Overview
• What is money?
• Why do people hold money?
• How does the use of money contribute to economic
efficiency?
• What are the functions of money?
• How is the money supply measured?
Money
• Money is an asset used for conducting transactions
(one definition)
• It is one component of a wealth portfolio
• Money has been developed independently in many
human societies
• R.A. Radford, “The Economic Organization of a POW
Camp”
Monetary Mysteries
• Productive (physical) assets – aid in
production
• Financial assets – pay interest or dividends
• Money is a dominated asset
A dominated asset is an asset that pays lower
returns under all circumstances than another
asset
Why, then, do people hold money?
What economic function does money serve?
Slide Summary
• The nominal return on currency is always 0
• Bonds always pay a higher nominal – and hence
real – return
• (It is assumed here that Treasuries are default risk
free so that currency and Treasuries have the same
default risk)
• Since the nominal return on currency is 0, the
opportunity cost of holding currency is the return on
a relevant alternative asset, here 1-year Treasuries
• The opportunity cost of holding currency has varied
significantly over time in the U.S. and much more in
countries with high inflation
Nominal Interest Rate:
One-Year Treasury
Source:
Board of Governors of the Federal Reserve System (US), 1-Year Treasury Constant Maturity Rate [GS1], retrieved from FRED,
Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GS1, May 24, 2020
Deep Thoughts
• “People hold money because they want to buy
things”
• Liquidity
More liquid assets can be traded more quickly at a
higher portion of their value
• Currency is the most liquid asset
• The use of money requires that individuals hold
inventories of money
Social Coordination and
Economic Efficiency
• Autarky
When economic units produce for their own
consumption and do not trade
• There are efficiency gains from specializing in
production
• But people generally want to consume a wide range
of goods and services
• To get people to specialize there must be some
mechanism that, in effect, allows them to trade their
output for others’ output
The Difficulty of Nonmonetary
Market Exchanges
• Barter
The direct trade of goods and services for other
goods and services
• Double coincidence of wants
When each party to a transaction wants what the
other is offering
• Double coincidence of timing
When each party wants to trade at the same time
The Difficulty of Nonmonetary
Market Exchanges
• Bilateral barter
Trade of goods and services between two parties
• Multilateral barter
Trade of goods and services between more than
two parties
The Difficulty of Nonmonetary
Market Exchanges
• High transactions costs
Search costs associated with finding trading
partners
• High information costs (number of prices)
N goods
N (N – 1) prices
N (N – 1) / 2 unique prices
• No generalized store of purchasing power
Information Costs: Example
• 3 goods: X, Y, and Z
• There are 6 prices
Units of X per unit of Y – X/Y
Units of Y per unit of X – Y/X
Units of X per unit of Z – X/Z
Units of Z per unit of X – Z/X
Units of Y per unit of Z – Y/Z
Units of Z per unit of Y – Z/Y
• 3 of these prices reciprocals, leaving 3 unique
prices, e.g., X/Y, X/Z, Y/Z
Information Costs: Example
• The following table summarizes how the number of
prices grows as the number of goods increases
Goods Prices Unique Prices
2 2 1
3 6 3
⁞ ⁞ ⁞
10 90 45
⁞ ⁞ ⁞
100 9,900 4,950
⁞ ⁞ ⁞
N N (N - 1) N (N - 1) / 2
Functions of Money:
Medium of Exchange
• An asset generally accepted in payment for goods
and services and to settle debts
• Types of media of exchange
Commodity money
Money that has intrinsic value
Fiat money
Money that does not have intrinsic value
• Legal tender
Assets designated legal tender will legally satisfy
contracts denominated in legal tender when legal
tender is offered in payment
Functions of Money:
Unit of Account
• The use of a monetary unit to record prices and
accounts
• The unit of account function can be separate from
medium of exchange but usually the same because
this reduces transactions costs
• If there are N goods (excluding the monetary
asset), then there are N unique prices
Functions of Money:
Temporary Store of Value
• An asset that will retain some of its value in the
future
• All assets serve as temporary stores of value
• Changes in the price level make money a temporary
store of value
• Inflation
A rise in the price level
• Deflation
A fall in the price level
The Value of the Dollar (U.S)
(Using the CPI)
Value of $1 US dollar (1913 cents)
120
100
80
60
40
20
0
1913 1918 1923 1928 1933 1938 1943 1948 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008
Value of $1 US dollars in 1913 cents
Slide Summary
• The nominal return on currency is 0%
• The real return equals -π, where π = the inflation
rate
• Currency has been a relatively poor store of value
over the past century
• Rapid periods of inflation (WW I, WW II, and the
1970s) led to rapid erosion in the purchasing power
• The 1920 recession and Great Depression were
periods of significant deflation
Functions of Money:
Standard of Deferred Payment
• The use of money in contracts specifying future
payment
Measuring the Money Supply
• Transactions approach
The money supply consists of those assets that
serve as media of exchange
• Liquidity approach
Assets vary in liquidity
The money supply consists of those assets that
have a certain level of liquidity
• There is no unique measure of the money supply
Monetary Aggregates in Canada
Liquidity and the Rate of Return
Nominal Real
Currency 0 -π
Demand deposits
w/o min. bal. 0 -π
w/ min. bal. 0.10 0.10 – π
Savings deposits 0.40 0.40 – π
Time deposits (1-year) 0.25 0.25 – π
Highest rates on balances from http://www.citibank.com
The Money Supply
• Summary
Currency and bank reserves are supplied by the
government (monetary base)
Financial intermediaries (primarily banks) also
play a role in creating the money supply
More liquid assets earn lower returns
Government Interest in Money
• Governments from early on have been interested in
money
• Modern governments
Define what can serve as money
Control the production of money
Government Interest in Money
• Reasons – the selfless
Creating a single monetary standard and currency
system reduces information and transactions
costs (public good)
• Reasons – the selfish
Seigniorage
The monopoly profit the government receives
from its control over the production of money
Counterfeiters and other suppliers of money
reduce the government’s seigniorage
How Seigniorage Works Today
• Example: The Bank of Canada (BoC)
• The BoC buys securities (open market purchases)
The monetary base increases (liabilities on which
the BoC pays no interest)
The BoC receives interest on the securities it now
holds
• The BoC lends money to banks
The monetary base increases (liabilities on which
the BoC pays no interest)
The BoC receives interest on the loan
