ch_2_nature_of_money.pdf

Chapter 2 The nature of money 2.1 Introduction Fiat money is indispensable in modern economic systems, although it has been part of daily life as far back as 9000 BC, when grain and cattle were used in Anatolia and Mesopotamia for exchange purposes. While we take the usage of some form of money as...

Chapter 2 The nature of money 2.1 Introduction Fiat money is indispensable in modern economic systems, although it has been part of daily life as far back as 9000 BC, when grain and cattle were used in Anatolia and Mesopotamia for exchange purposes. While we take the usage of some form of money as granted, we need to understand why it exists, its functions and properties. In particular, we need to solve the double coincidence of wants problem associated with barter and to resolve the lack of trust between the payer and the payee in a transaction. 2.2 Aims The aim of the chapter is to introduce the main ingredients of a monetary economy. We will introduce money for exchange purposes of goods and services. We will describe its functions, why money is useful in trade, its types and properties. 2.3 Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: discuss the nature and shortcomings of a barter economy list and describe the general functions performed by money describe the Wicksell problem and demonstrate how indirect barter can lead to the emergence of a commodity money describe the differences between transactions using credit cards and bank debit cards list and describe what the different types of money are. 2.4 Reading advice You will certainly find it easiest, and probably most useful, to read the appropriate sections on the nature of money in one or more of the basic textbooks before you move 17 2. The nature of money on to the material in this chapter.1 All textbooks on money and banking will have a section covering the material here. However the best, although most difficult, is that of Goodhart (1989a) Chapter 2 – see below under ‘Essential reading’. You may find it helpful to read Goodhart (1989b) first – see below under ‘Further reading’. 2.5 Essential reading Goodhart, C.A.E. Money, Information and Uncertainty. (London: Macmillan, 1989a) Chapter 2. Lewis, M.K. and P.D. Mizen Monetary Economics. (Oxford; New York: Oxford University Press, 2000) Chapters 1 and 2. 2.6 Further reading Clower, R.W. ‘Introduction’ in Clower, R.W. (ed.) Monetary Theory: Selected readings. (Harmondsworth: Penguin, 1969). Goodhart, C.A.E. ‘The Development of Monetary Theory’ in Llewellyn, D.T. (ed.) Reflections on Money. (Basingstoke: Macmillan, 1989b). Harris, L. Monetary Theory. (New York; London: McGraw-Hill, 1985) Chapter 1. Kiyotaki, N. and J.H. Moore ‘Evil is the Root of all Money’. Clarendon Lecture series, Lecture 1 (2001). Kiyotaki, N. and R. Wright ‘Acceptability, Means of Payment, and Media of Exchange’, Federal Reserve Bank of Minneapolis Quarterly Review, Summer 1992. Also in Newman, P., M. Milgate and J. Eatwell (eds) The New Palgrave Dictionary of Money and Finance. (London: Macmillan, 1994). McCallum, B. Monetary Economics. (New York; Macmillan; London: Collier Macmillan, 1989). Newlyn, W.T. and R.P. Bootle Theory of Money. (Oxford: Clarendon Press, 1978) Chapter 1. 2.7 What is money? Money is defined by its function rather than the form in which it takes. In this sense, money is defined as ‘anything which is in general use, and generally accepted, as a means of payment.’ In the past, money has taken the form of corn, rice, cattle, shells, various precious metals and more recently, pieces of paper issued by governments. In all cases though, money was and is used as a means of payment in exchange. The payer in a transaction (he or she who is purchasing a good or service) hands over money to the value of the item bought and at this point the payee (the seller of the good or service) 1 See for example, Harris, and Newlyn and Bootle. 18 2.8. The functions of money accepts that the payment is complete. The payee neither holds any further claims on the payer, nor on any third party who may have produced or issued the money. In this chapter we will discuss and explain the important functions, properties and different types of money. We will also explain why we use money and compare the alternative trading strategies, both with and without money. 