CHAPTER 2 – THE NATURE OF MONEY

EXTRA QUESTIONS & INTERESTING POINTS TO GO INTO

 How does investment work in an economy without money?
 Why does the value of money fall every year (philosophical & monetary context)
 Could the entire world use one currency? Why and Why not?

ESSENTIAL READING

CHAPTER 1 – NATURE OF MONETARY ECONOMY

A. LEWIS ET AL 2000

1.1 WHAT IS MONETARY ECONOMICS?

 We look at an economy concerned mostly with production, consumption, expenditure, and incomes
all done in monetary terms.

Classical Quantity Theory

Keynesian Tradition?

1.2 THE FUNCTIONS OF MONEY

The new monetary economics school separates the unit of account function from other functions. In
contrary to John Hicks statement. In standard value theory we know that utility is attached to consumption or
production, however money facilitates consumption and production but isn’t directly used for either.
Therefore challenging to put it within a theoretical framework.

Perspective on Money: What are the principle inconveniences experienced in its absence?

 Assume economic system with no monetary assets.

1. There would be no unit to value things (absence of unit of account)

2. Existence of all inefficiencies of barter system
3. High probability of low investment levels and tendency to misallocate any investments
(No unit could invest less than its saving since there would be no financial assets to put the rest into)

 If money was introduced to economy:

1. Unit of account & Unit of contract

2. Means of Exchange/ Payment
3. Liquid store of Value (Will increase efficiency of resource allocation)

 UNIT OF ACCOUNT
 Reduce number of unnecessary calculations required to achieve a valuation of the goods (T=1/2n(n-
1)) thing check
 Permit rational economic calculations to take place: a common unit of account allows individuals to
compare goods and services that would otherwise be impossible to compare => therefore, allowing
them to easily order preferences and make rational choices.
 Transmit economic information:
 Unit of contract (Schneider et al, 2017) add

But the value of money in terms of goods and services fall from year to year. Then we can say that
money in this sense is a poor unit of account. “man has not yet succeeded in providing for himself a
money with a stable value” (Harrod, 1969). Then why is money used in this sense at all?

 MEDIUM OF EXCHANGE
 Cash solves the inefficiency and inconvenience of the barter system. The barter system was the norm
for a large part of the recorded history. Ex: Medieval times, revival of barter in domestic economies,
concept of gift economies can all be used as examples – Further research area

 Money simplifies economic transactions: with the need for double coincidence of wants bartering can
be time consuming and expensive.
  Increases the number of similar transactions and similarity of terms of contract increases competition.
Ex: if 10,000 people were to buy soap in a money based economy they would all make similar
transactions and by weight of numbers create a competitive situation in the buying side of the
market. However, in a barter economy, the same 10,000 would form different smaller groups
depending on which commodity they used to pay for their soap.

  Clover 1967 on this point shows how some of the pros of using money can be achieved under
barter by using a number of market innovations:

 “Goods do not buy goods in any organized market” (Clover, 1969)

 STORE OF VALUE
 According to Keynes in 1937, once the social institution of money is established variations in the form
and quantity of the exchange medium itself does not have great significance. Instead the importance
of money comes from its function as a store of wealth.
 Keynesian tradition  money is an asset with constant nominal purchasing power, where the
capital value doesn’t fluctuate with the interest rate.
 This function allows the person to buy later than he/she sells. There is greater cost and inconvenience
in storing goods rather than money itself (deterioration, desire to wait and be prepared for later
opportunities of a good purchase).

HOWEVER, NOTE that money isn’t the only store of value. There are many other assets which serve the
same function – some doing an even better job.

Then WHAT ADVANTAGES DOES MONEY HAVE OVER OTHER ASSETS? These advantages are collectively
called LIQUIDITY (Lewis, 1990). Liquidity is a matter of degree. The concept is multidimensional and not
measurable also has few dependencies on the predictions or perspectives of individuals and market
conditions. BELOW ARE THE MAIN ASPECTS OF LIQUIDITY.

1. Marketability: Readily and immediately accepted for payment by a large number of people over a
large geographical area
2. Predictability: of the value of the asset
3. Reversibility: Real assets lack this aspect. Ex: car
4. Divisibility: the size of the smallest unit in which exchange can take place in an asset => important
determinant of the flexibility of an asset in exchange.

 Friedman (1961, 1969b): Money is a ‘temporary abode of purchasing power’.

