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CHAPTER 2: What Is Money?
FOCUS OF THE CHAPTER
This chapter provides a brief analysis of money, and its importance in the economy. The
analysis deals with the definition of money, problems in economies without money
(barter), what money does in a money economy, types of money used in the historical
evolution of money, how to measure the supply of money, types of money used in
Canada, the relationship between the money supply and economic activity (price level,
GDP, etc.). The impact of inflation on social welfare is also discussed.
Learning Objectives:
 Identify why monetary economies are prevalent around the world
 Understand the functions of money and identify the special features of a monetary
standard
 Trace the monetary standards that have existed through history and their evolution
 Understand the basic features of and definitions used in measuring Canada’s money
supply
 Determine why a multiplicity of money supply definitions exist
 Identify what economic factors affect the purchasing power of money
SECTION SUMMARIES
Why Money?
Money is not necessarily legal currency (notes and coins). Money is any asset (or assets)
that the public in general accepts as capable of performing certain functions (the functions
of money). The social agreement (or acceptance) is the most important requirement.
Money is believed to improve economic efficiency and social welfare.
Barter: Barter is the direct exchange of commodities without the use of money
(exchanging commodities for commodities). Barter is less efficient than monetary
exchange (selling one commodity for money and buying another using that money). The
exchange is not possible unless there is a ‘‘double coincidence of wants’’ (i.e., the wants
of the two parties match exactly), a condition not easy to satisfy. Time and other real
costs of completing a transaction (transaction cost) are therefore higher with barter. There
are other difficulties with barter as well.
The Functions of Money: Money fulfills three basic functions as: 1) a medium of
exchange (as payment for goods and services); 2) a unit of account (as a yardstick for
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measuring value or price); and 3) a store of value (as an asset in terms of which the
storage of wealth is possible). As a generally acceptable medium of exchange, money is
perfectly liquid and eliminates the need for a double coincidence of wants. The ease with
which an asset can be converted into a medium of exchange is called liquidity.
The suggestion that money must be designated as legal tender is not appropriate
since the confidence of the public, not government enforcement, ultimately decides which
assets will be used as money. Transaction costs can be lowered by using media of
transaction such as traveller's cheques or credit cards. The medium of exchange function
does not imply the store of value function, as there other interest rate-bearing assets than
money (or cash) which may function better as stores of value.
Monetary Standards
A society’s monetary standard is the basis of its monetary arrangements and includes
rules, regulations, and customs regarding the issue and use of money. Broadly, two
monetary standards are found in history: commodity standards and fiat-money
standards. Under a commodity standard the monetary unit is defined as a commodity
such as gold (a physical asset) in a specified quantity and often quality. The physical
commodity itself, or minted coins made from it or papers convertible into the commodity,
were used as circulating media (actually used in transactions). Under a fiat-money
standard (paper-money standard), the circulating media are the legal tender (notes and
coins whose monetary worth is determined and guaranteed by the taxing and borrowing
powers of the government), and have virtually no commodity value. No monetary
standard is perfect, but fiat-money standards have become more popular and widespread.
Gold Standard
Gold has been the commodity most often used as money. Many countries have used
versions of a gold standard in which the exchange rate is fixed to the price of gold.
Canada had a gold standard from 1854 to 1914 and from 1926 to 1931. Before 1914,
many countries in the West were on a classical gold standard according to which their
currencies were convertible into gold on demand. Under this system, the price of gold
was fixed and exchange rate fluctuations were limited.
In a pure gold standard circulating notes are fully (100%) backed by gold. The
ability of governments and monetary authorities to manipulate the money supply (the
power of discretionary monetary policy) is very limited, and hence it is easy to maintain
price stability. However, the limited power of monetary policy and other inflexibilities
under a pure gold standard may exacerbate economic problems in a recession.
Bimetallism: A monetary system based on two metals, such as gold and silver, is called
bimetallism. The exchange rate between the two metals is fixed. Changes in the relative
market value of the two metals can lead to the operation of Gresham’s Law, which states
that "Bad money drives good money out of circulation."
