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Money

Lecture 1

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Presentation Objectives

• The importance of money in a sound economy

• The main functions, qualities and development of money

• The concept of definition and measurement of the money supply in an economy

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MONEY

• ‘Makes the world go round’

• ‘The love of money is the root of all evil’

• A form of payment in coins or notes

• Cash [old French casse – box for money], loot, greenbacks, beer vouchers.

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What is Money?

• At first sight the answer to this question seems obvious• 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.

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What is Money?

• It is almost impossible to define money in terms of its physical form or properties since these are so diverse. Therefore any definition must be based on its functions.

• The accepted common medium of exchange for goods and services in the marketplace that functions as the unit of account, a means of deferred payment and a store of value.

• Economists tend to define money as anything readily acceptable as a means of payment. Usually this means notes, coins and bank deposits. However, one Authority says it is "an extremely difficult concept to define with precision." The supply of money comes under any number of definitions.

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What can serve as money?

Commodities must satisfy the following properties to serve as money:

• Widely accepted

• Standardized

• Divisible

• Easy to carry

• Not deteriorate easily

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Functions of Money

Medium of Exchange

Unit of Account

Store of Value (Wealth)

Standard of Deferred Payment

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• From the four main functions of money, the exchange function and asset function stand out as containing the essential features of money.

The Functions of Money

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The Banking System

• In the past, precious metals (e.g. gold or silver) were used as a medium of exchange

• Later on, paper currency was issued, but only central banks were allowed to issue paper currency that was convertible into gold

• Abandonment of the gold standard: currencies were no longer convertible by law into anything valuable

• Today almost all currency is fiat money, which is widely accepted because it is declared by government to be legal tender (http://en.wikipedia.org/wiki/Fiat_currency)

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• Central banks are the ultimate providers of high-powered money

High powered money = currency (bank notes and coins) in private circulation plus the quantity held by the banking system in deposits held with the Central Bank– also referred to as the monetary base or M0

• High powered money is an asset to anyone in the private sector who holds it but is a liability of the Central Bank

=>Monetary conditions in an economy can be influenced by altering the stock of high powered money

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=>The Central Bank can increase the amount of high powered money in the economy through open-market operations (OMO)

– This involves the purchase of securities (usually government bonds) undertaken with newly issued high-powered money

– The government guarantees to pay a fixed interest per year and repay the principal at some future date

– Government bonds considered to carry less risk than private sector bonds

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The Ratios Approach to the creation of deposit money

• Two ratios are important in the determination of the level of deposit creation: – Commercial banks’ reserve ratio – Ratio of currency to deposits held by the public

Let R = cash held in bank reserves

C = cash held by the non-bank public

H = level of high-powered money in the economy

=> then: C + R = H

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The Functions of Money (Extra)

• Medium of Exchange

• Unit of Account

• A Store of Value

• A Standard of Deferred Payments (or Credit Standard)

• A Means of Unilateral Transactions

• A Means of Influencing Economic Activity

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Official Definitions of Money

Difficult to define unambiguously

M0 - wide monetary base

Cash outside Bank of England + Banks' operational deposits with Bank of England.

“Narrow” and “broad” definitions M0 is referred to as the "wide monetary base" or "narrow money" and M4 is referred to as "broad money" or simply "the money supply".

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M4 - Cash outside banks (ie. in circulation with the public and non-bank firms) + private-sector retail bank and building society deposits + Private-sector wholesale bank and building society deposits and Certificates of Deposit (CD).

M0 and M4 are the ones commonly published

Official Definitions of Money

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Narrow and Broad Money in the UK(£’s billion)

Wide Monetary Base (M0) 24.4

- Banks Cash & Balance at Central Bank 3.1

= Notes and Coins in Circulation 21.3

+ Banks’ Retail Deposits 228.2

+ Building Society’s Deposits & Shares 205.0

+ Wholesale Deposits 211.6

= Money Supply (M4) 661.1

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Changing the Money Supply

If the central bank wants to raise money supply, it can use the following instruments:

a) it can lower the required reserve ratio

b) it can lower its discount ratea) and b) affect the money multiplier

c) it can engage in open market operations (OMO)

This affects the monetary base (H)

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HOW TO MAKE MONEY

http://www.bankofengland.co.uk/

http://www.royalmint.com/

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Advantages of Silver and Gold Coins

• Acceptable

• Scarce

• Indestructible

• Recognizable

• Portable

• Homogeneous

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Flow of Funds

Diagram shows how funds flow between the household and company sectors. Households supply labour services and receive wages. Companies provide goods and services and receive payments

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Financial Services

Why is this subject important (and interesting)?

• Financial service sector in the UK is very large

• Financial services are important to firms, governments and households

• Structure of financial markets affects how governments can exercise macroeconomic policy

• Microeconomics learnt so far does not deal with many financial issues

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The Financial System

End Users“Ultimate” Lenders (Savers): Households, firms, governments“Ultimate” Borrowers (Investors): Firms, governments, households

Financial IntermediariesBanks, insurance companies, pension funds

Financial Marketsbonds, company shares, derivatives and foreign exchange

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The Flow of Funds Through the Financial System

Financial Intermediaries

Financial Markets

Ultimate Lenders Ultimate Borrowers

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References - Web

• http://www.britishmuseum.org/explore/themes/money/introduction.aspx