UNIT 1: INTRODUCTION

Contents
1.0 Aims and Objectives
1.1 Introduction
1.2 Functions of Money
1.3 The Evolution of Money
1.4 Measuring Money
1.5 Money, Near Money, and Liquidity
1.6 Summary
1.7 Answers to Check Your Progress
1.8 References

1.0 AIMS AND OBJECTIVES

The objective of this unit is to introduce the students with the basic concepts of money. After
completing this unit students will
 understand the functions of money
 know the evolution of money
 identify the measurements and other concepts of money

1.1 INTRODUCTION

It would certainly be an exaggeration to say that all economic problems are the result of
malfunctions in the monetary system, but we can for sure say that some of the most important
ones are related to the monetary system. Inflation is a monetary problem in the obvious sense
that it means that our monetary unit, which is the birr, is losing value. It is also a mone tary
problem if: substantial and sustained inflations have occurred only when the quantity of
money has risen at a fast rate. Hence, one can say that major inflations are "caused" by a rapid
rise in the supply of money. Unemployment, while it has many non-monetary aspects, is also
closely connected with changes in the money supply. If the supply of money rises at a faster

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than expected rate, this lowers unemployment temporarily, while a sharp decrease in the
quantity of money usually increases unemployment temporarily.

Obviously, monetary theory', the theory that deals with the relation between changes in the
quantity of money, interest rates, and changes in money income, is an important topic, and so
is monetary policy, which is concerned with how the quantity of money and interest rates
should be managed. In general it is very important concept that needs to be studied. In doing
so, we start with introducing ourselves with the basics of money
.
1.2 FUNCTIONS OF MONEY

Instead of defining money either so narrowly as just currency or so broadly as to include all
wealth, economists define money by its functions. Anything that functions as a medium of
exchange, as a standard of value, or as an extremely liquid store of wealth is considered
money, these functions of money need explaining

That is, money acts as (1) a medium of exchange, (2) a standard of value, (3) a standard of
deferred payments, and (4) a store of wealth. The first two of these func tions are the ones that
are unique to money.
I. Money as a medium of Exchange
The medium of exchange function is obvious; we use money as an interme diary in exchange.
We exchange goods and services for money, and then exchange this money for those goods
and we want to acquire. Such a roundabout
roundabout system of exchange avoids the great disadvantage
of barter, as it needs for double coincidence of wants. In other words to effect barter we have
to find someone who wants to obtain the goods and services we have to offer and, at the same
time, can provide the goods and services we want to obtain in exchange.

II. Money as a standard of value and deferred payment

The second function of money is to act as a standard of value, which simply means that we
use money as a way of comparing worth. We think of, and express, the values of goods and
services in terms of money, so that money is the measuring rod of value the same way as a
mile is a measure of distance. Obviously, a modern economy requires continual comparisons
of value; buyers have to compare the offers of numerous sellers, and this would be hard to do

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if different sellers denominated their prices in different goods; for example, if one shop
demands two birr of butter for a birr of beef, and another shop demands ten pencils for a birr
of beef, which shop is cheaper? A similar problem would arise in deciding whether to buy,
say, beef or fish, if the price of beef is expressed in terms of butter and the price of fish in
terms of another good. To make rational decisions we would have to know the ratios at which
any one good exchange for all the others.

Suppose that we have a very simple economy with only five commodities, A, B, C, D, and E.
If there is no standard of value, and we want to know the exchange ratios of these five
commodities in terms of each other, we have lo earn ten different exchange ratios (A—B, A—
C, A—D, A—E, B—C, B—D, B—E, C—D, C—E, D—E). But if we use one of these five
commodities, say A, as our standard of value, we can express the prices of the other four
goods in terms of it, and thus we have to learn only four exchange rates (A—B, A—C, A—D,
A—E). In general, with N commodities, if there is no standard of value, we have to learn (N
—l) exchange rates between them. The first part of the expression is N—1 because the
exchange rate of a commodity with itself is obviously unity, so that we have to discover the
exchange rates of only N—1 commodities.

One particular function of a standard of value is to act as a standard of deferred payment. That
is, a standard in which debts are expressed. This use of a standard of value creates serious
problems because, as unfortunately we (have all found out, the value of money varies over
time; the dollar you lent last (year will not buy as much when you receive it back this year. In
this respect, money is a poor standard of value.

III. Money as a store of wealth

The final function of money is to serve as a store of wealth. Although this function of money
is no more important than the other ones.

Money has several peculiarities as a store of wealth. One is that it has no, or only trivial,
transaction costs. People who decide to hold any other asset as a store of wealth must take the
money they receive as income and buy this asset. Later on, when they want to obtain goods or
other assets in place of this asset they have to exchange it for money. Both of these

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transactions, from money into this asset and, later on, from this asset back into money,
involve a cost.

