Summary What is Money?
Money Summary • • • • •
What is money? Real and nominal interest rates Dynamic monetary model Neutrality of money Friedman rule
What is Money? • Functions of money: a. Medium of exchange Money is accepted as payment in exchange for goods, and goods accepted in exchange for money b. Unit of account Labour contracts express wages in term of money, etc. c. Store of value Money can be stored and spent in the future (it does not physically depreciate, but value may change) • Alternative forms of money: ○ Commodity money ○ Commodity-backed paper currency ○ Circulating private bank notes ○ Fiat money ○ Transactions deposits at banks
Search Model of Money ○ Barter exchange is difficult in highly developed, specialized economies ○ Economic exchange requires search costs These costs are high when economic agents are specialised in consumption and production and can only trade a good or service for another good or service ○ Search costs reduced dramatically if everyone accepts money in exchange for goods and services Simple search model of money 3 types of individuals □ Each produces one particular good □ Each individual only wants to consume one particular good Different from that it produces □ Each has a series of meetings with other individuals At random times Meeting only one person at a time □ Each meeting, the two individuals decide whether to trade or not Trade is difficult if there is an absence of the double coincidence of wants □ Absence of double coincidence of wants = One or more of the two individuals does not have something that the other would like Example of simple search model of money • Individuals only accept as payment the goods that they want to consume themselves • Absence of double coincidence • ∴ no trade takes place
• Type II this time accepts good 1 even though they don't wish to consume it • They then trade this with Type I to get good 2 • This makes good 1 a commodity money
Commodity money Allows exchange to take place Requirements: □ Storable □ Easy to verify quality □ Transportable □ Divisible e.g. precious metals have been the most common Tokens representing claims to the commodity can also be traded Private credit Example of private credit in the form of I.O.U. • Trade the I.O.U.s
In principle, allows exchange to take place Requirements for issuer of I.O.U: □ Known to be able and willing to honour the I.O.U □ In addition, those who subsequently hold the I.O.U must also trust the issuer These are demanding requirements in all but the smallest communities Credit vs. Money I.O.U.s are not automatically media of exchange
Course Notes Page 27
I.O.U.s are not automatically media of exchange □ ∴ not automatically money How can I.O.U.s can become money? □ Issued by large, well-known and trusted financial intermediary □ Banknotes were claims to deposits at banks i.e. they were I.O.U.s Can private I.O.U.s be accepted as payment? □ Yes, if endorsed by a financial intermediary □ Financial intermediaries/credit reference agencies scrutinize the credit -worthiness of individuals □ e.g. credit cards Individuals can pay without holding any money Costly electronic payment system to verify transactions remotely Costly to collect information on credit histories Fiat money Intrinsically worthless object issued as money by a central bank or government Accepted by private agents as payment for goods on the belief that others will accept it in exchange for goods Like an I.O.U but now of the government Overcomes the absence of the double coincidence of wants problem Example of fiat money
It is an efficient system: □ Allows exchange easily to take place □ Low resource cost because money has no intrinsic value Risks: □ Use of money depends on belief that others will accept it given no intrinsic value □ Beliefs could be self-fulfilling □ Abuse of money issuing powers by governments (i.e. hyperinflation)
A Dynamic Monetary Model ○ Extends the dynamic model to incorporate money ○ A variant of a cash-in-advance model ○ Assumes that consumers and firms require cash on hand to purchase goods or can use a system of credit (at some cost) ○ There are 3 time periods ○ Past ○ Present ○ Future
Money, prices and inflation ○ ○ ○ ○
Stock of money: M Price level: P Inflation rate (expected): i Current price level = P, expected future price level = P'
○ Expected inflation =
Real and nominal interest rates ○ Real interest rate = r Save one unit of goods today and receive 1 + r units of goods in the future ○ Nominal interest rate = R Save one unit of money today and receive 1 + R units of money in the future
Fisher equation
○ Tells us real return r given by nominal interest rate R Relationships between goods and money, today and in the future One unit of goods today buys P units of money today One unit of money invested today yields 1 + R units of money in the future One unit of money in the future buys 1 / P' units of goods in the future ○ Exact fisher equation: : ○ If we multiply both sides by ○ ○ This is because if both r and i are small then ri is negligible ○ ∴ approximate fisher equation:
US real and nominal interest rates Graph of US real and nominal interest rates
○
○ Very high nominal interest rates when inflation is very high ○ Nominal interest rates are not negative ○ Real interest rates can be significantly negative