Canada’s Early Paper Money: Canada’s early experience with paper-money standards
(for example, when playing cards and pieces of cardboard were used as circulating
media) were not happy, in particular when the paper money was not fully backed by
redemptions. Under the paper standard known as Army Bills, the circulating media
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were redeemed in full. Prior to Confederation in 1867 the private notes issued by private
banks were believed to be the best way to satisfy the need for money. Circulating coins
appeared only in 1858. By 1866 provincial notes were introduced. Government
effectively had monopoly over small denomination notes while the private banks
circulated larger denomination notes. Following Confederation, dominion notes replaced
provincial notes, and the first Bank Act was introduced. In the mid 1930s the Bank of
Canada was created, and the Bank of Canada notes replaced the dominion notes and
private bank notes.
Fiat Money and Central Banks: As the adoption of fiat-money standards became
widespread in the twentieth century, the importance of central banks increased. A
central bank (e.g., Bank of Canada) is a national bank which is owned by the public
sector and is responsible for the conduct of monetary policy. It acts as the banker for
the federal (central) government, and entertains a certain degree of independence from
the government.
Measuring the Money Supply
The amount of money available in the economy is called the money supply or money
stock. Money may include many assets other than currency in circulation (notes and
coins), and therefore, the measurement of its supply is not simple.
Some Helpful Concepts:
Types of Banks and Deposits: Banks are a group of deposit-taking financial institutions which
include chartered banks (e.g., Bank of Montreal, Bank of Nova Scotia), and near banks such as
trust companies and credit unions. Depositors lend their funds to the banks Therefore, the deposits
are assets to the depositor and liabilities to the institution. The deposits are of four types: 1) current
accounts and personal chequing accounts; 2) savings deposits; 3) term deposits; and 4) money
market mutual funds.
Cheques and Cheque Clearing: A cheque is a written order for a bank to transfer a specific
amount of funds from the writer’s account to someone else. In a system of many banks, a large
number of transactions are done every day using cheques which require the transfer of funds
between the banks and changes in the balances of accounts. In Canada this is done by the
Canadian Payments Association, which operates an automated cheque-clearing system (a clearing
house). Computer technology has increased the speed of cheque clearing, but at all times some
cheques are in transit. As a result, the double counting of money held by financial institutions is
unavoidable. Therefore, an estimate called private sector float is used to adjust for the amount of
double counting.
Definitions of the Money Supply: Empirical definitions used in Canada, from the
narrowest to the broadest, are listed below.
1) Currency in Circulation, i.e., the notes and coins outside the banking system.
2) M1. The currency in circulation plus current, demand, and personal chequing accounts
at chartered banks, net of the private sector float.
3) M2. M1 plus non-personal notice deposits and personal savings deposits at chartered
banks.
4) M2+. M2 plus notice and term deposits at near banks, generally at trust and mortgage
loan companies.
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5) M3. M2 plus non-personal fixed-term deposits at chartered banks plus the Canadian
dollar value of foreign currency deposits of residents booked in Canada.
Some Possible Refinements: Still broader measures of the money supply may be constructed which
include some liquid assets such as Canada Savings Bonds, unused portions of credit card balances,
and consumer or residential mortgage credit. Each of the money supply definitions measures the
aggregate value of many different types of assets. Divisia Indexes have been developed to take into
account the degree of liquidity of different assets included in the definitions of money supply.
Why So Many Monetary Aggregates? The link between the money supply and key
macro aggregates such as GDP and price level has evolved over time because of financial
innovations and deregulation. In response to new developments in the financial sector and
the economy, the Bank of Canada has introduced a series of monetary aggregates. These
aggregates are crucial variables in the analysis of economic performance and monetary
policy effectiveness.
Seasonal Adjustment: Seasonal adjustments, calculated to smooth seasonal variations of money
supply aggregates, are less necessary as we move from narrow to broad definitions.
Inflation and Social Welfare
Inflation is an increase in the general level of prices. Inflation reduces the purchasing
power (real value) of money and decreases social welfare through a redistribution of
income and other harmful effects. Social costs result because inflation upsets the debtorcreditor relationship; influences the government revenue motive for inflation; creates a
deadweight loss for society; leads to the additional cost of distinguishing nominal from
real magnitudes; increases menu costs, poses problems for accounting in historical and
current values; and generates uncertainty associated with higher and volatile prices.
MULTIPLE-CHOICE QUESTIONS
1. For an asset to act as money, the asset must
a) be legally accepted as a medium of exchange.
b) be commonly accepted by the public as a medium of exchange.
c) have a physical existence.
d) be made out of or fully backed by a precious metal.
2. Which of the following is not a function of money?
a) unit of account.
b) medium of exchange.
c) store of value.
d) intermediation.