2.8 The functions of money Below, we will discuss the three main functions of money, although, arguably, some authors will expand these into four.2 Money as a means of payment As suggested above, the most important function of money is its use as a means of payment – money being used to pay for items purchased or to settle any debts. A related role of money is that as a medium of exchange, which Wicksell defined as an object which is taken in exchange, not on its own account. . . not to be consumed by the receiver or to be employed in technical production, but to be exchanged for something else within a longer or shorter period of time.’3 In this sense, a means of payment can also be a medium of exchange. A gold coin for example, used to buy a piece of land, will be a means of payment (the seller of the land will not hold a claim on the payee who has just handed over the gold) but it will also be a medium of exchange. The receiver of the gold coin will not use it for decorative purposes or to ‘make’ any other goods or services, but will use it as a medium of exchange when he or she wishes to purchase a good or service some time in the future. However, the converse is not necessarily true.4 That which may act as a medium of exchange may not act simultaneously as a means of payment. For example, if I wish to pay for a television set using a credit card, the seller may accept this as a medium of exchange. Although the television shop’s account may be credited effectively immediately, it may not be a means of payment since I, the payer, still have a debt outstanding, namely that to the credit card company. I have merely replaced a debt to the television shop with a debt to the credit card issuer. The purchase of the television set with the credit card is then not a means of payment. For this reason we will not include credit cards, trade credit between firms, or any other line of credit such as unused overdraft facilities, in our definition of money. 2 The fourth function of money commonly quoted, is that of a standard for deferred payment. This simply means that if something is bought today although payment for it does not have to be made until some later date, then the amount due for deferred payment can be measured in terms of money. 3 Wicksell, 1906, quoted by Kiyotaki and Wright, (1992). 4 For an excellent analysis of the differences between ‘means of payment’ and ‘medium of exchange’ see Goodhart (1989a) Chapter 2, Section 4. 19 2. The nature of money Money as a unit of account This function is also described as money acting as a measure of exchange value, money acting as a standard of value, or money as a numeraire. The essential point about this function is that money is acting as a common denominator, in terms of which the value in exchange of all goods and services can be expressed. Money is simply acting as a unit of measurement in the same way that metres measure length and kilograms measure weight. Money in this sense is being used to measure the value of goods, services and assets relative to other goods, services and assets. If it is convenient to trade all commodities in exchange for a single commodity, so it is convenient to measure the prices of all commodities in terms of a single unit, rather than record the relative price of every good in terms of every other good. If there is to be a single unit of account, it is again clearly convenient (though not necessary) that the unit of account be the medium of exchange, given that goods actually exchange against the medium of exchange. A clear advantage of having a single unit of account is that it greatly reduces the number of exchange ratios between goods and services. With four goods (A, B, C and D), in order to facilitate exchange, exchange ratios of each good in terms of all the others must be available (i.e. the six ratios A:B, A:C, A:D, B:C, B:D and C:D must be available). In fact with n goods, there are n(n − 1) = 2 relative prices. However, if we introduce a fifth good, ‘money’ that acts as a unit of account then there only need to be four prices. With n goods and money being the n + 1-th commodity acting as a unit of account, we only need n prices. For example, with 1,000 goods and no unit of account, the economy needs 499,500 relative prices of one good in terms of another. Introducing money as a unit of account dramatically reduces this to only 1,000. Thus, having money as a unit of account can encourage trade by making it easier for individuals to know how much one good is worth in terms of another. Money as a store of value The exchange attributes of money, in particular that it is durable and can readily be used in the purchase of goods, also mean that people may wish to hold it as an asset, that is as part of their stock of wealth. In this sense, money serves as a store of value: it is permitting the separation in time of the act of sale from the act of purchase. The existence of a means of payment enables a person to sell a good without simultaneously having to buy another good in exchange. Receiving a means of payment in exchange for the good sold allows the seller to hold on to it until such time as it is needed to be exchanged for the goods and services he or she requires. Money is not unique as a store of value: any asset, such as equities, bonds, real estate, antiques and works of art can all act as stores of value. Money itself is sometimes a poor store of value. This will occur when the relative price of money falls as a result of the money prices of other goods and services rising, that is, during periods of inflation. 