Money_ Nature, Economic functions and creation process

1. Money_ Nature, Economic functions and creation process

2. Outline • Introduction • What is money? • The evolution of money • Money and its Functions • Modern money and definition of monetary aggregates • Commercial Banks and Money Creation • The Central Bank and its functions

3. Introduction • What is money?

4. Introduction • What is money? • The set of assets in an economy that people regularly use to buy goods and services from other people • Money is anything that is generally accepted as payment for goods and services, or in the repayment of debt • Can plots of land, or shares in a company be cited as examples of money? Why/not?

5. The Evolution of Money • Barter System • Commodity/Metallic Money • Paper Money • Fractionally-backed paper money • Fiat Money • Credit Money • Electronic Money

6. The Evolution of Money • The Barter system • The direct exchange of one good or service for another • Examples?

7. Money throughout the history of the world Shells Live stock Precious stones Skulls Pearls Wheat Feathers Brass Silver Gold Paper money

8. The Evolution of Money • What do you think are some shortcomings of the barter system?

9. The Barter Economy • Shortcomings of a Barter Economy • Double coincidence of wants • Laborious and time consuming • Lack of a common measure of value • Assume 4 commodities in the market • Yam, fish, oranges, okro • Exchange terms of • yam for fish, • yam for oranges, • yam for okro, • fish for oranges, • fish for okro, • oranges for okro........... SIX TERMS OF EXCHANGE!! • Therefore, with n different products, [n(n-1)]/2 terms of exchange required

10. Short comings of Barter… • Indivisibility of different goods • An apple for a mango... OK • A fish for a cow (leg?) ...... • Difficulty in storing value • Cattle could die, maize get mouldy, equipment get obsolete • Difficult to make deferred payments • Commodity could increase/decrease in value over time • Quality of product could deteriorate • Difficult to agree on specific product to make future payments

11. Metallic Money • Commodity (and Metallic) money • When money takes the form of a commodity with intrinsic value, it is called commodity money • The term intrinsic value means that the item would have value even if it were not used as money. • All sorts of commodities have been used as money in the past. Examples?

12. Metallic Money… • Commodity and Metallic money • Past examples of ‘commodity’ money • Grains in agricultural communities • Cattle among pastoralists • Cowrie shells in Ghana • Cigarettes among soldiers around WWII • Gold and silver coins • What do you think are some potential problems associated with commodity money?

13. Metallic Money… • Commodity and Metallic money • Gold and silver had many great advantages • High and stable price • Durability • Divisibility • Easily recognized and acceptable • In the past, exact weight of gold and silver carried around in payment for goods and services • E.g. 1 ounce of gold= Ghc1 • …therefore Ghc1,000,000= 1million ounces of gold • Bulky business… also risky to carry loads of gold around • Introduction of coinage • Government made coins with some part precious minerals and other parts base materials to increase durability- affixed its stamp to guarantee coins value • Issue of coin debasement • Read on Gresham’s Law- “Bad money chases out good money”

17. Shortcomings of Metallic Money • Problems with Commodity money • Cannot ensure standardized quality • Not all cattle are same size and weight • Difficult to store and prevent loss of value • Supply uncertain e.g. Maize and floods, cattle and disease... • Not portable • Not always divisible

21. The Evolution of Money • Paper Money • An important way that paper money came into existence was through the practice of storing gold with blacksmiths for safekeeping • The goldsmiths handed over receipts in exchange for gold • With a promise to hand over the gold on demand, to the bearer of the receipt • As the receipts became acceptable for settling market transactions, they became money • more convenient than carrying around bulky pieces of gold • Later on, this storage function was taken over by banks • Their promissory notes were called bank notes

22. The Evolution of Money • Fractionally-backed paper money • When money is convertible into gold, the country is said to be following the gold standard • In the past, paper money was very convenient to use • Few people ever converted back into gold • Banks took advantage of this • Banks were able to issue more loans/ bank notes than the amount of gold it held in its vaults • Good business since loans yield interest • In this situation, the currency is only fractionally backed by gold reserves • Problem?