 MONEY AS LIQUIDITY
 Keynes & the Liquidity Preference Theory is a key aspect of this area
 Purpose of wealth accumulation => ensure command over future goods and services
 When there is doubt about future purchasing power of money & wide divergence between capital
certainty in real and monetary terms liquidity preference is inverted. In this scenario, ‘money ceases
to be the asset to which liquidity preference attaches’ (Robinson, 1951)
 Money best performs its function as a store of value or a temporary abode of purchasing power
when held jointly with other financial or real assets (Lewis)
  MONEY AS A SPECIAL ASSET
 Once we remove the medium of exchange function then money seems to stand on equal ground as
many other assets. According to Friedman et al 1970: ‘no reason a fairly narrowly defined subtotal
of liquid assets should have any special importance’.

 HOW IS MONEY ESTABLISHED?

 A medium of exchange will arise even in an economy which starts with barter (Jones, 1976)
 According to Menger (1892) assets that are destined to acceptability as money are distinguished by
their superior marketability. To qualify for this process the assets should be divisible, portable, easy to
store etc.
 What is the argument between the two where moneyness confers liquidity vs liquidity confers
moneyness?

CHAPTER 2 – MONETARY STANDARDS

 MAIN ARGUMANET: Various monetary systems have a different monetary standard  From this
point monetary outcomes such as the price determination will change.

OBSERVATIONS MADE BY HICKS & LEWIS

 All monetary economies (not only those with developed financial institutions) have a basic credit
element – therefore the concept of credit and debt payment fundamental to understand role of
money in market systems (A Market Theory of Money Hicks 1989).

 3 Components of a transaction involving trading of a commodity or financial instrument

1. Contractual agreement specifying terms of exchange i.e. payment method, price and quantity –
comes first
2. Delivery i.e., physical transfer of ownership of product These 2 can happen either way
3. The final payment

This entire transaction takes place ‘on the spot’ in auction markets.
However, the representative transaction isn’t a simple spot payment of “goods for goods” or ‘money for
goods’ but involves deferred or advanced payments in some way  therefore the above 3 components are
always separated in time.
Money’s role is twofold where it is ‘
a. an amalgam of unit of account and unit of contract functions.  Called THE STANDARD OF VALUE
(HICKS)
b. Means of Payment
c. Temporary Store of Value: Necessary to store of purchasing power if the purchase decisions take
place later. BUT: This function isn’t distinctive since there are other stores of value, some
 presumably with better rates of return. Therefore Hicks argues that we are only left with 2
distinguishing features: standard of value & medium of payment.

MONETARY DEFINITIONS

Name Definition Example

Monetary Standard Defines the measure of value + provides Could take the form of ‘Hard
basis for ultimate repayment of debt. Money’ [such as gold, silver] or
NOT the same as money itself. ‘Fiat Money’.
‘Criterion or reference point guiding the
social arrangement & constituting the
ultimate asset combing the twin
functions of standard of value and
means of payment’ (Lewis).
Monetary System Refers to whole and different types of
money available.
‘Set of policies and/or arrangements
carried out by and through monetary
institutions which constitute the
structure’ (Lewis).
Monetary ‘Ways in which various elements of this
Mechanism system interact & operate, and thereby
with the process that enable
achievement of the standard (Lewis).

Monetary Regime

Can we establish money in such a way that there is no annual inflation levels and also no
risk of overprinting?

What does linking money to an external object achieve?

1. Ensure confidence in money
2. Sustain the social convention by protecting against overissue of money – thereby restricting the
debasment of currency by authorities

Any and all forms of gold standards has implications for the exchange rates relationship
Exchange standards distinguished from gold standard
THE GOLD STANDARD
B. GOODHART 1989A

C. GOODHART 1989B

D. ADAM SMITH

STUDY GUIDE POINTS

LECTURE NOTES + POINTS
TUTES POINTS
PAST PAPER LEARNINGS
VIDEO POINTS
EXTRA READINGS

A. KIYOTAKI 2001

B. HUMPHREY 1985

C. NEWMAN ET AL 1994

MAIN SUMMARY OF ALL POINTS

WHAT IS MONETARY ECONOMICS?

2.7: WHAT IS MONEY? (DEFINE WITH CRITICAL COMMENTARY AND EXAMPLES)

The definition for money is rooted in its function rather than it’s the form it takes.
2.8: THE FUNCTIONS OF MONEY

1. Means of Payment
2. Unit of Account
3. Store of Value
4. Medium of Exchange
5. Money as Liquidity
6. Money as a Special Asset
7. Money Neutrality

PAST PAPER QUESTION SUMMARY

2019 ZA Q1
In most countries fiat money is quantitatively larger than credit money?

2019 ZB Q1
Commodity money is inefficient compared to fiat money.