3. The exchange of commodities for commodities is called
a) barter.
b) indirect exchange.
c) asset transformation.
d) monetary exchange.
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4. A double coincidence of wants is
a) a condition easily satisfied in a direct exchange economy.
b) a condition not easily satisfied in barter.
c) a desirable property of money.
d) a function of money.
5. The two broad monetary standards found in the history of money are
a) gold standard and silver standard.
b) bimetallism and trimetallism.
c) monometallism and bimetallism.
d) commodity standard and paper-money standard.
6. Legal tender is the circulating medium under
a) the gold standard.
b) bimetallism.
c) commodity standards.
d) fiat-money standards.
7. Under the pure gold standard
a) circulating notes are fully backed by gold.
b) the authorities can easily manipulate the money supply.
c) price stability is difficult to achieve.
d) the power of monetary policy is unlimited.
8. “Bad money drives good money out of circulation.” This is a statement of
a) monetary policy rule.
b) Okun’s law.
c) Gresham’s law.
d) the paradox of thrift.
9. Which of the following is the correct definition of M1 money supply?
a) currency held in and outside the banks plus notice deposits at chartered banks
b) currency in circulation plus demand deposits at chartered banks
c) currency held in and outside the banks plus demand deposits at chartered banks
d) currency in circulation plus demand deposits at chartered banks and near banks
10. Which of the following is not true of inflation?
a) It reduces purchasing power of money.
b) It favours lenders and penalizes borrowers.
c) It redistributes income in favour of variable income earners.
d) It decreases social welfare.
PROBLEMS
1. Consider the following data (all in millions of dollars):
Currency in circulation
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100
Demand deposits at chartered banks (personal chequing accounts)
Notice deposits at chartered banks (current accounts)
Non-personal notice and personal savings deposits at chartered banks
Notice and term deposits at near banks
Non-personal term and foreign currency deposits
200
500
600
300
400
Compute the magnitude of
a) M1
b) M2
c) M2+ and
d) M3
2. What are the problems of a barter economy compared to those of a monetary-exchange
economy?
3. State Gresham’s law and describe a situation in which the law might operate.
4. Describe some of the advantages and disadvantages of using commodity money in an
economy.
ANSWER SECTION
Answers to multiple-choice questions:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
b
d
a
b
d
d
a
c
b
b
(see pages 15, 16)
(see page 17)
(see page 16)
(see page 16)
(see pages 18, 19)
(see page 19)
(see page 19)
(see page 20)
(see page 25)
(see page 30)
Answers to problems:
1. a) M1 = 100 + 200 + 500 = 800 million dollars
b) M2 = 800 + 600 = 1400 million dollars
c) M2+ =1400 + 300 = 1700 million dollars
d) M3 = 1400 + 400 = 1800 million dollars
2. The problem of satisfying a double coincidence of wants for successful completion of
an exchange is the most widely encountered problem under the barter system. This
difficulty leads to higher transaction costs and to lower volume of exchanges. When the
goods to be traded are of unequal value, the difficulty of dividing the goods for exchange
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without a considerable loss to one party (problem of divisibility) is another problem.
Moreover, the absence of a satisfactory unit of measurement and a store of value (such as
money) also creates problems. For instance, in barter there is no standard unit of
measurement like the Canadian dollar to express the price or value of commodities or
other objects. Although commodities other than money can also function as a store of
value (for accumulation of wealth), money provides a more liquid and less costly store
of value.
3. Gresham’s law states that bad (cheap) money drives good (dear) money out
of circulation. Suppose that under bimetallism, gold and silver coins are used as
circulating media in a country. Also, suppose for some reason that the supply of silver has
increased greatly, making silver less scarce, and hence that the relative price of silver has
dropped. Now, people would prefer to use more silver coins in transactions and to hoard
gold coins. As a result, the gold coins eventually would be driven out of circulation.
4. Commodity money such as gold and silver has intrinsic value. Therefore, it can also be
used as commodities (e.g., to make jewellery), in addition to being using as money. The
supply of such money cannot easily be changed by the authorities, and, therefore, price
stability can be easily maintained. However, the supply of money depends on the
production of the commodity (e.g., the discovery of new gold deposits) and the quantity
of the commodity used for other purposes. Therefore, the supply is not related directly
to the level of economic activity, and cannot be increased as required by increased
economic activity.
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