UNIT 11.

THE MONETARY POLICY

1. Introduction: barter and development of money

Have You Got Change for a Cow?

Of all humankind’s inventions, money stands out as one of the most widespread and useful. A day
probably does not go by that you don’t use it or think about it. It’s hard to imagine a time when
people didn’t have money, and it can be scary to imagine what your life would be without it. From
barter to shells to coin to paper to digital, the story of money spans much of human history.

Before money was invented, and in times when money was either worthless or extremely scarce,
barter was used as a means for people to get what they needed or wanted. Barter is simply the act
of exchanging one good or service for another good or service. An example of barter is when a
farmer trades a dozen chicken eggs with a baker for a fresh loaf of bread. Although barter was more
common in the past, it still exists today.

2. Definition of Money

Regardless of the form it takes (gold bar, euro bill…), money is anything that functions as a medium
of exchange, store of value, or standard of value.

3. Characteristics of Money

Money works when it is having the following characteristics: portability, durability, divisibility,
stability, and acceptability.

1. Portability refers to the ease with which money can be carried from place to place.
2. Durability means that when you forget to remove it from your pocket before doing the
laundry, it will probably not end up breaking.

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 3. Divisibility means your money can be broken into smaller units and end up finding its way
between the cushions of your couch.
4. Stability exists when money’s value does not vary too much (a dollar today buys pretty much
the same amount of something as it did last week and will next week).
5. Acceptability means people agree that the money represents what it is supposed to
represent and are willing to exchange goods and services for it.

4. Types of Money

Commodity Money

When relatively scarce minerals, metals, or agricultural products are used as a means of exchange
they are considered commodity money. Gold and silver struck into coins are examples of commodity
money. An advantage of commodity money is that it can be used for purposes other than money.

In the 1980s, many women adorned themselves in jewellery featuring gold coins, such as the Chinese
Panda or the Canadian Maple Leaf. American colonists not only smoked tobacco, but they also used
it as money. The salt we take for granted was at one time scarce enough that Roman soldiers were
paid in it.

On the other hand, a commodity’s usefulness also makes it a disadvantage to using it as money. If a
country is dependent upon using a commodity for its money and as a resource, then money may be
too precious to spend.

Representative Money- Coins and banknotes

Representative money developed as an alternative to commodity money. One of the properties of

Inconvertible Fiat Money

Inconvertible fiat refers to both paper and virtual money that is intrinsically insignificant and is not
exchangeable or backed by some real commodity. It is money because the government says so and

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we are willing to accept it. The U.S. dollar, the euro, the pound, the yen, and most other world
currencies meet the definition of inconvertible fiat.

5. The Money Supply

a) Definition
The money supply or the circulating money in an economy is defined as the sum of the cash money
(coins and banknotes) i.e. the money that individuals and companies have, plus the bank deposits.

b) Monetary aggregates

A monetary aggregate is a magnitude which gathers different kinds of money. They are established
by the European Central Bank (ECB).

They are those variables that quantify the existent money in an economy and the money used by
Governments, together with the central banks, for making decisions and performing economic
analysis.

In Europe, in what it is called the Eurozone (countries members of the European Union that have
the euro as a common currency), have been established and defined 3 monetary aggregates:

1. Narrow money (M1) includes currency, i.e. banknotes and coins, as well as balances which
can immediately be converted into currency or used for cashless payments, i.e. overnight
deposits.

M1 is the sum of currency in circulation and overnight deposits

2. "Intermediate" money (M2) comprises narrow money (M1) and, in addition, deposits with
a maturity of up to two years and deposits redeemable at a period of notice of up to three
months. Depending on their degree of moneyness, such deposits can be converted into
components of narrow money, but in some cases, there may be restrictions involved, such
as the need for advance notification, delays, penalties, or fees. The definition of M2 reflects
the particular interest in analysing and monitoring a monetary aggregate that, in addition
to currency, consists of deposits which are liquid.

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 M2 is the sum of M1, deposits with an agreed maturity of up to two years and deposits
redeemable at notice of up to three months

3. Broad money (M3) comprises M2 and marketable instruments issued by the MFI sector.
Certain money market instruments, in particular money market fund (MMF) shares/units
and repurchase agreements are included in this aggregate. A high degree of liquidity and
price certainty make these instruments close substitutes for deposits. As a result of their
inclusion, M3 is less affected by substitution between various liquid asset categories than
narrower definitions of money, and is therefore more stable.

M3 is the sum of M2, repurchase agreements, money market fund shares/units and debt
securities with a maturity of up to two years.

6. The Money Demand

a) Functions of money

The money has three main different functions:

1: Medium of exchange when it is being used for the purpose of buying and selling goods and
services or to pay off debts.

2: Store of value as you get money today and you are still able to use it in the future. Money is not
only used for transactions, but it is also a financial asset. In this sense, many companies or families
decide to keep some money as part of their wealth, as in comparison to other assets (buildings,
gold…), this one is relatively less risky, as the liquidity is complete.

3: Standard of value when you are using it to measure how much a good or service is worth.

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b) The opportunity cost of money

The services provided by money are not fee, the opportunity cost of having money are the interests
for having that money instead of having another type of asset or investment (with lower liquidity or
riskier).

In other words, people must pay for having the possibility of asking for borrowing money, and the
cost of borrowing, expressed in annual euros for each euro loaned, is what we know as the interest
rate.

Conclusion: The interest rate is the payment which is done for using money. We need to pay for the
possibility of using money. The cost of money for each euro borrowed, in annual terms, is what we
call interest rate.

c) The money demand

People and companies use money for doing their transactions: households for buying goods and
services and companies for paying their workers or purchasing raw materials. This need of money is
what we call the money demand.

There are two variables which affect the money demand:

1) The real income: The bigger the income earned by households, the greater will the purchases be,
and therefore, the bigger the demand for money (i.e. the money they will use as a medium of
exchange).

2) The opportunity cost of money: If the interest rates increase, but the rest of other variables stay
constant, the money demand will decrease, as the opportunity cost of money will get bigger.

7. Creation of bank money and the multiplier effect

The commercial banks are financial institutions which are authorised to grant credits and accept
deposits.

They are obliged to have Reserve requirement (minimum reserves) in order to face the withdrawal
of those deposits by its clients and for fulfilling with security measures.

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The minimum reserves are assets that the banks possess:

a) as cash in their banks

b) as funds deposited in the Central Bank.

On the other hand, money is created when the bank continues to lend its excess reserves. For
example, a 100.000 € checking deposit generates an increase in excess reserves of 90.000 €. If the
bank lends the full 90.000 € to a customer who in turn purchases a recreational vehicle, the seller
of the vehicle might then deposit the 90.000 € in the bank.

What happened to the checkable deposit balance in the bank? It grew from 100.000 € to 190.000 €
in a short period of time. Money was created. The process does not stop with just this transaction.

You can see that the bank now has 90.000 € in new deposits. The bank will hold 10% as required
reserve and lend the rest. The profits of the loan will be re-deposited, and now 81.000 € of new
money is created.

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Bibliography

• David Broadbent, Chris Lindle, Kristie McHale, Sarah Oxley & Andy Park (2015). A-level
Economics, CGP, England.
• Michael Mandel (2012). Economics, the basics (second edition), McGraw- Hill, New
• David A Mayer (2010). The Everything Economics Book: From Theory to Practice, Adams
Media.

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