TOPIC 1

THE NATURE AND ECONOMIC ROLE OF MONEY

INTRODUCTION

In this topic, we go deeper into the economic role of money, the basics of
which you will have already studied in introductory and intermediate
modules.
STRUCTURE
1. Introduction.
2. Unit of Account
3. Medium of Exchange.
4. Store of Value.
5. Definitions of and Criteria for Liquidity.
6. Keynes Versus Classics
INTRODUCTION

LEARNING RESOURCES:
Lecture Notes and Recordings
Lewis and Mizen, Chapter 1 (and optionally 2, especially in relation to
Assignment 1)
The Stone Money of Yap (4-min audio with text)
Discussion Questions on the Nature and Role of Money
INTRODUCTION

Money has three functions:

1 Unit of account (a measure of value)
2 Medium of exchange (a means of payment)
3 Store of value (an asset).
UNIT OF ACCOUNT

A unit of account is a measure of the value of each object – a good,

service, asset, etc. – in the economy.
A unit of account need not be a physical object, but in practise, money
serves as the unit of account.
The value of every object is measured by the number of units of money
which exchange for one unit of the object. This is also known as the
price or the monetary value.
Strictly speaking, as we shall see, what is more important than the price
of a good, service or asset is its relative price, or the number of units of
some other good (or service or asset) in question, that are of equal value
in exchange with the good (or service or asset) in question.
Let us use the term exchange ratio to describe the above. We shall soon
see that a relative price captures exactly what we mean by exchange ratio.
UNIT OF ACCOUNT

Imagine an economy with 2 goods: Apples and Bananas. Between two

goods there is only one exchange ratio to think about. units of
Apples/Banana (or its inverse: units of Banana/Apple).
Suppose each Apple is worth 2 Bananas. Then the exchange ratio of
Apples with Bananas is 2 Bananas/Apple (and the inverse exchange ratio
is 0.5 Apples/Banana).
Suppose now there are 3 goods: Apples, Bananas and Cabbages. We will
now need to define three exchange ratios:
Apples/Bananas
Apples/Cabbages
Bananas/Cabbages.
Suppose the Apple/Banana exchange ratio is as before and that 3 Apples
exchange for 1 Cabbage. Then the exchange ratios are: Bananas/Apple
= 0.5, Apples/Cabbage = 3 and Bananas/Cabbage = 6
UNIT OF ACCOUNT

With a fourth good: Dates; you would need 6 ratios:

Apples/Bananas , Apples/Cabbage, Apples/Dates, Bananas/Cabbages,
Bananas/Dates, Cabbages/Dates.
The number of exchange ratios are increasing faster than the number of
goods.
For n goods, a total of (1/2)n (n − 1) exchange ratios are needed to
completely describe the economic values of all the goods in the absence
of a common measure of value.
UNIT OF ACCOUNT

If n is very large then the number of exchange ratios can be

approximated as n2 /2.
If n = 700 (approximate number of broad category items in the CPI)
245,000 different exchange ratios would be needed.
With a common yardstick to measure economic worth (euros, pounds,
dollars), only n money prices are needed. From these we can calculate
relative prices for any pair of goods.
UNIT OF ACCOUNT

In the example of 3 goods, keeping the exchange ratios as they were

above, suppose the price of Apples is PA = 0.5. Then the price of
Bananas would be PB = 0.25, that of Cabbages would be PC = 1.5 and
so on.
The relative prices would be
PA /PB = 0.5/0.25 = 2 (units of Bananas per Apple);
PC /PA = 1.5/0.5 = 3 (units of Apples per Cabbage);
PC /PB = 1.5/0.25 = 6 (units of Bananas per Cabbage)
which are exactly the exchange ratios we started off with.
Note: Be careful in interpreting units. An object’s price is units of
money that are worth one unit of the object, so units of the object
appear in the denominator of its price. To get the exchange rate:
Bananas/Apple, you need to divide the monetary price of apples by the
monetary price of bananas in order to end up with a measure that has
units of Bananas i the numerator and units of Apples in the denominator.
UNIT OF ACCOUNT

The use of money as a unit of account allows for economy of

measurement and record-keeping.
However, unlike a ruler which measures length in a consistent and reliable
fashion, money measures value only imperfectly ... because its own value
is not a constant (due to inflation).
MEDIUM OF EXCHANGE

Barter is a one-step exchange of one good for another.

