To understand why people hold money, imagine what life would
be like without it. Suppose that people hold no cash and have no
bank deposits that they can transfer to others by writing cheques.
You go into McDonalds to purchase a hamburger. How are you
going to pay for it? At a wage rate of $10 per hour, probably the
best method of payment is to wash dishes for 25 minutes. But if
you are a lawyer, this might be embarrassing, although you might
be able to persuade the franchise owner to accept 3 minutes of
legal advice. Moreover, as a lawyer, how are you going to charge
people for your services? Presumably they would have to supply
you with appropriate goods and services in return.
Without money, exchange between individuals has to take the
form of barter. The problem with barter is that it requires the
double coincidence of wants---each party to the exchange must want
to sell what the other wants to buy. In the absence of money, an
enormous fraction of people's time and effort will be used up making
exchange by pursuing and arranging barter opportunities---this
would drastically reduce the time available to produce goods and
services that can be consumed or invested.
But why can't the double coincidence problem of barter be avoided by
a system of loans or credits cleared through a clearing house? For
example, the CCSMT (Community of Churches, Synagogues, Mosques and
Temples), a morally impeccable social service group, could offer to
clear private exchanges every month. A particular commodity could
be designated a numeraire, and all individuals would simply note all
sums owing to them for end-of-month clearance. The first problem
with such a system is that the services of religious groups and
other social service organizations are not free---resources would
required for the simple mechanics of clearing transactions and this
would not be cheap, even in the era of modern computers. The other
problem, of course, is that not everyone is honest. There would be
no constraint on overspending one's income---or the
implementation and enforcement of such a constraint would be very
costly. To make exchange in this fashion, one would have to verify
the credit-worthiness of every transactor dealt with. This would,
be prohibitively expensive for small transactions, though not for
purchase of major items like cars or houses. A credit-clearance
system would thus be impractical even in traditional societies with
strong cultural and religious controls. Something has always been
used throughout history, not only as a unit of account, but
as a medium of exchange. This is the basic function of
money---to reduce the resource cost of making transactions.
Money is often viewed as having an additional function---to act
as a store of value through time. In this respect, however, money
is not special. Houses, cars, TV sets, clothes, and all other forms
of capital are stores of value. Being a store of value simply
designates money as a form of capital. The stock of money, like
the stocks of buildings, machines, and human skills, is part of the
economy's stock of capital. The output flow from money is the goods
and services that can be produced with labour and capital that would
otherwise have been tied up doing barter or checking people's
credit-worthiness.
Historically, even primitive societies used some form of money.
Precious metals---usually gold or silver---were typically the unit
of account and medium of exchange until 100 years ago. In medieval
times, kings and feudal lords minted gold (or silver) into coins to
provide a standard for transactions--hence the term Gold Standard.
As the financial system evolved it became inconvenient to hold
actual gold coin and people would customarily deposit the gold for
safe-keeping with a bank in return for bank-notes that the bank
agreed to redeem for gold at any time. This paper money was as good
as gold in the sense that it was freely convertible into gold coin.
Then, instead of issuing bank notes, it became convenient for
banks to give depositors accounts from which they could withdraw
paper money, or gold, and on which they could write cheques that
would transfer the funds to other people in payment for goods and
services. The medium of exchange then consisted of not only gold
coin and paper money, but bank deposits as well.
At this point problems arose when banks issued paper money that
they subsequently were unable to redeem in gold on request. This
led to government regulations on who could own banks and government
monitoring of day-to-day bank operations. It was then but a short
step for the government to assume responsibility for issuing all
paper money---the government then assumed the obligation to redeem
this paper money in gold on request.
The gold standard system evolved to the point where very few
people held monetary gold---everyone operated with paper money,
token coins (which like paper money were redeemable in gold) and
bank deposits. Gold was the standard for the monetary system in
the sense that all deposits and circulating media were convertible
into gold on demand. This implied that, even though gold was not
used in transactions, the total quantity of money in circulation
(token coins, paper money and deposits) was limited by the quantity
of gold held by the government as backing for it. The government
had to maintain gold reserves in case someone wanted to convert
paper money into gold. It had to provide gold backing for all the
paper money it issued.
In a gold standard system of this sort, the only function of
the link of paper money to gold is the limiting effect of available
gold reserves on the quantity of money the government can issue.