Agents in the model Course Notes Page 28
What is money? Real and nominal interest rates Dynamic monetary model Neutrality of money Friedman rule
What is Money? • Functions of money: a. Medium of exchange Money is accepted as payment in exchange for goods, and goods accepted in exchange for money b. Unit of account Labour contracts express wages in term of money, etc. c. Store of value Money can be stored and spent in the future (it does not physically depreciate, but value may change) • Alternative forms of money: ○ Commodity money ○ Commodity-backed paper currency ○ Circulating private bank notes ○ Fiat money ○ Transactions deposits at banks
Search Model of Money ○ Barter exchange is difficult in highly developed, specialized economies ○ Economic exchange requires search costs These costs are high when economic agents are specialised in consumption and production and can only trade a good or service for another good or service ○ Search costs reduced dramatically if everyone accepts money in exchange for goods and services Simple search model of money 3 types of individuals □ Each produces one particular good □ Each individual only wants to consume one particular good Different from that it produces □ Each has a series of meetings with other individuals At random times Meeting only one person at a time □ Each meeting, the two individuals decide whether to trade or not Trade is difficult if there is an absence of the double coincidence of wants □ Absence of double coincidence of wants = One or more of the two individuals does not have something that the other would like Example of simple search model of money • Individuals only accept as payment the goods that they want to consume themselves • Absence of double coincidence • ∴ no trade takes place
• Type II this time accepts good 1 even though they don't wish to consume it • They then trade this with Type I to get good 2 • This makes good 1 a commodity money
Commodity money Allows exchange to take place Requirements: □ Storable □ Easy to verify quality □ Transportable □ Divisible e.g. precious metals have been the most common Tokens representing claims to the commodity can also be traded Private credit Example of private credit in the form of I.O.U. • Trade the I.O.U.s
In principle, allows exchange to take place Requirements for issuer of I.O.U: □ Known to be able and willing to honour the I.O.U □ In addition, those who subsequently hold the I.O.U must also trust the issuer These are demanding requirements in all but the smallest communities Credit vs. Money I.O.U.s are not automatically media of exchange
Course Notes Page 27
I.O.U.s are not automatically media of exchange □ ∴ not automatically money How can I.O.U.s can become money? □ Issued by large, well-known and trusted financial intermediary □ Banknotes were claims to deposits at banks i.e. they were I.O.U.s Can private I.O.U.s be accepted as payment? □ Yes, if endorsed by a financial intermediary □ Financial intermediaries/credit reference agencies scrutinize the credit -worthiness of individuals □ e.g. credit cards Individuals can pay without holding any money Costly electronic payment system to verify transactions remotely Costly to collect information on credit histories Fiat money Intrinsically worthless object issued as money by a central bank or government Accepted by private agents as payment for goods on the belief that others will accept it in exchange for goods Like an I.O.U but now of the government Overcomes the absence of the double coincidence of wants problem Example of fiat money
It is an efficient system: □ Allows exchange easily to take place □ Low resource cost because money has no intrinsic value Risks: □ Use of money depends on belief that others will accept it given no intrinsic value □ Beliefs could be self-fulfilling □ Abuse of money issuing powers by governments (i.e. hyperinflation)
A Dynamic Monetary Model ○ Extends the dynamic model to incorporate money ○ A variant of a cash-in-advance model ○ Assumes that consumers and firms require cash on hand to purchase goods or can use a system of credit (at some cost) ○ There are 3 time periods ○ Past ○ Present ○ Future
Money, prices and inflation ○ ○ ○ ○
Stock of money: M Price level: P Inflation rate (expected): i Current price level = P, expected future price level = P'
○ Expected inflation =
Real and nominal interest rates ○ Real interest rate = r Save one unit of goods today and receive 1 + r units of goods in the future ○ Nominal interest rate = R Save one unit of money today and receive 1 + R units of money in the future
Fisher equation
○ Tells us real return r given by nominal interest rate R Relationships between goods and money, today and in the future One unit of goods today buys P units of money today One unit of money invested today yields 1 + R units of money in the future One unit of money in the future buys 1 / P' units of goods in the future ○ Exact fisher equation: : ○ If we multiply both sides by ○ ○ This is because if both r and i are small then ri is negligible ○ ∴ approximate fisher equation:
US real and nominal interest rates Graph of US real and nominal interest rates
○
○ Very high nominal interest rates when inflation is very high ○ Nominal interest rates are not negative ○ Real interest rates can be significantly negative
Agents in the model Course Notes Page 28
