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CHAPTER 2
WHAT IS MONEY?
The emphasis in these questions is on various definitions of the money supply. Certain
theoretical concepts related to the functions of money are also examined. The notion
that inflation is a tax on money is also emphasized and a list of the costs of inflation is
provided and discussed. The chapter also discusses the principal historical regimes in
Canadian economic history such as the Gold Standard and Bimetallism.
PROBLEMS
1.
M1
M2
M2+
M3
=
=
=
=
1,000 + 3,000 + 10,000 = 14,000
14,000 + 12,000 = 26,000
26,000 + 6,000
= 32,000
26,000 + 9,000 = 35,000
2.
Yes, because it is part of the currency outside banks' component of M1.
3.
A rough calculation suggests that 5% inflation annually will increase the price
level by 30% in 6 years (actually its 34% via the compounding effect to be
studied in chapter 5) so that a consumer will need about $1.30 six years from now
to buy $1 worth of today’s goods and services, or 1/1.3=.77 .This means that $1
six years from now will be worth only about 77% of what its worth today
(actually closer to 75% when compounding is factored in). For the 14 year case,
the answer is 5% times 14 which is 98% with compounding so that purchasing
power will have been halved.
4.
Yes, it is. If a monetary economy operates and there are n commodities (including
money), the number of possible transactions is n-1, since each commodity can be
traded for itself and money. Under a barter system, it can be shown that the
number of transactions would be ½[n(n-1)]. Take a numerical example: if n=3,
then, under a monetary system, there are 2 possible transactions (2-1); in a barter
system there are 1/2(32)=3. Therefore, a barter arrangement is more inefficient
in that it increases the number of transactions made in an economy and its costs.
The differences become larger the larger the number of commodities in an
economy.
5. The answer requires that one examine table 2.2. Simply put, M1+ and M1++ include
financial assets NOT included in M1. In particular, deposits at trusts and credit unions
of the chequable variety are included in M1+ while M1++ includes deposits of the
non-chequable variety at these same institutions.
6. Seigniorage is the “profit” made from the issue of money. It is generally assumed that
money is essentially costless to produce. Increases in the money supply are
inflationary and, therefore, reduce the purchasing power of money. Hence,
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seigniorage can be thought of as the “tax” rate on the purchasing power of money,
that is, inflation (), times the amount being taxed, or the purchasing power of money
which is measured as real balances (i.e., M/P, where M is the money supply and P is
the price level. This can be expressed in equation form as follows:
Seigniorage = (M/P)
DISCUSSION QUESTIONS
1.
2.
a.
The card is the medium of exchange because it is the physical device used
to settle all transactions while credits in the computerized system is the
medium of account.
b.
Since all prices continue to be quoted in dollars, the dollar is the unit of
account.
c.
It is clearly a monetary economy since a medium of exchange and a unit
of account both exist. One of the problems is the cost of running such a
complicated computerized system. Is it more efficient, given the present
technology, than a conventional monetary system? What about small
businesses that might not find it economical to link up with the network?
Habit persistence is also a problem as there are many individuals who
would continue to want to use cash instead of a card.
What the statement means is that the M2 less M1 component of the money supply
rose by $12 million while M1 fell by $5 million. The net change to M2 is thus 125=$7 million. For example, it is possible that individuals sold, say, $12 million
worth of Canada Savings Bonds and placed the proceeds in their savings account.
At the same time, say, because its near Christmas time, currency withdrawals
might have totalled $5 million thereby reducing M1. As we shall see later in the
text, there is also a multiplier effect to be considered, but we can ignore this issue
for now.
3.
Banks must keep reserves to cover day-to-day cash needs of the public, as well as
to cover cheques written on accounts by other banks. Banks, therefore, will keep
reserves even if not legally required to do so. Also, the Bank of Canada will
require banks to maintain at least a zero balance for clearers; otherwise, the
clearers will incur substantial penalties for negative balances.
4.
No. One of the spurs to financial innovations were the high inflation rates of the
late 1970s and early 1980s. This stimulated, world-wide, a search for alternatives
to cash and non-interest bearing checking accounts, or accounts whose returns
were regulated in some fashion. Finally, the elimination of capital controls means
that cross-border shopping for financial instruments also becomes possible.
