Money Basics Essay, Research Paper
moneya commodity accepted by general consent as a medium of economic exchange. It is the medium in which prices and values are expressed, it circulates from person to person and country to country, thus facilitating trade, and it is the principal measure of wealth.The subject of money has fascinated wise men from the time of Aristotle to the present day because it is so full of mystery and paradox. The piece of paper labelled one dollar or 100 francs or 10 kroner or 1,000 yen is little different, as paper, from a piece of the same size torn from a newspaper or magazine, yet it will enable its bearer to command some measure of food, drink, clothing, and the remaining goods of life while the other is fit only to light the fire. Whence the difference?The easy answer, and the right one, is that people accept money as such because they know that others will. The pieces of paper are valuable because everyone thinks they are, and everyone thinks they are because in his experience they always have been. At bottom money is, then, a social convention, but a convention of uncommon strength that people will abide by even under extreme provocation. The strength of the convention is, of course, what enables governments to profit by inflating the currency. But it is not indestructible. When great variations occur in the quantity of these pieces of paper as they have during and after wars they may be seen to be, after all, no more than pieces of paper. People will then seek substitutes like the cigarettes and cognac that for a time became the medium of exchange in Germany after World War II. As John Stuart Mill wrote:There cannot, in short, be intrinsically a more insignificant thing, in the economy of society, than money; except in the character of a contrivance for sparing time and labour. It is a machinery for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order. (Principles of Political Economy, W.J. Ashley [ed.], 1909, p. 488.)Mill was perfectly correct, although one must add that there is hardly a contrivance man possesses that can do more damage to a society when it goes wrong.Functions of money The basic function of money is to enable buying to be separated from selling, thus permitting trade to take place without the so-called double coincidence of barter. If a person has something to sell and wants something else in return, it is not necessary to search for someone able and willing to make the desired exchange of items. The person can sell the surplus item for general purchasing power that is, money to anyone who wants to buy it and then use the proceeds to buy the desired item from anyone who wants to sell it.The importance of this function of money is dramatically illustrated by the experience of Germany just after World War II, when paper money was rendered largely useless because, despite inflationary conditions, price controls were effectively enforced by the American, French, and British armies of occupation. People had to resort to barter or to inefficient money substitutes. The result was to cut total output of the economy in half. The German economic miracle just after 1948 reflected partly a currency reform by the occupation authorities, but some economists hold that it stemmed primarily from the German government’s elimination of all price controls, thereby permitting a money economy to replace a barter economy.Separation of the act of sale from the act of purchase requires the existence of something that will be generally accepted in payment this is the medium of exchange function of money. But there must also be something that can serve as a temporary abode of purchasing power, in which the seller holds the proceeds in the interim between the first sale and the subsequent purchase, or from which the buyer can extract the general purchasing power with which to pay for what is bought. This is the asset function of money.Varieties of money Anything can serve as money that habit or social convention and successful experience endow with the quality of general acceptability, and a variety of items have so served from the wampum (beads made from shells) of American Indians to cowries (brightly coloured shells) in India, to whales’ teeth among the Fijians, to tobacco among early colonists in North America, to large stone disks on the Pacific island of Yap, to cigarettes and liquor in post-World War II Germany. The wide use of cattle as money in primitive times survives in the word pecuniary, which comes from the Latin pecus, meaninVarieties of money Metallic money The use of metals as money has occurred throughout history. As Aristotle observed,The various necessities of life are not easily carried about, and hence man agreed to employ in their dealings with each other something which was intrinsically useful and easily applicable to the purposes of life, for example, iron, silver, and the like. Of this the value was at first measured by size and weight, but in process of time they put a stamp upon it, to save the trouble of weighing and to mark the value.The use of metal for money can be traced back to more than 2,000 years before the birth of Christ. But standardization and certification in the form of coinage, as referred to by Aristotle, did not occur except perhaps in isolated instances until the 7th century BC. Historians generally assign to Lydia, a state in Anatolia, priority in using coined money. The first coins were made of electrum, a natural mixture of gold and silver, and were crude, bean-shaped ingots bearing a primitive punchmark certifying to either weight or fineness, or both.The use of coins enabled payment to be by tale, or count, rather than weight, greatly facilitating commerce. But this in turn encouraged clipping (shaving off tiny slivers from the sides or edges of coins) and sweating (shaking a bunch of coins together