23. The Evolution of Money • Fiat money • This is money without intrinsic value • A fiat is an order or decree, and fiat money is established as money by government decree. • During the period between WWI and WWII, all countries abandoned the gold standard • Paper money came to be accepted, not because it was backed by gold, but because the government had ordered it to be accepted • This order (fiat) for money to be legal tender for settlement of all debt is what gave rise to fiat/ inconvertible money • On any Ghana cedi note, one observes the following • “This note is issued on statutory authority and is legal tender for the payment of any amount”.

27. Modern money and definition of monetary aggregates • Modern money is made up of coins, paper currency and bank deposits • Coins, unlike in the past, contain only a tiny fraction of the face value of the coin • How can we be so certain? • Modern coins, like paper money, are merely tokens • Customers continue to deposit their coins and paper money in the bank • In order to pay debts, customers may withdraw money and hand over to creditors… or…. • Banks may transfer claims to their money through the issuance of cheques (an instruction to the bank to make the payment) • Bank deposits on which cheques can be drawn are referred to as deposit money

28. Modern Money • Kinds of Deposit money • Demand or current account deposits • The owner can withdraw cash on demand • The bank issues cheques and agrees to transfer such deposits from one person to another when ordered to do so • Savings or time deposits • Owner must give notice of intention to withdraw cash • Banks don’t often enforce this rule, however • No cheques issued • Higher interest rates on savings accounts

29. The Functions and Characteristics of Money • Money has four important functions: • Medium of Exchange • A store of value • A unit of account • A standard of deferred payments

30. Medium of Exchange • A medium of exchange is the item that buyers give to sellers in exchange for goods and services • Money serves as a means of exchanging one good for another • The transfer of money allows the transaction to take place • In the absence of money, goods would be exchanged through a barter system • In order to serve as a medium of exchange, money must possess the following qualities: • It must be readily acceptable • Any example of a situation in which money not readily acceptable? • It must be easily portable • It must be divisible • It must not be easy to counterfeit

31. A Store of Value • A store of value is an item that people can use to transfer purchasing power from the present to the future. • Many goods, and all services, cannot be stored up for future use • Money can be stored • Sell goods today, store money and have ability to purchase other goods in the future • Implication: money must have a stable value over time • Why is this important? • Changing value over time implies changing purchasing power

32. A Unit of Account • A unit of account is the yardstick people use to post prices and record debts. • Money must be able to value or cost goods, services, assets etc • i.e. a measurement of value • E.g. If a shirt is Ghc30 and a pen is Ghc3, we don’t say that the price of a shirt is 10 pens. • We quote, instead, using money as the measure of economic value.

33. A Standard of Deferred Payment • Money can be used as a standard benchmark for specifying future payments for current purchases • that is, buying now and paying later • Here, money acts as a unit of account, with the added dimension of time • Important implication • Money must retain its value

34. Definitions of Money • Definitions of money in Ghana • Narrow definition of money • M1= currency + demand deposits • Broad definition of money • M2= M1 + time deposits (quasi- money) • M2+ = M2 + foreign currency deposits • Even broader definitions of money exist • M3, M4, etc

35. Commercial Banks and Money Creation • The amount of money that an individual holds includes • Currency (coins and paper money) • Demand deposits (balance in checking account) • Because demand deposits are held with banks, behaviour of banks can influence quantity of demand deposits in economy • And therefore the money supply • We examine 2 cases • 100% reserve banking • Fractional reserve banking

36. Commercial Banks and the Money Supply • Reserves • Deposits that banks have received but have not loaned out • The simple case of 100% reserve banking • All deposits are held as reserves • Banks sole purpose is to provide safe place for money • Do not give loans • Banks do not influence the supply of money • T-account below (shows changes in banks assets and liabilities):