2.9 Why do we have money? The use of money helps facilitate trade since in the absence of money, trade has to proceed through barter, that is the direct exchange of one good for another. 20 2.9. Why do we have money? Barter Barter tends to be associated with primitive economies in which individual households operate in an isolated manner, and in particular have no sophisticated information systems concerning what is going on in the rest of the economy. For various reasons households may wish to consume a different bundle of goods from those they produce, so that there are gains from trade. The problem is how to achieve these potential gains, given that trade is a voluntary activity and can proceed only when it is to the benefit of both parties. In barter, there has to be what is known as a ‘double coincidence of wants’. If I grow corn but want to consume apples, not only do I have to find someone willing to trade apples but they must also want what I have to offer, namely corn. In other words for trade to be mutually beneficial, it is necessary not only that trader A has what trader B wants but also that trader B has something to offer in exchange which trader A wants. It is quite possible that no trade will occur, especially in cases where the goods desired are so specialised that the probability of a double coincidence of wants occurring is so low that the cost of finding a match (for example in terms of advertising, transport, and so on) becomes very large and outweighs the increased utility derived from trade. Even if the goods offered for trade are readily available, it may still be the case that no trade occurs. This is the subject of the Wicksell problem in which it is impossible to secure gains from trade through bilateral exchange. The Wicksell problem Consider the situation in Table 2.1 and shown in Figure 2.1. There are three individuals who each only produce one good but derive more utility from the consumption of another. Avinash produces bread but wants wine, Nicole produces wine but wants apples and Edwin has apples but wants bread. In this situation, no bilateral exchange will result. Edwin will not trade with Nicole since he derives more utility from consuming his own apples than he does from Nicole’s wine. The utility maximising situation is shown in Figure 2.1 but under the assumption of no commitment, this will never arise. Avinash will not want to give his bread to Edwin, hoping to receive wine from Nicole since after receiving bread, Edwin has no incentive to give apples to Nicole who in turn will have no incentive to hand over her wine to Avinash. The system will collapse to autarky (in which all individuals become self-sufficient). However, models of this type can lead to the emergence of indirect barter. In indirect barter a trader accepts a good not because she or he wants to consume it but because of the possibility that it may result in a future trade. In the above example, Avinash may trade his bread for apples, not because he wants to consume the apples but in the knowledge that when meeting Nicole, she will be willing to trade her wine for those goods. This may seem an obvious solution at first glance but if we assume traders meet at random (or do not know how long it will be before they meet a prospective trader) then considerable risk may be taken on in this transaction. The goods Avinash accepts in exchange for his bread may deteriorate before he meets Nicole, in which case Nicole will not want to trade. Let us assume that the apples do not perish. The situation of indirect barter is shown in 21 2. The nature of money Table 2.1: Figure 2.1: Figure 2.2. If apples are used in both stages of the trading process then each trader will gain. In indirect barter, commodities are acquired not for consumption but for the purposes of making future exchanges. They should therefore have appropriate physical attributes; in particular they should be durable, portable and homogeneous (or at least easily valued). In primitive societies money emerged from the process of indirect barter, and took the form initially of staple foodstuffs like corn or rice. With the development of technologies, which allowed the separation of metals, money increasingly took the form of precious metals, especially gold. Money and trust The solution of indirect barter in the Wicksell problem arises almost entirely from the lack of trust between traders. As shown in Figure 2.1, each trader could maximise utility by giving his or her goods to the next person in the triangle. However, Avinash could not trust Edwin to hand over his apples to Nicole once he gave him his bread and neither could he trust Nicole to hand over her wine once (or if) she received Edwin’s 22 2.9. Why do we have money? Figure 2.2: apples. Let us consider another situation. Suppose I visit my dentist and I pay for his services