Monetary Economics

Jagdish Handa

• Publisher: Routledge
• Year: 2002
• ISBN:
  9781134638086
• Edition: 1
• Topic: Business
• Subtopic: Business generale
• Index: Business

A comprehensive overview of advanced monetary economics, integrating the presentation of monetary theory with empirical formulations and their empirical tests. Unlike most texts this book brings together in a single unified source the core areas of monetary economics. Key features include:
* cross-country comparison of central banking in the US, UK and developing countries
* theories and empirical studies on money demand, including precautionary and buffer stock models and monetary aggregation
* detailed comparison of Keynesian and modern classical macroeconomic theoretical and policy models
* a focus on the role of money and financial institutions and growth.

part
one

INTRODUCTION AND HERITAGE

chapter
one

INTRODUCTION

Monetary economics has both a microeconomics component and a macroeconomics one.

The fundamental questions of monetary economics concern the proper definition of money, its demand and supply, and its impact on the economy.

The financial assets that can serve the medium of payments role of money have changed over time so that the proper definition of money has also kept changing.

Commercial banks are only one type of financial intermediaries. The distinction between banks and other financial institutions has increasingly become blurred in recent decades as the barriers between them have been reduced or eliminated and the competition between them for the public’s deposits has increased.

At the level of the overall economy, monetary economics is a central part of macroeconomics. The main paradigms of macroeconomics are the classical and the Keynesian ones. The former studies the competitive economy at its full employment equilibrium, while the latter studies its deviations away from this equilibrium.

Monetary policy has to be studied in the context of macroeconomics.

key concepts introduced in this chapter

• The functions of money

• Money supply versus money stock

• The definition of money

• M1, M2 and broader definitions of money

• Financial intermediaries

• The creation of money by banks

• The classical paradigm for macroeconomics

• The Walrasian general equilibrium model

• Neoclassical, traditional classical, modern classical and new classical models

• The Keynesian paradigm for macroeconomics

Monetary economics is the economics of the money stock and of its repercussions on the economy. It studies the money and financial markets, the extent to which money and its substitutes influence the behaviour of the economic units in their decisions and the implications of that influence in the macroeconomic context.

In a monetary economy, virtually all exchanges of commodities among distinct economic agents are against money and virtually all loans are made in money and not in commodities, so that virtually all market transactions in a modern monetary economy involve money.¹ Therefore, the scope of monetary economics is a very wide one. Few aspects of a monetary economy are totally divorced from the role of money and the efficiency of its provision and usage.

Monetary economics has both a microeconomics and a macroeconomics part.

The microeconomics part of monetary economics

The microeconomics part of monetary economics focuses on the study of the demand and supply of money and their equilibrium. No study of monetary economics can be even minimally adequate without a s tudy of the behaviour of those financial institutions whose behaviour determines the money stock and its close substitutes. The institutions supplying the main components of the money stock are the monetary authorities – often a euphemism for the central banking system of the country² – and the commercial banks. The commercial banks are themselves part of the wider system of financial intermediaries which determine the supply of some of the components of money as well as the substitutes for money, also known as near-monies.

The three major components of the microeconomics part of monetary economics are the demand for money, covered in Chapters 4 to 9, the supply of money, covered in Chapter 10, and the central bank and financial institutions, covered in Chapters 11 and 12.

The macroeconomics part of monetary economics:
money in the macroeconomy

The macroeconomics part of monetary economics is closely integrated into the standard short-run macroeconomic theory. The reason for such closeness in short-run analysis is that monetary phenomena are pervasive in their influence on virtually all the major macroeconomic variables in the short run. Among variables influenced by the shifts in the supply and demand for money are national output and employment, the rate of unemployment, interest rates, exports and imports, exchange rates and the balance of payments. And among the most important questions in macroeconomic analysis are whether – to what extent and how – the changes in the money supply, prices and inflation affect the above variables, especially national output and employment. This part of monetary economics is presented in Chapters 13 to 21.