37. Commercial Banks and the Money Supply • The bank’s assetsare the reserves it holds in its vaults • The bank’s liabilitiesare the amounts it owes to its depositors • When assets are equal to liabilities, the accounting statement is called a balance sheet • Under 100% reserve banking, money supply is unchanged/ no new money has been created as • Decrease in currency • Increase in demand deposits by same amount

38. Fractional-Reserve Banking • Soon enough, bankers may realize that leaving all that money in their vaults is unnecessary • Can give a fraction out as loans and make more money • Bank only needs to keep enough so that depositors who come to withdraw some of the money can access it • Fractional-reserve banking • Banks hold only a fraction of deposits as reserves • Terminology • Reserve ratio • Fraction of deposits that banks hold as reserves e.g. 10% • Often determined as a combination of bank policy and central bank directives • Reserve requirement • Minimum amount of reserves that banks must hold; set by the Central Bank • Banks may hold more than this- i.e. excess reserves

39. Fractional-Reserve Banking • Excess reserve • Banks may hold reserves above the legal minimum set by the Central Bank • Re-examine First National Bank scenario, with fractional reserve banking • Reserve ratio 10% • Total assets still equal liabilities

40. Fractional-Reserve Banking • Does the bank create any new money with fractional reserve banking? • Yes! How?? • Before Bank made any loans, money supply= 100 • After loans, money supply increases • Demand depositers still have 100 • New loan collectors now have 90 in currency • Total money supply= Currency + Demand deposits= 190

41. The Money Multiplier Process • The newly created 90 is not the end of the money-creation process, however • The 90 borrowed from First National Bank may be deposited in another bank • Second National Bank • The T-accounts table is shown below

42. The Money Multiplier Process • Assuming that Second National Bank also has a reserve ratio of 10%, it keeps 9 and is able to give 81 as loans • Thereby creating additional money of 81 • Again, we assume that the loan of 81 collected from Second National Bank is deposited in another bank • Third National Bank. • Its T-accounts given below:

43. The Money Multiplier • Each time that money is deposited and a bank loan is made, more money is created. • Exactly how much money is created from the original 100 deposit? • The money multiplier • Original deposit = $100.00 • First National lending = $ 90.00 [= .9 × $100.00] • Second National lending = $ 81.00 [= .9 × $90.00] • Third National lending = $ 72.90 [= .9 × $81.00] • … • Total money supply = $1,000.00

44. The Money Multiplier • The amount of money the banking system generates with each dollar of reserves is called the money multiplier • What determines the size of the money multiplier? The reserve ratio • Money multiplier= Reciprocal of the reserve ratio = 1/R • In our example, money multiplier= 1/0.1= 10 • This is why new money generated from initial $100 deposit is 10 x $100= $1,000 • The higher the reserve ratio • The smaller the money multiplier • …and vice versa

45. The Central Bank and its Functions • Whenever an economy uses fiat money, some agency must be responsible for regulating the system • This is the central bank • An institution designed to oversee the banking system and regulate the quantity of money in the economy • In Ghana, this is the Bank of Ghana • Examples of central banks around the world include the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve (in the US), etc

46. The Central Bank and its Functions • Issue of Currency • The central bank alone is responsible for the issuance of currency in order to ensure control over the volume of currency and credit • Banker to the Government • The bank carries out all banking business of the government • Keeps government’s cash balances in current account • Makes payments and accepts receipts on behalf of government • Gives loans and temporary advances to government

47. The Central Bank and its Functions • Banker’s Bank • Regulates the activities of all commercial banks in the country • Custodian of cash reserves • Lender of last resort • Controls Money Supply • Through use of monetary policy instruments • Bank rate- rate at which central banks lend to commercial banks • Open market operations- buying and selling of government securities e.g. treasury bills • Cash Reserve ratio- proportion of deposits that commercial banks keep with central banks

48. Next Class • The Supply of Money, The Demand for Money, and Equilibrium In The Money Market • The supply of money • Temporary assumption of fixed money supply • The demand for money • The Transactions Demand for Money • The Precautionary Demand for Money • The Speculative Demand for Money • The Demand for Money Function