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ECON 4100
Monetary Economics
William D. Lastrapes
Fall 2008
Money
Specialization is necessary for high productivity, high
standards of living.
Trade and exchange are necessary for specialization.
Money reduces costs of and facilitates exchange.
So without money, low standard of living for all.
Money
The study of money is the study of how people
trade, the mechanics of the payments system.
Such mechanics are typically ignored in micro
models of voluntary exchange and efficient
allocation of resources.
Voluntary exchange without money
Barter: exchange of goods for direct consumption.
(Double) coincidence of wants: for mutually
beneficial trade to occur under barter, a seller
must find a buyer who wants what he or she has,
and has what he or she wants.
Voluntary exchange without money
“The butcher has more meat in his shop than he
himself can consume, and the brewer and the
baker would each of them be willing to purchase
a part of it. But they have nothing to offer in
exchange, except the different productions of
their respective trades, and the butcher is already
provided with all the bread and beer which he has
immediate occasion for. No exchange can, in this
case be made between them.” -- Adam Smith
Solutions to the coincidence of wants
• Central market (with trading posts). The key here
is providing information.
Solutions to the coincidence of wants
• Indirect barter: accept some goods for trade, not
consumption.
A stylized example:
Solutions to the coincidence of wants
Preference
Endowment First trade
Final trade
Butcher
Beer
Meat
Beer (from brewer)
Brewer
Bread
Beer
Baker
Meat
Bread
Bread (from
baker)
Bread (from
butcher)
Meat (from
butcher)
Solutions to the coincidence of wants
• Money will evolve from indirect barter as a single good
becomes most ‘saleable.’
“In order to avoid the inconveniency of such situations [no
possible exchange], every prudent man in every period
of society, after the first establishment of the division of
labour, must naturally have endeavoured to manage his
affairs in such a manner as to have at all times by him,
besides the peculiar produce of his own industry, a
certain quantity of some one commodity or other, such
as he imagined few people would be likely to refuse in
exchange for the produce of their industry.” -- Smith
Claim on labor
To Kill a Mockingbird
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Good morning, Mr. Finch. I didn't want
to bother you none. I brung you these
here hickory nuts as part of my
entailment. Well, I thank you.
The collards we had last week were
delicious.
Scout, I think maybe, uh, next time Mr.
Cunningham comes, you better not call
me. I think it embarrasses him to be
thanked.
Why does he bring you all this stuff?
He's paying me for some legal work I
did for him.
Why does he pay you like this?
That's the only way he can. He has no
money.
Modern barter
Modern day barter systems: the internet can be
used to provide information about exchange,
which can promote direct (i.e. barter) exchange.
An example:
http://www.merchantsbarter.com/
Functions of money
Money is an asset or store of value that facilitates
exchange. Money is neither income, nor wealth.
Two basic functions of money:
• medium of exchange – generally accepted means
of payment
• medium or unit of account, or a standard of
value.
Functions of money
Relative prices
With n goods: n(n-1)/2 relative prices.
n= 5 → 10; n = 100 → 4950 relative prices.
Under barter, must keep track of all.
With unit of account, only keep track of n-1 prices,
and easily compute relative prices. Example:
relative price of apples in terms of oranges is the
unit of account price of apples divided by unit of
account price of oranges.
Functions of money
Logically, the medium of exchange function and
unit of account function need not be served by
the same commodity. For example, gold might be
medium of exchange, ‘dollars’ might be unit of
account.
Comments
• Menger (1871): money
evolves spontaneously
• Most saleable goods: scarce,
durable, portable, divisible,
and homogeneous
• Cattle one of the first media
of exchange and media of
account; but metals (gold and
silver most common
historically)
Modern money
• Paper currency
Modern money
• Paper currency
• Checkable deposits at
banks (checking
accounts)
• Stored-value cards
• Local currencies
http://www.berkshares.org/
• Pay pal?
Alternatives to money
• Credit
• Liquid assets
• Gold and silver?
Purchasing power of money and
inflation
• Purchasing power of money: value in exchange
for other goods: how much a monetary unit can
buy.
• Price level: the reciprocal of the purchasing
power of money; the money price of the ‘average
good.’
• Inflation rate: rate of change of price level over
time
US Price level (CPI)
US Inflation (CPI)
Recent US inflation
Purchasing power of money and
inflation
• Hyperinflation: extreme inflation (say greater
than 50% per month). At this rate, $1 item on
Jan. 1 would cost $130 on Dec. 31.
• German hyperinflation: inflation rate was 322%
per month from August 1922 to November 1923.
German wholesale price index
12/1914
12/1921
12/1922
12/1923
Index
125
3,490
147,480
126,160,000,000,000
mon. rate
4.3%
36.6%
455%
Inflation
Inflation occurs when the quantity of money grows faster than the
demand to hold it. If there is too much money, people try to spend
it on goods and services, driving prices up.
“Too much money chasing too few goods.”
“Inflation is always and everywhere a monetary phenomenon.”
Hyperinflations occur when money supply growth far exceeds
money demand growth, as in Post World War I Germany. Such
hyperinflation can only happen with fiat money when money is
cheap to produce and there is no ‘anchor’ for its quantity.
Measuring the quantity of money
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M1 = Currency held outside of banks + checkable
deposits issued by financial institutions + traveler’s
checks
M2 = M1 + plus savings deposits (including money
market deposit accounts) and small-denomination (less
than $100,000) time deposits issued by financial
institutions; and shares in retail money market mutual
funds (funds with initial investments of less than
$50,000), net of retirement accounts.
MZM = M2 + institutional money market mutual
funds – small denomination time deposits.
M1 money stock
M1 money stock
M2 money stock
Real money balances
M = nominal stock of money (in unit of account)
P = price level
M/P = real money stock; the quantity of money in terms of
its purchasing power, what it can buy.
An example: the real value of $100, if bread is $2 a loaf, is
50 loaves of bread.
A ‘shopping time model’ of money
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Households consume leisure and other stuff
They can shop or consume leisure.
Opportunity cost of shopping is leisure.
Shopping time can be reduced by incurring
transactions costs.
• Optimal shopping time minimizes total costs of
exchange.
A ‘shopping time model’ of money
Costs
Total costs
Waiting costs
Transactions costs
Shopping
Time
A ‘shopping time model’ of money
Costs
Waiting costs
Transactions costs
with barter
Transactions costs
With money
Shopping
Time