A monetary trade, by contrast, typically takes two steps.
At first glance, barter might therefore appear to be simpler.
MEDIUM OF EXCHANGE

But barter can take place only when a double coincidence of wants exists
(William Stanley Jevons, Great Britain, 1835-1882).

There are two types of frictions that can impede d.c.o.w: (i) Costly
barter (ii) Misaligned preferences
MEDIUM OF EXCHANGE: COSTLY BARTER
One problem with d.c.o.w. is that it entails searching for an appropriate
trade partner: an agent that has Apples and wants Bananas has to find
someone who does not just want Apples or someone who has Bananas
but must find someone who has Bananas and wants Apples.
This can be costly in terms of both time and resources.
One way that societies have evolved to reduce search costs is to have
specialised shops which sell one or a limited range of items and we know
where to go to buy them.
However, without a medium of exchange, such shops alone might not be
enough.
A shop could not just sell the Apples as traders coming in who want to
buy Apples would need to bring items that the seller of Apples wishes to
accept as end products.
An alternative would be to set up a network of doubly specialised shops
that allow for direct barter of one good for another. Let us call such
shops “trading posts”.
MEDIUM OF EXCHANGE: COSTLY BARTER

If there were only two commodities, Apples and Bananas, a single trading
post could be set up where Apples and Bananas can be directly bartered
with each other.
With three commodities, A, B and C, three specialised trading post: A
↔ B, B ↔ C, and A↔ C (↔ indicates the possibility of barter).
With four, A,B,C, D, six trading posts .....
In an economy in which no medium of exchange exists, there would need
to be (1/2)n (n − 1) trading posts, i.e. one for each pair of commodities.
With the use of a medium of exchange, only one shop of the sort we are
familiar with, is required per commodity, as the buyer of any good always
pays with money.
MEDIUM OF EXCHANGE: COSTLY BARTER

The use of a medium of exchange economises on the number of

trading posts needed to facilitate bilateral exchange.
MEDIUM OF EXCHANGE: MISALIGNED PREFERENCES
Even if trading posts could be set up for each pair of objects in the
economy, some of these posts might not have any trades due to
misalignments of endowments and preferences.
A famous example:
Suppose there are three traders: Harriet, Ina and Jamal and three goods:
Apples, Bananas and Cabbages. The three traders are initially endowed
as follows:
Harriet has 3 Apples;
Ina has 6 Bananas;
Jamal has 1 Cabbage.
Suppose that they have the following preferences:
Harriet: 6 Bananas  3 Apples  1 Cabbage;
Ina: 1 Cabbage  6 Bananas  3 Apples;
Jamal: 3 Apples  1 Cabbage  6 Bananas.
where “” means “is preferred to”.
MEDIUM OF EXCHANGE: MISALIGNED PREFERENCES

Each trader’s endowment is equal in value to every other trader’s

endowment and therefore a swap of endowments in which Harriet gets
the 6 Bananas, Ina the Cabbage and Jamal the 3 Apples will make all
three better off.
But this cannot happen through bilateral trading between any pair of
them. When Harriet meets Ina, the latter prefers her own endowment to
Harriet’s; when Ina meets Jamal, he prefers his endowment to hers and
when Jamal meets Harriet, she prefers her endowment to his.
MEDIUM OF EXCHANGE: MISALIGNED PREFERENCES
Now suppose that in addition to the three goods, there is a fourth object
“Money” and that Harriet is initially in possession of not just 3 Apples
but also one unit of this object called Money.
Now, the following bilateral trades can take place, starting with Harriet
and Ina.
MEDIUM OF EXCHANGE: MISALIGNED PREFERENCES

In each trade quid pro quo is maintained: like trades for like in the sense
that one unit of money equals in value 1C, 3A or 6B.
The use of money as a medium of exchange makes possible
bilateral trades which might otherwise be impossible because of
misalignment between endowments and preferences.
STORE OF VALUE