in a leather bag and collecting the dust that was thereby knocked off) in the hope of passing on the lighter coin at its face value. Gresham’s law (that bad money drives out good when there is a fixed rate of exchange between them) came into operation, and heavy, good coins were held for their metallic value, while light coins were passed on. The coins became lighter and lighter, and prices higher and higher. Then payment by weight would be resumed for large transactions, and there would be pressure for recoinage. These particular defects were largely ended by the milling of coins (making serrations around the circumference of a coin), which began in the late 17th century.A more serious matter was the attempt by the sovereign to benefit from the monopoly of coinage. In this respect, Greek and Roman experience offers an interesting contrast. Though Solon, on taking office in Athens in 594 BC, did institute a partial debasement of the currency, for the next four centuries, until the absorption of Greece into the Roman Empire, the Athenian drachma had an almost constant silver content (67 grains of fine silver until Alexander, 65 grains thereafter) and became the standard coin of trade in Greece and in much of Asia and Europe as well. Even after the Roman conquest, the drachma continued to be minted and widely used.The Roman experience was very different. Not long after the silver denarius, patterned after the Greek drachma, was introduced in about 212 BC, the prior copper coinage (aes, or libra) began to be debased until, by the time the empire began, its weight had been reduced from one pound to half an ounce. The silver denarius and the gold aureus (introduced about 87 BC) suffered only minor debasement until the time of Nero (AD 54), when almost continuous tampering with the coinage began. The metal content of the gold and silver coins was reduced, and the proportion of alloy was increased to three-fourths or more of its weight. Debasement in Rome (as ever since) was a reflection of the state’s inability or unwillingness to finance its expenditures through explicit taxes. But the debasement in turn worsened Rome’s economic situation and undoubtedly contributed to the collapse of the empire.Paper money In the late 18th and early 19th centuries, paper money and bank notes spread widely. The bulk of the money in use came to consist not of actual gold or silver but of fiduciary money promises to pay specified amounts of gold and silver. These promises were initially issued by individuals or companies as bank notes or as the transferrable book entries that came to be called deposits. But gradually the state assumed a role.From fiduciary paper money promising to pay gold or silver, it is a short step to fiat paper money that is, notes that are issued on the fiat of the sovereign, are specified to be so many dollars or francs or yen, and are legal tender but are not promises to pay something else. The first large-scale issue in a Western country occurred in France in the early 18th century (though there are reports of paper money in China many centuries earlier). Later, the French revolutionary government issued paper money in the form of assignats from 1789 to 1796. The American colonies and later the Continental Congress issued bills of credit that could be used in making payments. These early experiments gave fiat money a deservedly bad name. The money was overissued, and prices rose drastically until the money became worthless or was redeemed in metallic money (or promises to pay metallic money) at a small fraction of its initial value.Subsequent issues of fiat money in the major countries during the 19th century were temporary departures from a metallic standard. In Great Britain, for example, payment of gold for the outstanding bank notes was suspended during the Napoleonic Wars (1797 1815). As a result, gold coin and bullion became more expensive in terms of paper. Similarly, in the United States during the Civil War, convertibility of Union currency (greenbacks) into specie was suspended, and resumption did not occur until 1879. At its peak, in 1864, the greenback price of gold, nominally equivalent to $100, reached more than $250.Standards of value In the Middle Ages, when money consisted primarily of coins, silver and gold coins circulated simultaneously. As governments came increasingly to take over the coinage, and especially as fiduciary money was introduced, they tended to specify their nominal monetary units in terms of fixed weights of both silver and gold to adopt a national bimetallic standard. Gresham’s law, however, usually assured that the bimetallic standard degenerated into a monometallic standard: if the quantity of silver designated as the monetary equivalent of one ounce of gold was less than the quantity that could be purchased in the market for one ounce of gold (i.e., if the mint overvalued silver), no one would bring gold to be coined. If one had gold, it was better to buy silver and bring it to be coined. Silver, the cheaper metal, drove out gold and became the standard. This happened in most of the countries of Europe, so that by the early 19th century all were effectively on a silver standard. In Britain, on the other hand, the ratio established in the 18th century at the advice of Sir Isaac Newton, then serving as master of the mint, overvalued gold and therefore led to an effective gold standard. In the United States a ratio of 15 ounces of silver to one ounce of gold was set in 1792. This ratio overvalued silver, so silver became the standard. In 1834 the ratio was altered to 16 to one, which overvalued gold, so gold became the standard.The gold standard The great gold discoveries in California and Australia in the 1840s and ’50s produced a temporary decline in the value of gold in terms of silver. This price change, plus the dominance of Britain in