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CH 12
CH 12
CH 12
Financial System 12
CHAPTER
Money: What Is It and How Did It Come to
Be?
Money: A Definition
To the layperson, the words income, credit, and wealth are synonyms
for money. In each of the next three sentences, the word money is
used incorrectly; the word in parentheses is the word an economist
would use.
1. How much money (income) did you earn last year?
2. Most of her money (wealth) is tied up in real estate.
3. It sure is difficult to get money (credit) in today’s tight mortgage
market.
In economics, the words money, income, credit, and wealth are not
synonyms. The most general definition of money is any good that
is widely accepted for purposes of exchange (payment for goods
and services) and the repayment of debt.
Money: What Is It and How Did It Come to
Be?
Three Functions of Money
Money has three major functions; it is a:
▪ Medium of exchange
▪ Unit of account
▪ Store of value
Money: What Is It and How Did It Come to
Be?
Medium of Exchange
A medium of exchange is an object that is generally
accepted in exchange for goods and services.
In the absence of money, people would need to exchange
goods and services directly, which is called barter.
Barter requires a double coincidence of wants, which is
rare, so barter is costly – it requires either much search, or
lots of specialized middle-men.
Money: What Is It and How Did It Come to
Be?
Unit of Account
In a money economy, a person
doesn’t have to know the price of an
apple in terms of oranges, pizzas,
chickens, or potato chips, as in a
barter economy. A person needs only
to know the price in terms of money.
A unit of account is an agreed
measure for stating the prices of
goods and services.
This Table illustrates how money
simplifies comparisons.
Because all goods are denominated in
money, determining relative prices is
easy and quick.
Money: What Is It and How Did It Come to
Be?
Store of Value
The store of value function is related to a good’s ability to
maintain its value over time. This is the least exclusive
function of money because other goods—for example,
paintings, houses, and stamps—can store value too. At
times, money has not maintained its value well, such as
during high-inflationary periods. For the most part, though,
money has served as a satisfactory store of value.
This function allows us to accept payment in money for our
productive efforts and to keep that money until we decide
how we want to spend it.
Money: What Is It and How Did It Come to
Be?
From a Barter to a Money Economy: The Origins of
Money
▪ How did we move from a barter to a money economy? Did a
king or queen issue an edict: “Let there be money”? Actually,
money evolved in a much more natural, market-oriented
manner.
▪ Making exchanges takes longer (on average) in a barter
economy than in a money economy because the transaction
costs are higher in a barter economy since it requires double
coincidence of wants.
▪ The more people accept good G for its relatively greater acceptability,
the greater its relative acceptability becomes, in turn causing more
people to accept it.
Money: What Is It and How Did It Come to
Be?
From a Barter to a Money Economy: The Origins of
Money
▪ Some will use them to work, others will use them for leisure,
and still others will divide the available time between work and
leisure.
Money: What Is It and How Did It Come to
Be?
Money, Leisure, and Output
▪ Thus, a money economy is likely to have both more output
(because of the increased production) and more leisure time
than a barter economy.
▪ In other words, a money economy is likely to be richer in both
goods and leisure than a barter economy.
➢ Gold was not only inconvenient for customers to carry, but it was
also inconvenient for merchants to accept - gold is heavy.
➢ Gold is unsafe to carry around - can easily draw the attention of
thieves.
➢ Storing gold at home can also be risky.
How Banking Developed
▪ Goldsmiths were thus the first bankers. They took in other people’s
gold and stored it for them.
Direct finance
▪ In direct finance, the lenders and borrowers come together in a market
setting, such as the bond market. In the bond market, people who
want to borrow funds issue bonds.
▪ For example, company A might issue a bond that promises to pay an
interest rate of 10 percent annually for the next 10 years. A person with
funds to lend might then buy that bond for a particular price.
▪ The buying and selling in a bond market are simply lending and
borrowing. The buyer of the bond is the lender, and the seller of the
bond is the borrower.
Direct and Indirect Finance
Indirect finance
▪ In indirect finance, lenders and borrowers go through a financial
intermediary, which takes in funds from people who want to save
and then lends the funds to people who want to borrow.
▪ Through one door the savers come in, looking for a place to deposit
their funds and earn regular interest payments. Through another
door come the borrowers, seeking loans on which they will pay
interest.
Commercial Banks
A commercial bank is a private firm that is licensed to
receive deposits and make loans.
A commercial bank’s balance sheet summarizes its
business and lists the bank’s assets, liabilities, and net
worth.
The objective of a commercial bank is to maximize the net
worth of its stockholders, by making profits.
Adverse Selection and Moral Hazard
Problems
▪ When it comes to lending and borrowing, both adverse
selection and moral hazards can arise. Both are the result of
asymmetric information.
▪ Think of it this way: Two people want a loan. One person is a good
credit risk, and the other is a bad credit risk. The person who is the
bad credit risk is the person more likely to ask for the loan.
Adverse Selection and Moral Hazard
Problems
Before the loan is made
▪ Suppose two people, Selim and Salina, want to borrow Tk. 100,000 ,
and Malek has Tk. 100,000 to lend.
▪ Salina wants to borrow the Tk. 100,000 to buy a piece of equipment for
her small business. She plans to pay back the loan, and she takes her
loan commitments very seriously. She is the Good type.
▪ Selim wants to borrow the Tk. 100,000 so that he can gamble. He will
pay back the loan only if he wins big gambling. He is not the type of
person who takes his loan commitments seriously. He is the Bad type.
▪ Who is more likely to ask Malek for the loan, Selim or Salina?
▪ Selim is because he knows that he will pay back the loan only if he
wins big in gambling; he sees a loan as essentially “free money.”
Heads, Selim wins; tails, Malek loses!
Adverse Selection and Moral Hazard
Problems
Before the loan is made
▪ If Malek can’t separate the good types from the bad types, what can
he do? He might just decide not to give a loan to anyone. In other
words, his inability to solve the adverse selection problem may be
enough for him to decide not to lend to anyone.
▪ At this point, a financial intermediary can help. A bank does not
require Malek to worry about who will and who will not pay back a
loan. Malek needs simply to turn over his saved funds to the bank, in
return for the bank’s promise to pay him say a 5 percent interest rate
per year.
▪ Then, the bank takes on the responsibility of trying to separate the
good types from the bad ones. The bank will run a credit check on
everyone; the bank will collect information on who has a job and who
doesn’t; the bank will ask the borrower to put up some collateral on
the loan; and so on. In other words, the bank’s job is to solve the
adverse selection problem.
Adverse Selection and Moral Hazard
Problems
After the loan is made
▪ The moral hazard problem exists when one party to a transaction
changes his or her behavior in a way that is hidden from and costly to
the other party.
▪ Suppose you want to lend some saved funds. You give Selim a Tk.
100,000 loan because he promised you that he was going to use the
funds to help him get through university. Instead, once Selim receives
the money, he decides to use the funds to buy some clothes and take a
vacation to Thailand.
This Figure
illustrates
money creation
with many
banks.