The Monetary System

Three Functions of
Money
① Medium of Exchange: anything that is
readily acceptable as payment.
② Unit of Account: serves as a unit of account
to help us compare the relative values of
goods.
③ Store of Value: a way to keep some of our
wealth in a readily spendable form for future
needs.
The Two Types of Money
Commodity Money: something that performs
the function of money and has alternative,
nonmonetary uses.
Examples: Gold, silver
Fiat Money: something that serves as money
but has no other important uses.
Examples: Coins, currency, check deposits
The nature of money
What is money ?
It is whatever a given society at a given time
agrees to use as a means of exchange
Do not confuse money and wealth
In other words, money is what we decide it
to be as a society
It is a social institution
Its existence is therefore always based on the
level of trust within a society
There are several types of currency
The nature of money
Commodity money
A situation where a commodity serves as currency
Very close to barter, but with the currency-
commodity dominating the exchanges
Gold, silver, salt, cigarettes, sea shells, marbles.
Not necessarily intrinsically valuable, but often so:
doesn’t require much trust.
The commodity is usually rare (limited supply)
Has desirable properties: divisible
The nature of money
Token money:
A situation where the currency is officially backed on
a commodity.
The commodity itself is not exchanged, instead tokens
representing units of the commodity are exchanged
(ex: bank notes in the Gold Standard)
This requires a higher level of trust, as the intrinsic
value of the token is much less than the face value.
The tokens can always be converted into the
commodity on demand.
The nature of money
Fiat money:
Where money exists simply by law (an act of
government): it must be accepted in repayment of
all debts
Money as a sign, a symbol.
It typically has no intrinsic value (except for
pennies!)
Its face value is backed entirely by the state’s
credibility
This requires a high level of trust in the institution
that creates it.
The nature of money
Most countries nowadays use fiat currency,
because money supply can be controlled.
 This is important for financing the economy
In a commodity/token currency system, the
money supply is exogenous
 Restricted money supply during WWI, which caused
most countries to temporarily abandon it.
In a fiat system, the supply can be adjusted
as necessary.
Money : function and
creation process
The nature of money

The classical and Keynesian functions

of money

The creation of money by the banking

system
The classical and Keynesian
functions
The classical functions of money
 Also called the Aristotelian functions.
 Aristotle was intrigued by the problem of
commensurability: how can intrinsically different
goods have an exchange value?
 His conclusion : exchange can only occur if the
goods are equal in a given comparable measure

1st function: Means of exchange

 Simplifies exchange compared to barter: no need for
a double coincidence of wants
The classical and
Keynesian functions
2nd function : unit of account
 Money is divisible, so can be used to measure and
compare the values of different goods (price
system)

3rd function: Reserve of value

 Payments made in money do not lose their value
over time, unlike barter or payments in kind
 Money allows the conservation of values through
time (discounting inflation)
The classical and
Keynesian functions
Keynes’ “General theory of employment, interest
and money ” introduced more functions, leading to
a debate about the role of money in the economy

The central argument is the existence of a

preference for liquidity in agents
 With uncertainty, agents will prefer to hold liquidities as
away of adapting faster to the risky environment
 Money is the most liquid and least risky way of holding
assets: it is always accepted in transactions
 Money will be demanded for its intrinsic properties
The classical and
Keynesian functions
Keynes identifies 3 “motives” for demanding money
The transaction motive:
 money is required for exchange (similar to the “classical
functions”)
 This demand is a positive function of income

The precaution motive:

 Holding some liquidity is the best option in the presence of
uncertainty.
 This is also a positive function of income
The classical and
Keynesian functions
The speculation motive:
 This motive embodies the trade-off between holding
liquidities and assets.
 Liquidity is preferred, but does not pay interest. Assets
pay interest, but are not as liquid
 Therefore the interest rate is the opportunity cost of
holding liquidity : as it increases people will hold less
liquidity
This leads to an overall demand for money of the

( )
following form:
M
M =d
= L Y,i
P + −
The classical and
Keynesian functions
This has lead to an important debate on the effect
of money in the economy between:
 Those who believe that money is neutral (i.e. does not
affect real economic variables)
 Classical approach, quantity theory approach
 Those who believe that money is not neutral (it can affect
real variables)
 This is due to the role of the interest rate on money demand
The debate is not closed yet, but has moved to a
short-term/long-term debate
Money is neutral in the LR, not in the SR
The classical and
Keynesian functions
The Keynesian argument for non-neutral money will
be shown in greater detail in the next few weeks (IS-
LM)

What about the “classical” approach?