5.
The effect of the annual rush on RRSPs would be smoothed out in seasonally
adjusted figures to the extent that it is predictable. Postal strikes are unpredictable
and are not seasonal events. Some adjustment might be made in seasonally
adjusted data to reflect the effects of a postal strike on currency, although these
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effects have become less important with, for example, the introduction of
automatic tellers for cash withdrawals or bill payments.
6.
The answer to this question can be found by reading section 2.5. The government
generates revenue from printing money, which allows it to purchase commodities
whose value greatly exceeds the costs of creating money in the first place.
Inflation also implies that more cash is held since it costs more money over time
to purchase the same quantity of goods and services. Since holding money (i.e.,
cash) incurs an opportunity cost, the necessity of having to carry more money to
finance a given level of spending is equivalent to a tax on money.
7.
The following is one example of the re-distributive impact of inflation. If you
believe that an inflationary policy permits the current generation to enjoy greater
wealth (and, therefore, consumption) via an increase in government debt, then
chances are that this debt will have to be paid off by future generations either
through still higher inflation (with all the costs attendant to this outcome) or, most
likely, via higher taxes.
8.
Answers, of course, will vary but many economists would agree that items 1, 7
and 8 have the greatest social costs. Upsetting the creditor-debtor relationship
affects the efficiency of capital markets; the volatility of inflation affects the costs
of making economic decisions; and the impact of unemployment is felt
throughout society potentially through higher taxes and social unrest.
9.
We shall return to this topic in chapter 26 (see, especially, Economics Focus
26.2). It is difficult to think of many “benefits” from inflation but one should
perhaps make a distinction between low and high inflation. Existing studies reveal
that inflation rates of 10% or less do not seem to harm economic growth while
inflation rates than exceed 30% have harmful effects on growth.
Some “benefits” from zero inflation Some costs of zero inflation
Price stability protects the value of Some price variation is essential to keep
assets
individuals and businesses searching for
the
best
price-quality/quantity
combination for goods and services
Wage growth can focus on Price stability may come at the expense
productivity improvements
of higher unemployment – lower
economic growth, or both
Prevents governments and central History has few experiences with zero
banks from using “surprise” inflation inflation for long periods of time
to stimulate economic activity
10.
The article assumes that, by monopolizing the note issue, governments can use the
printing press to print money to finance their spending. As we saw in chapter 1,
inflation is really a phenomenon of the post WWII era when governments around
the world took over central banks. With the stagflation of the 1970s and 1980s,
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emphasis turned toward providing central banks with more autonomy as well as
specifying targets for inflation. There is little evidence, though this point is
somewhat controversial, that the issue of notes by private banks for example,
produces more price stability. We return to this topic in chapter 19.
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CANSIM QUESTION
The Table below reproduces the relevant data from Attah-Mensah and Nott’s article,
Table 1 as well as the calculations based on the data from CANSIM. The data are
available from the publisher. Note that Attah-Mensah and Nott’s calculations use
quarterly data and calculate the growth rates using fourth quarter to fourth quarter percent
changes. In CANSIM download the data at the annual frequency and choose end for the
frequency conversion.
Attah-Mensah Nott
1986 1993
1994
-90
10.7 8.2
7.0
5.6
8.2
7.0
0.9
-4.0
-2.4
1995
4.4
19962001
NA
2.0
0.0
NA
NA
CANSIM
1986-90
1993
1994
1995
11.85
8.9
6.5
4.5
19962001
6.6
6.7
9.7
8.5
2.1
3.0
-3.0
2.4
0.50
9.0
6.0
The first line is M2++, the second is M1+ and the third is M1++. The differences are
small and due to the use of annual as opposed to quarterly data so there is an extra bit of
averaging. The correlations between percent changes in these monetary aggregates and
inflation suggest a slight preference for M1++ (correlation of 65% in the 1986-1999
period) with the correlation between inflation and M2++ at 56% and the one between
M1+ and inflation at –2%. Figures for the 1996-2001 period are annual averages.The
figure below (ends in 1999) plots the annual growth rates of the 3 monetary aggregates
and inflation.
0.15
0.10
0.05
0.00
-0.05
86
88
90
92
inflation
M2++
94
96
98
M1+
M1++
10
00