A second characteristic of money as a store of wealth is that, quite obviously, its value in
terms of money is fixed. This is important because debts are normally stated in money terms.
Hence money has a fixed value in terms of debts and certain commitments, such as rental
payments. Those who want an asset that will allow them to pay off a debt have a definite
incentive to hold money.

The absence of significant transactions costs and the fixity of its value in terms of debts are
the two basic characteristics of money as a store of wealth.

1.3 THE EVOLUTION OF MONEY

In its earlier stages of development, commodities like spears, skins, stones, axes, tea, shells,
tobacco, precious stones, etc. were used as money. The choice of such commodities was
determined by factors like location of the community, climatic conditions, stage of cultural
and economic development, etc. In primitive agricultural
agricultural communities animals were the most
obvious form of wealth and consequently, cattle were used as money. But this type of money
(commodity money) lacked standardization. Its supplies were uncertain, it was indivisible too,
it could not be stored and it also involved expenditure upon its own maintenance.
Furthermore, it, used to be bulky and unportable.

As society progressed, the character of commodity money also changed. Metals

Metals came into use
in place of animals and other rough commodities. Gold and silver were the two metals which
were first used as money. These metals, because of their certain attractiveness began to be in
large demand and in course of time came to be regarded as 'natural money'. In order to give
recognition to such metallic
metallic money central coinage was introduced.

But even metallic money was not free from defects. It was not safe to take metallic money
while going out to make purchases and therefore, people took with them written documents
like the traveler’s cheque issued by reputed financiers
financiers as evidence of their command over
certain quantity of money specified on the face of these documents. These documents, a mere
substitute for actual money, were the first stage in the history of the development of paper

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money. People accepted them because they knew that these could be readily exchanged for
money on demand. Thus, the letters of credit which were simply bank's promise to pay money
came to be regarded as money. This is the second stage in the development of paper money.
As people gradually became more used to bank notes, which contained an obligation for
conversion into gold or silver, they were regarded as actual money, and this was the third
stage in the history of the development of paper money. Today these notes circulate as full-
fledged money even without any obligation for conversion. Thus, gold and silver as money
metals have been finally replaced and there is hardly any country in the world today where
metallic coins circulate, except in the form of token coins.

It is thus clear that the use of money arose out of the inconveniences of barter: although in the
international sphere barter continued to be practiced for a long time. A feature of a transaction
involving money is that direct exchange gives way to indirect exchange. In a barter
transaction giving and taking are both comprised in a single act; the use of money separates
these two processes, since first a commodity
commodity is sold out for money, and then subsequently, at
a later time the money so obtained is used to make the desired purchase. Let us add a word
about the way money has been invented. As soon as people realized the difficulty of double
coincidence of wants and that of exchanging commodities, which if divided would lose their
quality; they first used a commodity as a unit of account or as a standard of value.

In the earliest stage, as already stated, commodities were used as standard of value and unit of
account; in the second stage metallic money was used and in the final stage the paper money
is in use. Now with the help of this unit of account, values of .different goods and services
could be expressed and compared. This led to the extension of area of exchange and to the
emergence of the pricing system. Economic calculations became more rational and individual
choice-making became easier. This also extended the scope of markets, and provided ample
opportunities for specialization and division of labor. Now goods came to be brought and sold
independently. At the same time the dependence of one person on the other was completely
done away with. The use of time and efforts was substantially economized. When money
came to be accepted as a common measure of value and a medium of exchange, its storage
became easier and hence, money also started functioning as a store of value. This was the
final stage in the invention of money. As Crowther has pointed out "Money is one of the most

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fundamental of all man's inventions, every branch of knowledge has its fundamental
fundamental
discovery. In mechanics it is the wheel, in science it is the fire, in politics it is the vote.
Similarly, in economics, in the whole commercial side of man's social existence, money is the
essential invention on which all the rest is based.

But, to say that the barter system has been completely eliminated is wrong. In less developed
countries it still reigns supreme in the rural areas. Even today, in the field of international
trade, owing to the problem of international liquidity and scarcity of foreign exchange more
and more countries are resorting to bilateral trade agreements which are nothing but a
modified form of the old barter system.

1.4 MEASURING MONEY

The definition of money as anything that is generally accepted in payment for goods and
services tells us that money is defined by people's behavior. What makes asset money is that
people believe it will be accepted by others when making payment. As we have seen, many
different assets have performed this role over the centuries, ranging from gold to paper
currency to checking accounts. For that reason this behavioral definition does not tell us
exactly what assets in our economy should be considered money.

The narrowest definition of money that the central bank reports is M1, which corresponds to
the definition proposed by the theoretical approach and includes currency, checking account
deposits, and traveler's checks. These assets are clearly money because they can be used
directly as a medium of exchange.