If the government is a trustworthy custodian of the money supply,
resources can be saved by simply having the government issue and
control the money supply directly, without any gold-reserve backing.
Paper money would no longer be convertible into gold, but that would
not matter because no one needs to hold monetary gold anyway. The
supply of money in circulation is simply controlled directly by the
government monetary authority. The advantage is that resources
do not have to be wasted digging gold out of the ground for storage
in government vaults.
How does the government control the money supply? In most
countries, a government agency called the central bank is
entrusted with responsibility for managing the money supply. This agency
is usually somewhat independent of the government currently in
power---this is to prevent politicians from using money creation to finance
handouts to voters right before elections. The details of the process of
money creation are complex and are covered thoroughly in a later
Lesson, Monetary Policy Under Fixed Exchange Rates.
The complexity arises because the banking system plays an important role
in determining the money supply. This means that the central bank has to
work harder to maintain the money supply at the desired level.
Since the complexities relating to the banking system are not
relevant to the discussion that follows, we can ignore them here.
The central bank can be thought of as having two avenues of money-supply
control. First, it can buy and sell bonds from the private
sector. This is called open market operations. When the
bank buys bonds from the public, it gives money in return---that money is
put into circulation. Similarly, by selling bonds to the private sector
the central bank can take money out of circulation.
A second way the central bank can increase the money supply
is by purchasing bonds from other branches of government which then
spend the money in the provision of government services---this money
thus goes directly into circulation. This method of money creation
is typically called the printing press. The government as a
whole, which includes the central bank, is essentially borrowing from
itself and spending the proceeds---it is as if the government simply prints
money and spends it. The reason why countries make their central
banks independent of the political electoral process is to prevent
the government from borrowing from itself and printing money in this
fashion. This independence is achieved by appointing central bank
governors for long terms and not requiring them to be answerable to
the currently elected prime minister or president. We will see the
need for this more clearly in subsequent topics.
Essentially, the government faces a budget constraint of the sort
G = T + ΔB/Δt
+ ΔM/Δt
where G is government expenditure, T is the revenue
from taxes, B is the public's holdings of government bonds
M is the money supply, and ΔB/Δt and
ΔM/Δt refer to the change in the stocks of government
bonds and money held by the public in the current time period. This says
that the government must finance its expenditure by either levying taxes,
selling bonds to the public or printing money and increasing the money
stock. The government has to pay interest on bonds it sells, the stock of
which represents the public debt. And no one wants to pay taxes! Printing
money and spending it, on the other hand, appears on the surface to be
rather painless. You will learn why printing money is also not a
painless alternative in subsequent topics.
Before turning to the role of money in price
level determination and in generating inflation, we need to think
about how the quantity of money can be measured. Obviously, cash in
people's hands is part of the money supply. So is the quantity
of chequable deposits held in banks. Because cash and bank deposits
can be used directly to acquire goods and services they are said to
possess a quality called liquidity. In fact, cash is more
liquid than bank deposits because cheques can bounce and are therefore a bit
less acceptable than cash in making transactions---that is, they are not
absolutely convertible into cash at all times and places.
Time deposits---that is, deposits that can be converted into
cash by going to the bank or making a phone call but cannot be
transferred by cheque---are also quite liquid and are sometimes
counted as part of the money supply. Cash plus demand deposits
are referred to as M1 (the narrowest definition of money) and
cash plus both demand and time deposits is called M2. An even
broader definition of money, typically called M3, would include
additional assets less directly usable for making exchange, such as
short-term government bonds, etc.
There is no clear line separating money from non-monetary assets. And the
quantities of different measures of the money supply sometimes move in opposite
directions through time, making it difficult for central banks to conduct
monetary policy. Clearly, however, corporate bonds, common stocks, mortgages,
automobiles and houses, cannot be viewed as part of the money supply. Assets
become increasingly less liquid as they become more difficult to convert
quickly into a predictable amount of cash. Cars are thus less liquid than
common stocks, houses are less liquid than cars, and shoes are even
more illiquid.
It is now time for a test on this Topic. As always, commit yourself
to an answer in every case before looking at the one provided.
Our concern in this Lesson is with the causes of inflation.
We will show that the cause of all major inflations is excess
expansion of the money supply. To begin, we must deal with the
question of why money exists in the first place. Here we expand
on the analysis presented in the Lesson called The Dimensions of
Economic Activity.