When money is used as a medium of exchange, there is a gap between

sales and purchase.
During this time, money is used as a store of value (or an ‘asset’).
Hence, the m.o.e. role directly leads to the s.o.v. role.
But other objects are also stores of value: savings deposits, bonds,
stocks, property, jewellery ... without being media of exchange.
A medium of exchange is always also a store of value. But the
converse need not be true.
STORE OF VALUE

Money typically offers no reward, financial or otherwise, during the period

in which it is held (although in recent times, this is not literally true).
The other assets listed above all offer some reward or another.
In using money as a m.o.e. (and thus as a s.o.v.), people sacrifice the
benefits that other assets could offer. This is the opportunity cost of
holding money.
What then is the benefit of holding money?
LIQUIDITY

Liquidity is the ease with which an asset can be exchanged for other
assets and/or goods.
A m.o.e. is characterised by being the most liquid of all s.o.v.’s.
This is why economic agents are willing to forsake interest, what they get
in return is the convenience of money’s liquidity.
LIQUIDITY

Liquidity depends on:

1 Marketability (ease of sale, in great demand).
2 Predictability of its exchange value (Carl Menger 1840-1921, Polish-Austrian)

3 Reversibility (no gap between value in purchase and value in sale).

4 Divisibility (can be exchanged in arbitrarily small units).
LIQUIDITY

Money is used as a m.o.e. because it best embodies the above properties.

But note the circularity: money acts as the universal m.o.e. (within a
national economy) because it is liquid but it is liquid precisely because it
is the universally accepted m.o.e.
Is it possible that any arbitrary object could serve as money?
LIQUIDITY

No. There are some objective properties which help make an asset liquid:
1 Transportability.
2 Durability.
3 Inherent divisibility.
4 “Universal appeal” or at least no particular repulsiveness to anyone.
LIQUIDITY

In modern economies, money is intrinsically worthless, created and

supplied by a country’s central bank as an artificial object for the sole
purpose of fulfilling the three roles of money.
However, it meets all the objective criteria that are necessary to serve as
m.o.e.
LIQUIDITY

There are various measures of money supply

M0 (Coins plus paper currency; )
M1 (M0 + demand deposits);
M2 (M1 + savings deposits);
etc.

The conventional definition of money is M1.

LIQUIDITY

However, it is often debated why demand deposits are considered to be

“money” but savings accounts are not; this leads to some debate on
where the line between money and non-money amongst the various
monetary aggregates should be drawn.
What is true is that as we move to higher numbered aggregates, liquidity
shrinks and ‘reward’ grows, so M0 is more money-like than M1, M1 more
than M2, etc.
KEYNES VERSUS CLASSICS

People have to decide how to store value between interest-bearing (or

offering other forms of pecuniary rewards) assets and money.
The decision involves trading off liquidity for ‘interest’ (which is a
shorthand term to describe any sort of pecuniary reward).
KEYNES VERSUS CLASSICS

According to Keynes, the macroeconomic role for money arises because

money is more than just a medium of exchange or unit of account.
It arises because money interacts with other markets through spillovers
from the demand for liquidity by economic agents into the functioning of
other markets.
A greater desire for liquidity on the part of the public can lower the
demand for other assets as well as for goods.
KEYNES VERSUS CLASSICS

The Classical school, on the other hand, focused on the m.o.e. role and
downplayed the spillovers effects from money to markets for other assets
and/or goods.
It thus viewed money as a ‘’veil” which appeared very important on the
surface but in reality did not have any effect on real activity.
KEYNES VERSUS CLASSICS

Note that, in fulfilling its first two roles, the exact quantity of money did
not appear to be very important. In our example on misaligned
preferences, what we called a unit of money as part of Harriet’s initial
endowment was arbitrary. It is even possible that Harriet had 5 units of it
but each unit was worth only 1/5 of a Cabbage, 3/5 Apples and 1.2
Bananas.
This irrelevance of the amount in which money is present to the real
outcomes of my example (the trades that the use of a medium of
exchange makes possible) reflect the Classical viewpoint.
In debates about the macroeconomic effects of money, however, the
quantity of money, i.e. the level of the money supply plays a central role.
The rest of the module will be examining in detail the debates that have
emerged from these divergent views regarding the macroeconomic
importance of money.
END OF TOPIC 1