CLASS #19: MONEY

Chapters 7 and 15

• What is money?
• Why do people hold money?
• How is the Money Supply determined?
• What is a Currency Board?

What is money, and why do we use it?

Example: cigarettes as money in WWII Prisoner-of-War camps. Money as a device for making transactions.
Barter economy is inefficient because of: 1) search costs 2) lack of specialization. Why cigarettes. Cigarettes satisfy a number of criteria for being ``good money":

• cigarettes are portable, and ``divisible" - an individual cigarette has small enough value (medium of exchange).
• A cigarette is a fairly standardized commodity, whose value in terms of other goods is easy to ascertain (unit of value).
• Cigarettes do not spoil quickly (store of value).

But cigarettes (like gold) have an alternative use - resource cost.

What is money for?

• Money as a medium of exchange for transactions:
  money makes trade less costly .
• Money as unit of value:
  makes the value of other commodities or services easy to ascertain...
  when the ``real value" of money is not uncertain (remember CPI?).
  In countries with hyperinflation money prices are changed frequently and unpredictably: money, while still sometimes used as medium of exchange, is no longer used as unit of account (instead, dollars are used; Chile: ``unitad de fomento").
• Money as store of value:
  money as an asset: keep your savings under the mattress (why is it inefficient?).

The Monetary Aggregates

Assets differ in their ``moneyness", that is, in their ability to ``substitute" currency as a medium of exchange (and unit of value)

• M1: currency, checkable deposits (travelers' checks)
  most liquid (you can pay with checks... almost all the time)
  
• M2: M1 + savings deposits, time-deposits (1 day, 28 days), money market mutual funds
  less liquid (wait time, cannot write checks for less than...)
  changes in monetary aggregate due to ATM machines
• M3 and L: M2 + short term assets (treasury bill, commercial paper)
  ``liquidity": readily exchangeable, small default risk, etc.

What is the relevant monetary aggregate?

A bit of History: from Gold Coins, to Gold Standard, to Fiat Money

• In the middle age gold (silver) coins were used
  gold like cigarettes: good medium of exchange, unit of account, store of value,
  but ... uncertain value, money supply depended on availability of gold, resource cost.(South African gold in the 1800's)
• Past century and the aftermath of WWII (1945-1973): Gold Standard
  not necessary to carry around gold, but only pieces of papers that the Central Bank would be ready to convert into gold at a known -and fixed - rate.
  Private banks: money and government do not necessarily have to go together
  money supply still depended on availability of gold, but ... the parity rate could be changed.
• Fiat Money
  Paper money which has no intrinsic value, and whose value in terms of other commodities is not fixed.
  The first central bank: the Bank of England.
  Why do people hold money? Because they believe that other people will accept it as mean of payment.
  Money is legal tender: the government requires individuals to use money to pay taxes, and for settlement of debts.
  The value of goods and services in terms of money (prices)is not fixed, but it depends on a number of things, which will be discussed in the next class: the supply of money, real income, expectations ...

The Monetary Base and the Money Supply

Let us follow the example in the book: the Central Bank buys 1,000,000 coconuts in exchange for 1,000,000 ``florins".

Central Bank Balance Sheet
ASSETS		LIABILITIES
coconuts	1,000,000 fl.	currency	1,000,000 fl.

The liabilities of the Central Bank that are usable as money are the Monetary Base. Let us say people hold all their money as deposits in Bancomiendo:

Bancomiendo Balance Sheet
ASSETS		LIABILITIES
Currency	1,000,000 fl.	Deposits	1,000,000 fl.

If Reserves = Deposits, then Money Supply = Monetary Base
But if Bancomiendo has to keep only 20% ( $res=\frac{RES}{DEP}$) of deposits as reserves and uses the remaining 80% to make loans:

Bancomiendo Balance Sheet
ASSETS		LIABILITIES
Currency	1,000,000 fl.	Deposits	1,800,000 fl.
Loans	800,000 fl.

Now the amount of reserves again exceeds the amount of deposits. Therefore the bank keeps on lending until the total amount of currency is exactly equal to 20% of the total amount of deposits. That is until:

res DEP = BASE

Bancomiendo Balance Sheet
ASSETS		LIABILITIES
Currency	1,000,000 fl.	Deposits	5,000,000 fl.
Loans	4,000,000 fl.

Notice also that:

DEP=BASE+(1-res)BASE+(1-res)² BASE+...

In this economy the total money supply is:

$$M=DEP=\frac{BASE}{res}$$

the money multiplier is $\frac{1}{res}$. If people keep a fraction cu of their money as currency we have that:

M=CU+DEP,

and

BASE=RES+CU

.
So

$$\frac{M}{BASE}=\frac{CU+DEP}{RES+CU}=\frac{1+cu}{cu+res}$$

and the money multiplier is $\frac{1+cu}{cu+res}$ What happened during Bank Runs (Great Depression)?

• people want to hold more currency because they do not trust banks
• banks foresee bank runs, and have to hold more reserves
• both cu and res increase: money contraction.

Does the central bank really hold coconut (or gold) as assets to ``back up" its liabilities (Monetary Base)?
No! they -mostly- hold other pieces of paper: government bonds.
What is -more or less- a currency board?
The central bank holds only -say- US Treasury Bonds as liabilities: it can commit to convert -say- 10 Pesos for 1 Dollar.
The central bank holds as assets liabilities of other governments.
Question: would it be the same if the Mexican Central Bank held $ denominated bonds issued by the Mexican government?