney is only used for transactions, therefore only theherefore only the
“classical” functions apply. “classical” functions apply.
The classical and
The classical and
Keynesian functions
Keynesian functions
QTM states thatQTM states that velocity Vvelocity V (the number of times a(the number of times a
given
given money money is is used used in in a a given given time time period) period) and and thethe volume of
volume of transactions Ttransactions T are exogenous with respectare exogenous with respect to money M.
to money M.
Therefore increases in M lead to proportional increases in P Therefore increases in M lead to proportional increases in P
Inflation is a purelyInflation is a purely monetary monetary phenomenonphenomenon
But Keynesians argue this holds only in the LR: in theBut Keynesians argue this holds only in the LR: in the
SR, increasing M can change real variables because SR, increasing M can change real variables because of the
of the liquidity preferenceliquidity preference
ns ns Transactio Transactio Prices Prices Velocity Velocity Money Money T T P P V V M M ×× == ××
Money
Money
:
:
function
function
and
and
creation process
creation process
The nature of money
The nature of money
The classical and Keynesian functions
The classical and Keynesian functions
of money
of money
The creation of money by the banking
The creation of money by the banking
system
system
The creation of money
The creation of money
Most of the money is created by banks throughMost of the money is created by banks through
the process of credit (lending) the process of credit (lending)
What is the purpose of a bank?What is the purpose of a bank?
To hold the short term deposits of money by To hold the short term deposits of money by
agents agents
And make them available as long term loans toAnd make them available as long term loans to
other economic agents (which earn interest) other economic agents (which earn interest)
This funds economic activity (investment projects, This funds economic activity (investment projects,
consumer durable purchases) consumer durable purchases)
In the process, this In the process, this also creates money foralso creates money for
transactions in the economy transactions in the economy
The creation of money
The creation of money
The actors in this process are : The actors in this process are :
The agents: The agents:
Provide deposits to banks and take out Provide deposits to banks and take out loansloans
The banking system: The banking system:
Which take the deposits from agents and make theWhich take the deposits from agents and make the
loans to agents loans to agents
The central bank: The central bank:
Regulates the banking system (prudential regulations)Regulates the banking system (prudential regulations)
Provides “base money” to the banking systemProvides “base money” to the banking system
The creation of money
The creation of money
The amount of The amount of money money MM supplied by the supplied by the banks is larger banks is larger than the base than the base money money BB supplied by the supplied by the central bank central bank M>B M>B There is a net There is a net creation of creation of money ! money ! Central Bank Central Bank B Baannk k AA BBaannk k BB BBaannk k CC Agents Agents Interbank Interbank market market
Deposits and loans
Deposits and loans
Supplies base Supplies base money money BB (interbank (interbank liquidity) liquidity) Supplies money Supplies money M M to theto the economy economy
Credit Creation by a Single Bank
Credit Creation by a Single Bank
RRoouunnddss PPrriimmaarryy CCaasshh CCrreeddiit t CCrreeaattiioonn D
Deeppoossiittss RReesseerrvvees s ((2200%%))
1.
1. PPeerrssoon n ((AA)) RRss. . 1100000R0Rss. . 220000 RRss. . 880000
2. 2. PPeerrssoon n ((BB)) 880000 116600 664400 3. 3. PPeerrssoon n ((CC)) 664400 112288 551122 4. 4. PPeerrssoon n ((DD)) 551122 110022 441100 5. 5. --- --- --- ---6. 6. --- --- --- --- --- --- --- --- --- ---T Toottaall 55000000 10100000 44000000
Credit Multiplier
Credit Multiplier
Credit creatiCredit creation depends upon on depends upon the ratio of the ratio of cash reserves to deposicash reserves to deposits. Thets. The credit or the deposit multiplier is K= 1/r ; where K is the credit multiplier credit or the deposit multiplier is K= 1/r ; where K is the credit multiplier and r is the cash
and r is the cash reserve ratio. If cash reserve ratio is 20% thenreserve ratio. If cash reserve ratio is 20% then K= 1/r = 1/.2 = 5
K= 1/r = 1/.2 = 5
The higher the cash reserve The higher the cash reserve ratio, the lower would be ratio, the lower would be the credit multiplithe credit multiplier er and vice-versa.
and vice-versa.
Money Money Supply Supply Money Money Supply Supply P P r r i i c c e e L L e e v v e e l l ( ( P P ) ) V V a a l l u u e e o o f f M M o o n n e e y y P P P P 1 1 P P 2 2 M M 1 1 M M 2 2 MM 1/ 1/pp11 1/ 1/pp 1/ 1/pp22
Demand and Supply of
Demand and Supply of
Money
Money
1.
1. Transactions Transactions Theory Theory of of MoneyMoney 2.
2. Precautionary Motive Precautionary Motive Theory Theory of of MoneyMoney 3.
Supply of Money
Supply of Money
Central Bank of the CountryCentral Bank of the Country
Money Supply during recession/depressionMoney Supply during recession/depression
Money Supply during inflationMoney Supply during inflation
Equilibrium between demand and supply andEquilibrium between demand and supply and
rate of interest. rate of interest.
Money Supply in India
Money Supply in India
M
M11, M, M22, M, M33, and M, and M44
M or M
M or M11 = C + DD + OD= C + DD + OD ( C= currency held by the( C= currency held by the public, DD= Net Demand Deposits of Banks,
public, DD= Net Demand Deposits of Banks, OD= OtherOD= Other
Deposits of RBI ) Deposits of RBI )
M
M22 = M= M11 + Saving Deposits with Post Office+ Saving Deposits with Post Office
Saving Banks. Saving Banks. M
M33 = M= M11 + Net Time Deposits of Banks+ Net Time Deposits of Banks
M
M44 = M= M33 + Total Deposits with the Post Office+ Total Deposits with the Post Office
Savings Organization ( excluding National Savings Organization ( excluding National Saving Certificates)