It is grounded in the Quantity Theory of Money (QTM)
Classical dichotomy : nominal variables and real
variables are independent
Money is only used for transactions, therefore only the
“classical” functions apply.
The classical and
Keynesian functions
M × V = P× T
Money Velocity Prices Transactions

QTM states that velocity V (the number of times a

given money is used in a given time period) and the
volume of transactions T are exogenous with respect
to money M.
 Therefore increases in M lead to proportional increases in P
 Inflation is a purely monetary phenomenon

But Keynesians argue this holds only in the LR: in the

SR, increasing M can change real variables because
of the liquidity preference
Money : function and
creation process
The nature of money

The classical and Keynesian functions

of money

The creation of money by the banking

system
The creation of money
Most of the money is created by banks through
the process of credit (lending)
What is the purpose of a bank?
To hold the short term deposits of money by
agents
And make them available as long term loans to
other economic agents (which earn interest)
This funds economic activity (investment projects,
consumer durable purchases)
In the process, this also creates money for
transactions in the economy
The creation of money
The actors in this process are :

The agents:
 Provide deposits to banks and take out loans

The banking system:

 Which take the deposits from agents and make the
loans to agents
The central bank:
 Regulates the banking system (prudential regulations)

 Provides “base money” to the banking system

 Acts as the lender of last resort to banks

The creation of money
Central Bank
 The amount of
money M
Supplies base supplied by the
Interbank money B banks is larger
market
(interbank than the base
liquidity)
money B
supplied by the
Bank A Bank B Bank C
central bank
M>B
Supplies money
Deposits and loans M to the  There is a net
economy creation of
money !
Agents
Credit Creation by a Single Bank

Rounds Primary Cash Credit Creation

Deposits Reserves (20%)
1. Person (A) Rs. 1000Rs. 200 Rs. 800
2. Person (B) 800 160 640
3. Person (C) 640 128 512
4. Person (D) 512 102 410
5. ---- ---- ---- ----
6. ---- ---- ---- ----
---- ---- ---- ----
---- ---- ---- ----

Total 5000 1000 4000

Credit Multiplier

Credit creation depends upon the ratio of cash reserves to deposits. The
credit or the deposit multiplier is K= 1/r ; where K is the credit multiplier
and r is the cash reserve ratio. If cash reserve ratio is 20% then
K= 1/r = 1/.2 = 5

The higher the cash reserve ratio, the lower would be the credit multiplier
and vice-versa.

Credit creation under multiple banking system.

 P
Price Level

P
(P)

P
2

Money
Supply

1/p2
Value of
Money

1/p

1/p1

M M
Money
M
2 1 Supply
Demand and Supply of
Money

1. Transactions Theory of Money

2. Precautionary Motive Theory of Money
3. Speculative Motive Theory of Money
Supply of Money
Central Bank of the Country
Money Supply during recession/depression
Money Supply during inflation
Equilibrium between demand and supply and
rate of interest.
Liquidity trap
Money Supply
M , M , M , and M
1 2 3
in
4
India
M or M1 = C + DD + OD ( C= currency held by the
public, DD= Net Demand Deposits of Banks, OD= Other
Deposits of RBI )
M2 = M1 + Saving Deposits with Post Office
Saving Banks.
M3 = M1 + Net Time Deposits of Banks
M4 = M3 + Total Deposits with the Post Office
Savings Organization ( excluding National
Saving Certificates)