using a bank debit card.5 The bank will debit my account and credit that of the dentist. I have effectively given an IOU6 to the bank and the bank has given the dentist one of its IOUs. But why did I not just hand over one of my IOUs directly to the dentist? Perhaps it may be that my dentist does not trust me to repay once he tries to redeem my IOU. More realistically, he cannot use my IOU to make purchases with anyone else and the likelihood that he will ever want to redeem the IOU from me, by receiving an economics lesson, may be so small that he would never have agreed to spend his time fixing my teeth. If the dentist went to the grocers the following day trying to buy provisions with an IOU from an economics teacher, of whom the grocer had never heard, it is highly unlikely that the trade would be completed. On the other hand, if he tried to pay using the bank’s IOU, the grocer should happily agree to the sale, purely because everyone knows and trusts the bank. The difference between my IOU and that of the bank is that the bank’s IOU is liquid 5 This example is taken directly from ‘Evil is the Root of all Money’ by Kiyotaki and Moore (2001). The model presented in this paper is not necessary for this subject but the ideas discussed therein will greatly improve the reader’s intuition as to what is money and why we hold it. 6 ‘IOU’ is short for ‘I owe you’ and is merely a written statement acknowledging that a debt has been created, to be repaid sometime in the future. 23 2. The nature of money and functionally equivalent to cash. My IOU, on the other hand, is not liquid and cannot flow around the economy facilitating trades. As we will discuss later in this chapter, it is ‘credit’ money but serves the same purpose as the commodity money derived in the indirect barter problem, without having to use or lock up any goods in the payment process. Activity 2.1 Consider the problem in Figure 2.1. How could you introduce a bank and a system of IOUs to resolve the problem without having to use any commodity to act as a medium of exchange? The idea of trust and uncertainty are important ones when explaining the existence of money.7 If you do not know, or have any way of obtaining information as to the creditworthiness of, a prospective customer, there is a high risk that he or she may default on that debt. The risk is, however, minimised if the payer hands over an item of worth, such as commodity money or another store of value, or an IOU redeemable from a third party on which the payee has sufficient information, such as a bank. In this way it may be essential to hold money beforehand in order to make purchases. This is the whole idea behind ‘cash in advance’ (CIA) models that we will consider in a more macroeconomic setting in later chapters. People have to hold money in order to alleviate the problem of trust (or lack of trust) when transactions are made. 2.10 Types of money Up to now we have considered only two types of money: commodity money in the solution to the Wicksell problem, and credit money as the solution to the lack of trust in the issuance of private IOUs. Traditionally, however, money is divided into three types: commodity money fiat money credit money. Commodity money Commodity money derives from the use of commodities as exchange intermediaries in indirect barter. Commodity money has taken many forms, such as cattle, corn, seashells and suchlike, but in most societies, it has evolved towards the precious metals, copper, silver and, above all, gold. Such commodities are accepted in exchange because of their intrinsic value, even though the trader intends to use them in further exchange rather than for their own consumption. Commodity money is inefficient, in part because the commodities being used may not have ideal properties as exchange intermediaries but more fundamentally because it is unnecessary to use goods which have intrinsic value for a purpose which does not make use of that value. For example, using gold as a commodity money does not make use of the fact that gold does have some alternative utility-yielding use and could be used in more satisfying ways, such as through jewellery or ornaments. 7 On this issue, see Goodhart (1989a), Chapter 2, Section 2. 