The M2 monetary aggregate adds to Ml other assets that have check-writing features (money
market deposit accounts and money market mutual fund shares) and other assets (small
denomination time deposits, savings deposits, overnight repurchase agreements, that are
extremely liquid because they can be turned into cash quickly at very little cost. The M3
monetary aggregate adds to M2 somewhat less liquid assets such as large-denomination time
deposits, long-term repurchase agreements,
agreements, and institutional money market mutual fund
shares.

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The final measure, L, which is really not a measure of money at all, but is rather a measure of
highly liquid assets, adds to M3 several types of securities that are essentially highly liquid
bonds, such as short-term Treasury
Treasury securities, commercial paper, savings bonds, and the like.

1.5 MONEY, NEAR-MONEY, AND LIQUIDITY

Since monetary systems change over time, the assets that are considered money change too.
As a result the distinction between money and "other things" is not clear-cut. At any particular
time there may be some items that are just halfway in the process of becoming money. The
line of distinction between money and non-money is therefore blurry. Where we want to draw
this line depends, in part, on what our purpose is, that is, what particular function of money is
the most relevant for the problem at hand. For example, if we focus on the medium of
exchange function, we want to define money as just those items that generally function as a
medium of exchange.

But suppose that we stress the store of wealth function instead. If so, we want to include in the
definition of money those assets that are extremely liquid,
liquid, since it is its liquidity that
differentiates money from other stores of wealth.

The liquidity of an asset depends on (1) how easily it can be bought or sold, (2) the
transactions cost of buying or selling it, and (3) how stable and predictable its price is. Narrow
money, at one end of the scale, has perfect liquidity. Since it already is money there is no cost
and trouble in selling it, that is, in turning it into money and the price of a birr is constant at
one birr. Toward the other end of the scale there are items like real estate, which may take
quite some time to sell, involve a substantial brokerage cost, and may have to be sold at less
than the anticipated price. We can rank all items by their liquidity, that is, by their degree of
money ness.

This raises the question of where along this spectrum of liquidity and moneyness one should
draw the line between money and non-money. There is no point at which one can draw an
obvious and clear-cut line. Regardless of how broadly or narrowly one defines money there
are always some assets that, while excluded from the definition of money, are very close to
the borderline. Moneyness is a continuum. We therefore call items that are excluded from the
definition
definition of money, but are quite similar to some items that are included, near-monies.

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These near-monies are items that are highly liquid, but not quite as liquid as money.
Admittedly, this is rather vague, and it is not clear exactly what items should be included. At
one end of the spectrum this depends on the definition of money that is used. The other end of
the spectrum, where one draws the line between near-monies and those assets that are not
liquid enough to be considered near-monies, is rather arbitrary. While stock in corporations is
definitely
definitely not a near-money, it is not clear whether, say, a government security that matures
within one or two years should be considered a near-money.

Check Your Progress

1. List and discuss the function of money.
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2. Differentiate between money near money and liquidity.
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3. State the importance of money.
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4. Differentiate between M1 , M2 and M3.
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1.6 SUMMARY

Monetary theory deals with the relation between changes in the quantity of money, interest
rates, and changes in money income. Monetary policy on the other hand, is concerned with
how the quantity of money and interest rates should be managed.

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By definition money refers to anything that functions as a medium of exchange, as a standard
of value, or as store of wealth. Note that we said the use of money arose out of the
inconveniences of barter. This is because in a barter transaction giving and taking are both
comprised in a single act; the use of money separates these two processes, since first a com-
com-
modity is sold out for money, and then subsequently, at a later time the money so obtained is
used to make the desired purchase.

We have also seen the measurements of money. We said that M1, includes currency, checking
account deposits, and traveler's checks. M2 adds to Ml other assets that have check-writing
and other assets such as small denomination time deposits, savings deposits, and overnight
repurchase agreements. M3 adds to M2 assets such as large-denomination time deposits, long-
term repurchase agreements,
agreements, and institutional money market mutual fund shares.
Near-monies are items that are highly liquid, but not quite as liquid as money.

1.7 ANSWERS TO CHECK YOUR PROGRESS

Refer the text for the answers. The answers are explicitly discussed in sections 1.1 to 1.5

1.8 REFERENCES

 Goodhart, C. (1984) Monetary Theory and Practice, MacMillan, London

 Mishkin, F.S. (1986) The economics of Money, Banking and Financial Markets, Little
Brown and Company, Boston
 Stiglitz, Joseph (1997), Principles of Macroeconomics, W. W Norton & Company,
Newyork
 Dowd, K and M. Lweis (eds.) (1992) Current Issues in Financial and Monetary
Economics, MacMillan, London.