Money and Banking, Second Edition

William D. Gerdes

• Publisher: Business Expert Press
• Year: 2017
• ISBN:
  9781631576096
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

Let's learn about money! Money is a market phenomenon. It originated as a spontaneous social institution, and its use is still inextricably tied to market exchange. Therefore, the analysis of money occurs in a market setting. Use of monetary systems and a market setting as the underlying parameters ideally positions the reader to examine money in its various uses: as a medium of exchange, in credit markets, and as an instrument of monetary policy. Professor Gerdes believes that the study of money should commence at the most general level. Consequently, this book is anchored in the context of monetary systems (commodity, fiduciary, and fiat monies). This gives readers a very broad perspective-helping readers understand, for example, how the money used today differs from money used in the past, or how current money relates to money discovered by anthropologists in isolated subcultures. This book is perfect for courses in traditional money and banking courses, as well as undergraduate courses in monetary theory as well as sourcebook on money for business professionals.

CHAPTER 1

Money and Monetary Systems

Money, Barter, and Exchange

Apart from the act of production, voluntary exchange is the major means available for individuals to improve their material living standards. When two individuals engage in an exchange, the motive of each is to improve his or her welfare. Because each individual gives up something of lesser value for something they perceive to have greater value, the exchange is mutually beneficial. Both parties gain as a consequence of the transaction.

There are two general forms of voluntary exchange: barter and those involving money. Barter is a direct exchange, where goods and services are exchanged for other goods and services. A requisite for a barter transaction is the existence of a double coincidence of wants. Individual A, for example, possesses wheat but would like to exchange some of that wheat for a baseball glove. That individual must find another (individual B) who has a baseball glove he is willing to exchange for some wheat. If there are two such individuals, and they agree on a rate of exchange (e.g., two bushels of wheat for one glove), an exchange occurs.

Exchange involving the use of money is called indirect exchange. Rather than a direct exchange of goods as in barter, goods are exchanged for an intermediate good (money), which is then exchanged for other goods and services. At first, this appears to be less efficient since it requires an extra transaction. If it were less efficient, however, individuals would prefer barter to the use of money. In practice, that is not the case. Nearly all transactions that we observe involve the use of money.

What is money, and why is it that monetary transactions are the dominant form of exchange? Money is any generally accepted medium of exchange. While monies in use today are generally associated with governments, they are by nature more behavioral than governmental. They are a behavioral phenomenon in the sense that money is whatever individuals opt to use as an exchange medium.

The concept of money is necessarily dynamic because what people do select for use as money varies by time and place. In virtually every culture, money in use today differs from that used in the past. Moreover, at any point in time, one can observe different forms of money used in different locations. Money used for purchases in an African village market is different from the money used to settle bond transactions in the world’s major money centers. Both are different from that used in an isolated subculture in Papua New Guinea.

Economists introduce the concept of transaction costs to explain the dominance of monetary transactions over barter transactions. These costs are the resources that individuals must invest to participate in an exchange. They are of three principal types: (a) information costs, (b) transportation costs, and (c) storage costs.

Information is not a free good. If it were, quantities and offer prices of all goods and services would be known by everyone. Since a single individual does not possess all this information, resources frequently must be invested to acquire additional information prior to an exchange. In the barter example earlier, the individual with wheat must use resources to seek out an individual with a baseball glove. Once a generally accepted exchange medium is in use, it requires fewer resources to sell the wheat for money, and to use the money to purchase a baseball glove. With fewer resources expended, the transaction costs of exchange are reduced.

A second type of transaction cost is transportation costs. The parties involved in an exchange must transport the items to be exchanged. Most monies are relatively easy to transport, and one can do so at a relatively low cost. It is not very difficult, for example, to carry one’s wallet or check-book to the market. In a barter economy, by contrast, individuals must often transport commodities (such as wheat) to the market at a considerably higher cost. Thus, the use of money normally reduces transaction costs due to its relative ease of transport.

Finally, storage costs arise because of the necessity of storing items that are to be traded at a later date. Like other transaction costs, they normally cannot be avoided. In the case of barter, storage costs tend to be relatively high because of the greater number of commodities one must stock, and because some of them deteriorate while in storage. An example of the latter is grain spoilage that occurs during its holding period. In contrast to barter, money is generally less costly to store although there are storage costs here too. Today, they often assume the form of either service fees charged by banks or the erosion in the purchasing power of money due to inflation.

Because the use of money generally reduces the costs of engaging in voluntary exchange, the assumption is that its use greatly increases the number of exchanges that occur. Given that every voluntary exchange is wealth enhancing, the use of money contributes in a major way to improvements in our living standards.

Secondary Functions of Money

Money is defined in terms of its primary function: a medium of exchange. However, it serves other functions as well: as a store of value, unit of account, and standard of deferred payment. These are referred to as the secondary functions of money because they generally derive from its use as a medium of exchange.

The store of value function of money refers to its use as a vehicle for transferring purchasing power through time. It performs this function even when it is held for relatively short periods of time as an exchange medium. But, it also serves as a store of value when it is held for longer periods as a form of accumulated wealth.

Money also serves as a unit of account (or measure of value). In a monetary economy, the exchange value of all goods and services is quoted in terms of money, and comparative valuations are made by referring to monetary values of objects. If a watch sells for $100 and a tennis racquet for $200, we say that the tennis racquet is twice as valuable as the watch.