24 2.10. Types of money Fiat money Fiat money, whose archetype is the government-issued bank note or metal coin, is money that has physical substance but no intrinsic value. It is used because its use is established by custom and practice. People accept fiat money that they know to be intrinsically worthless because they know others will accept it in payment for goods and services. The value of fiat money is reinforced in society by the attribute of being ‘legal tender’, that is making it illegal for anyone to refuse payment in fiat money in settlement of a debt. In fact it is this legal ‘stamp’ and recognised power of the issuer, usually governments, which gives fiat money its unquestionable acceptance as a means of payment. Since fiat money is essentially worthless, there is a difference between the value of the goods such money can purchase and the smaller cost of printing this money. The difference is known as seigniorage and is effectively the profit made by the issuing authority when it produces currency. Credit money Whereas fiat money is not a claim on any commodity or individual, credit money is; it is the debt of a private person or institution. In the dentist example above, I gave an IOU to the bank, which in turn hands this debt over to the dentist. If he can pass this claim on to another individual, the grocer, in exchange for goods, then this debt is being used as a means of payment and so constitutes money. However, the asset that the grocer now has, the claim on the bank, is matched one-for-one with the bank’s claim on me. What the bank owes to the grocer (the bank’s liability) must be matched by what I owe the bank (the bank’s asset) in order for the bank’s balance sheet to balance. The limitation of credit money is that it can only function if both individuals, the dentist and me in the example, have complete confidence in the willingness and ability of the intermediary to honour the debt. If the bank fails then both my dentist and I would lose out since the dentist would still have a claim on me and I may not have the funds to honour that claim if the bank has been forced to close. Since there exists a private liability perfectly offsetting the asset acting as a means of payment (i.e. the money is generated inside the private system) credit money is also known as ‘inside money’. Fiat money, which cannot be matched against private sector claims (and is generated outside the private sector) is in a similar fashion, known as ‘outside money’. In the UK today, inside money is quantitatively much larger than outside money. At the time of writing, the nominal value of inside money is approximately 30 times the value of outside money, notes and coins. There may appear to be a contradiction at this point when we compare the definition of credit money to the discussion in the section ‘money as a means of payment’ where we argued that all forms of credit should not be included in our definition of money. In the above example, although I have replaced a debt to my dentist with a debt to my bank, this is commonly accepted as a means of payment since a transfer of credit to a current account has advantages such as safe-keeping and making use of book-keeping services at the bank. Only when all parties concerned are entirely confident the bank will not fail, will such transfers be a means of payment. Once the bank hears of my purchase at the dentist (via the swiping of the debit card), the bank debits my account and credits that 25 2. The nature of money of the payee, the dentist. Nothing further needs to be done since the payment is complete. If a purchase is made by credit card, however, a debt is still outstanding and has to be repaid. Similarly, if I paid by my bank debit card but went overdrawn, a debt would remain outstanding which I would later have to pay off. For this reason, overdraft facilities are not a means of payment. 2.11 Properties of money When discussing the appropriate properties of commodity money, we mentioned durability, portability and that it should be homogeneous. Other necessary properties are divisibility and recognisability. In fact all money should possess these properties: electronic transfers when purchases are made by bank debit card are themselves durable, if not in a physical sense, in that $1 credited to your account does not deteriorate over time. Another property that is just as important is that of acceptability, the probability that it will be accepted as a means of payment. Kiyotaki and Wright (1992) emphasise this property and argue that acceptability is not a property of the money per se. An equilibrium can be reached where one individual uses one money purely because they believe everyone else will use it: ‘When an object is more readily acceptable to other people in the economy, it is more likely that each individual will desire it and accept it as a medium of exchange. The implication is that the property of acceptability can have a self-reinforcing nature. . . (This) lead(s) to the conclusion that acceptability may not actually be a property of an object as much as it is a property of social convention.’ Kiyotaki and Wright, 1992, p.19. 2.12 A reminder of your learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: discuss the nature and shortcomings of a barter economy list and describe the general functions performed by money describe the Wicksell problem and demonstrate how indirect barter can lead to the emergence of a commodity money describe the differences between transactions using credit cards and bank debit cards list and describe what the different types of money are. 26