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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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The Functions of Money
• From the four main functions of money, the
exchange function and asset function
stand out as containing the essential
features 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
“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".
M0 - wide monetary base
Cash outside Bank of England +
Banks' operational deposits with Bank
of England.
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Official Definitions of Money
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
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Narrow and Broad Money in the UK
(£’s billion)
Wide Monetary Base (M0)
- Banks Cash & Balance at Central Bank
= Notes and Coins in Circulation
+ Banks’ Retail Deposits
+ Building Society’s Deposits & Shares
+ Wholesale Deposits
= Money Supply (M4)
24.4
3.1
21.3
228.2
205.0
211.6
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 rate
a) 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 Intermediaries
Banks, insurance companies, pension funds
Financial Markets
bonds, company shares, derivatives and foreign
exchange
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The Flow of Funds Through the Financial
System
Financial Intermediaries
Ultimate Lenders
Ultimate Borrowers
Financial Markets
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References - Web
• http://www.britishmuseum.org/explore/themes/money/introduction.aspx
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