A final function of money is that it is customary to write loan contracts in terms of money. In this function, money is referred to as a standard of deferred payment. It is not necessary that money serve this function. It is possible, for example, to write a loan contract in which the proceeds of the loan (and subsequent repayment) are payable in corn, wheat, or any other commodity. It is unlikely, however, that both parties in a loan contract would find one of these commodities agreeable. As a consequence, virtually all credit contracts involve payment in money.

Properties of Money

Many different objects have served as money: cattle, seashells, beads, calico cloth, animal skins, tobacco, and precious metals. Despite the wide variety of forms of money, there are certain properties that all monies tend to possess. These properties share a common feature. Their presence often reduces the transaction costs associated with the use of money in exchange activities. The various forms of money tend to possess these properties in different degrees.

Four properties are discussed here. One is portability. Most objects selected for use as money can be readily transported to the market. Animal skins are more portable than animals, metal coins are more portable than animal skins, and paper money is more portable than metal coins. It is apparent that reducing transaction costs through greater portability was an important consideration in the evolution of money.

A second common property of money is divisibility. In the marketplace, items with a wide range of exchange values are traded. Money that is more divisible has greater value because it can be used in purchasing both relatively high and relatively low value goods. Cattle, when used as money, do not have this divisibility feature. Precious metals do, as do the more modern forms of money.

Third, most monies are durable. If money does not have this property, it will lose exchange value between the time it is accepted in exchange and the time when it is offered again in exchange. This probably explains why precious metals were a preferred form of commodity money. Even with the adoption of paper money, durability remains a matter of concern. Issuing governments want to know how soon such money will have to be replaced as a consequence of wear and tear.

Finally, most monies are objects that are relatively scarce. Transactions costs tend to be high when an object that is not scarce is used. That is because there is a high probability that such money will lose exchange value during the holding period. Precious metals, once again, are an example of money that is not easily augmentable. The production costs of doing so generally are substantial. Paper money, on the other hand, can be readily augmented in a short period of time. Our experiment with fiat money in the past century reveals that scarcity is one of the problems associated with using such money.

Types of Monetary Systems

There are three general types of monetary systems: commodity, fiduciary, and fiat.¹ Nearly all of our accumulated monetary experience is with commodity money. Fiduciary elements were introduced only in recent centuries, and it was not until the 20th century that nearly every society converted to the use of fiat money. From a broad historical perspective, then, the type of money used by nearly everyone today is a relatively new phenomenon.

Commodity money has one important identifying characteristic. Its value when used for monetary purposes tends toward equivalency with its value when used for nonmonetary purposes. Although a great number of different objects have been used as commodity money, precious metals were the most popular. Bronze, iron, and, more recently, silver and gold are metals that were most widely used for this purpose.

Fiduciary money differs from commodity money in two respects. First, its value when used as money exceeds its value when used for nonmonetary purposes. Second, it has a convertibility option. The convertibility option is typically a (paper) contract to pay a specified amount of commodity money on demand. Under the gold standard, for example, printed on a ten-dollar bill was the statement “Pay to the Bearer on Demand: Ten Dollars.” When this note was presented to the issuer, the issuer was obliged to pay the bearer ten dollars in monetary gold.

Governments replaced fiduciary money arrangements with the fiat money standard that is currently in use. Fiat money has two distinctive features. Like fiduciary money, it has the property that its value when used as money exceeds its value when used for nonmonetary purposes.² The difference is the convertibility option. Fiduciary money is convertible (at issuing institutions) into commodity money on demand; fiat money is not.

This distinction is critical in understanding the origins of fiat money. Unlike commodity and fiduciary monies, fiat money was not a spontaneous market development. It did not result from the efforts of market participants to lower their transaction costs. Instead, it came about through the efforts of governments to gain greater control over money. Already active in the monetary process, 20th century governments invoked laws abrogating the convertibility option. Although this most recently happened in the 1930s, the history of fiduciary money standards is marked by earlier episodes where governments had suspended the convertibility option.

Governments found it particularly difficult to refrain from doing this during wartime. They were anxious to gain claims on more resources in order to prosecute the war effort. Although higher taxes always were an option, governments most often opted instead for printing more money. This choice places considerable stress on a fiduciary money system by significantly increasing the quantity of fiduciary money in use relative to commodity money. Ultimately, this jeopardizes the ability of issuers of fiduciary money to convert that money back into commodity money on demand. As a way around this problem, governments often passed laws suspending convertibility. Great Britain did this during the Napoleonic Wars as did the major adversaries during World War I.

The politics (and economics) of re-establishing fiduciary money arrangements after wars ended were both tedious and divisive. It took Great Britain nearly a decade to restore the gold standard after World War I. Shortly after she had done so, the major trading countries were caught in the midst of the Great Depression. Once again they suspended convertibility, but this time it was not a temporary expedient. Governments were too eager to wrest control of money from the private sector.

By now, however, individuals were quite accustomed to using paper money to effectuate exchanges. Under the fiduciary money standard, most individuals opted to make payment with paper money because of lower transaction costs. Thus, movement to the fi...

Table of contents

• Cover
• Title
• Copyright
• Chapter 1. Money and Monetary Systems
• Chapter 2. Money and Income
• Chapter 3. Interest Rates and Financial Markets
• Chapter 4. Central Banks and the Money Supply
• Chapter 5. Monetary Policy
• Chapter 6. Critiques of Monetary Policy
• Notes
• References
• Index
• Adpage