A departure from the traditional treatment of money in economic analysis has been provided in the last couple of decades by the overlapping generations models of money. These have different implications for monetary policy and its impact on the economy than the standard short-run macroeconomic models. While most textbooks on monetary economics exclude the overlapping generations models of money, they are an important new development in monetary economics. They are presented in Chapters 22 to 24.

The long-run analysis of monetary economics is less extensive and while macroeconomic growth theory is sometimes extended to include money, the resulting monetary growth theory is only a small element of monetary economics. It is also omitted from the usual textbook presentation of monetary economics. However, there is increasing emphasis on growth theory within macroeconomics and there are still unresolved questions about the role of money in growth. To investigate these issues, monetary growth theory is covered in Chapter 26, with Chapter 25 acting as a prelude to it by introducing the standard growth theory analysis without money.

There are different approaches to the macroeconomics of monetary policy. These include the Walrasian model, the classical group of models and the Keynesian group of models. We elucidate their differences at an introductory level towards the end of this chapter. Their detailed exposition is given in Chapters 13 to 17.

1.1 WHAT IS MONEY AND WHAT DOES IT DO?

1.1.1 The functions of money

Money is not itself the name of a particular asset and is best defined independently of the particular assets that may exist in the economy at any one time, since the assets which function as money tend to change over time in any given country and among countries. At a theoretical level, money is defined in terms of the functions that it performs. The traditional specification of these functions is:

(i) medium of exchange/payments;

(ii) store of value, sometimes specified as a temporary store of value or temporary abode of purchasing power;

(iii) standard of deferred payments;

(iv) unit of account.

Of these functions, the medium of payments is the absolutely essential function of money. Any asset that does not directly perform this function – or cannot indirectly perform it through a quick and costless transfer into a medium of exchange – cannot be designated as money. A developed economy usually has many assets which can perform such a role, though some do so better than others. The particular assets that perform this role vary over time, with currency being the only or main medium of exchange early in the evolution of monetary economies. It is complemented by demand deposits with the arrival of the banking system and then by an increasing array of financial assets as other financial intermediaries become established.

1.1.2 The definitions of money

Historically, the definitions of money have measured the quantity of money in the economy as the sum of those items that serve as media of exchange in the economy. However, at any time in a developed monetary economy, there may be other items that do not directly serve as a medium of exchange but are readily convertible into the medium of exchange at little cost and trouble and can simultaneously be a store of value. Such items are close substitutes for the medium of exchange itself. Consequently, there is a considerable measure of controversy and disagreement about whether to confine the definition of money to the narrow role of the medium of exchange or to include in this definition those items that are close substitutes for the medium of exchange.³

A theoretically oriented answer to this question would aim at a pure definition: money is that good which serves directly as a medium of exchange or payments. This approximates the narrow definition of money and is given the symbol M1. Close substitutes to money defined as the medium of payments are referred to as near-monies. The narrow definition of money – in common usage at the present time – is that money in the economy is the sum of the currency in the hands of the public and the public’s demand deposits in commercial banks, since the payments for commodities are only made by transfers of these from the buyer to the seller.

An empirical answer to the definition of the money stock is much more eclectic than its theoretical counterpart. It could define money narrowly or broadly, depending upon what substitutes to the medium of exchange are included or excluded. The broad definition that has won the widest acceptance among economists is known as (Milton) Friedman’s definition of money. It defines money as the sum of currency in the hands of the public plus all of the public’s deposits in commercial banks. The latter include demand deposits as well as time and savings deposits in com...

Table of contents

• Cover
• Half Title
• Dedication
• Title Page
• Copyright Page
• Table of Contents
• Preface
• Acknowledgments
• Part One Introduction and Heritage
• Part Two Money in the Economy
• Part Three The Demand for Money
• Part Four Money Supply and Central Banking
• Part Five Money in the Macro Economy
• Part Six Money in the Open Economy
• Part Seven The Rates of Interest in the Economy
• Part Eight Overlapping Generations Models of Money
• Part Nine Money and Financial Institutions in Growth Theory
• Index