Module: EC6012 International Monetary Economics

Date: 26th January 2008

Professor Edward Nell

History of Monetary Economics

Concept of money:
Origins in various cultures. Began as intermediary between 2 sides of a barter.
Means of exchange or medium of circulation. Facilitates and simplifies exchange.
“Money grows on trees” – was true for a tribe in the Gulf of Mexico who used a
berry as form of currency.
Primitive Money – agreement resides within the community, not necessarily
accepted outside the community.

Origins of money:
Lidya (Turkey) – used electrum, alloy of silver and gold. Relatively easy to mine
and purify. Became used in the Aegean region. Trading cargos, e.g. oil for wool –
needed to devise a method to reconcile the difference in value of the cargos.

Kings of Lydia, named Midas – added stamp to electrum. Introduced the idea of
credibility. Stamp gave guarantee that it could be exchanged for new coin, even if
it was worn and had lost weight – simplifies transaction, no need to weigh coins.
Stamped coin simplified commerce. Introduced concepts of state and credibility.
Mint must have reserve of metal, which comes from taxes.

Egypt - Perception of origins in Egypt, BUT not clear if this was this case. Not
clear if there was a sophisticated system of accounting and circulation.

Mesopotamia (now Iraq) – sophisticated system of accounting, including double

entry book keeping system and stone tablets. A rudimentary banking system. But
no sophisticated system of circulation. King Hammurabi, 1750BC – good records
of bookkeeping, debt, creditors and early version of financial institutions. Applied
to trade only.
1789: France – probably the richest and most powerful state in Europe, collapsed
due to inability to collect taxes

Coinage – involves credibility, which rests on power – the power to collect taxes.
Power to tax is based on agreement - no civil war.

Market – mint can stamp coin to determine value. Supply and demand determines
price of the metal. Value of the coin is what the mint will give you in exchange for
your ‘worn’ coin. Mint must also have credibility – coins should be minted with
full weight, i.e. a $1 coin should contain $1 weight in gold. When mint produces
underweight coin, the market concept is introduced – market decides value of coin.
Market value is determined by perceived credibility of mint/state. (similar concept
as the recent devaluation of Irish bonds).

Worthless Coins
There are historical examples of coins with no intrinsic value. South of France –
region where tin coins were issued by the lord and peasants could buy themselves
out of servitude. Completely based on sovereign power. Credibility no as much of
an issue as the practical value (buying out of servitude) was very visible.

Note the contrast between the 2 models – similar to gold vs paper concept.

Credibility – are there institutions in place to preserve credibility, to make it

believable? Especially important for paper money.

Paper Money
Practical issues – easier to carry than heavy metals, easier to conceal and does not
wear as coins do.

The promise was printed on the paper – “ I promise to pay the bearer..”. Has been
removed from US Fed Reserve notes, but is still on Sterling. Meaning was that
you would get silver in return for your note. Principle of backed money.

Banking- issue bank notes to give loans. Deposits of gold would be exchanged for
notes. Important distinction between real vs nominal money.
Real – Supply and demand determined, intrinsic value.

Nominal – no intrinsic value.

1695, Bank of Amsterdam – gigantic scandal. Bank had issued more notes than it
could honour with it’s reserves. This was done due to the small portion of notes
that came back to the bank, but was illegal at the time and the banks executives
went to jail. This was the beginning of the concept of Fractional Reserve Banking.
When the portion of notes that return can be reliably determined, a fractional
reserve can be used.

Fractional Reserve Banking

Based on leverage – a run on the banks can cause collapse, such as recent
nationalisation of Anglo Irish, which had a run of €4bn.

Banks can utilise insurance to protect against a run – this is a form of derivative.

Essential issue for banks is that they borrow short and lend long, which is the
reason why banks traditionally portrayed such a conservative image. Lending long
– buying assets. Borrowing short – taking deposits. If too many take their ‘short’
money out, there is a liquidity problem.

Model of borrowing short and lending long provides great potential but also has
the seeds of a crash.

Newton lost £20,000 in 1719/20.

Convertible paper – non-convertible paper

Shift from intrinsic value to tax and state based system of money.

Money is accepted because it is required to pay taxes – similar to the tin coins in
France.