international finance, led to a widespread shift from a silver standard to a gold standard. Germany adopted gold in 1871 73, the Latin Monetary Union (France, Italy, Belgium, Switzerland) in 1873 74, the Scandinavian Union (Denmark, Norway, and Sweden) and The Netherlands in 1875 76. By the final decades of the century, silver remained dominant only in the Far East (China, in particular). Elsewhere the gold standard reigned.The early 20th century was the great era of the international gold standard. Gold coins circulated in most of the world; paper money, whether issued by private banks or by government, was convertible on demand into gold coins or gold bullion at an official price (with perhaps the addition of a small fee); and bank deposits were convertible into either gold coin or paper currency that was itself convertible into gold. In a few countries, a minor variant prevailed the so-called gold-exchange standard, under which the currency was converted at a fixed price into the currency of another country (usually the British pound sterling) that was itself convertible into gold.There was, in effect, a single world money called by different names in different countries. A U.S. dollar, for example, was defined as 23.22 grains of pure gold (25.8 grains of gold 0.9000 fineness). A British pound sterling was defined as 113.00 grains of pure gold (123.274 grains of gold 11/12th fine). Accordingly, one British pound equalled 4.8665 U.S. dollars (113.00/23.22) at the official parity. The actual exchange rate could deviate from this only by an amount that corresponded to the cost of shipping gold. If the price of the pound sterling in terms of dollars rose to a considerably higher value than this in the foreign exchange market, someone in New York City who had a debt to pay in London might find that, rather than buy the needed pounds on the market, it was cheaper to get gold for dollars at a bank or at the U.S. subtreasury, ship the gold to London, and get pounds for the gold from the Bank of England. This set an upper limit to the exchange rate. Similarly, the cost of shipping gold from Britain to the United States set a lower limit. These limits were known as the gold points.Under such an international gold standard, the quantity of money in each country was determined by the specie-flow adjustment mechanism analyzed by 19th-century economists. If, for whatever reason, the quantity of money in a country rose unduly, this would tend to raise prices in that country relative to prices in other countries; the rise in prices would have the effect of discouraging exports and encouraging imports. The decreased supply of foreign currency from the sale of exports plus the increased demand for foreign currency to pay for imports would tend to raise the price of foreign currency in terms of domestic currency. As soon as this price hit the upper gold point, gold would be shipped out of the country to other countries. The decline in the amount of gold would produce in turn a reduction in the total amount of money because banks and government institutions, seeing their gold reserves decline, would want to protect themselves against further demands by reducing the claims against gold that were outstanding. This would tend to lower prices at home. The influx of gold abroad would have the opposite effect, increasing the quantity of money there and raising prices. These adjustments would continue until the gold flow ceased or was reversed.
This is precisely the mechanism that operates within a unified currency area, the mechanism that determines how much money there is in Illinois compared to how much there is in other states or how much there is in Wales compared to how much there is in other parts of the United Kingdom. In the early 20th century, most of the world was a unified currency area, so the gold standard functioned throughout the world. Its great advantage was that if permitted to operate it would greatly limit the power of any national government to engage in irresponsible monetary expansion. This was also its great disadvantage. In an era of big government and of full-employment policies, a real gold standard would tie the hands of governments in one of the most important areas of policy.The decline of gold World War I ended the real international gold standard. Most belligerents suspended the free convertibility of gold. The United States, even after its entry into the war, maintained convertibility but embargoed gold exports. For a few years after the end of the war, most nations had inconvertible national paper standards inconvertible in that paper money was not convertible into gold or silver. The exchange rate between any two currencies was a market rate that fluctuated from time to time. During this period this was regarded as a temporary phenomenon, like the British suspension of gold payments during the Napoleonic era, and the U.S. suspension during the Civil War greenback period. The great aim was a restoration of the prewar gold standard.This aim dominated monetary developments during the 1920s. Britain, still a major financial power, returned to gold in 1925. Winston Churchill, then chancellor of the Exchequer, decided to follow prevailing financial opinion and adopt the prewar parity (i.e., to define a pound sterling once again as equal to 123.274 grains of gold 11/12th fine). This produced exchange rates that, at the existing prices in sterling, overvalued the pound and so tended to produce gold outflows, especially after France returned to gold in 1928 at a parity that undervalued the franc. By 1929 the important currencies of the world, and most of the less important ones, were again linked to gold.The gold standard that was restored, however, was a far cry from the prewar gold standard. The establishment of the Federal Reserve System in the United States introduced an additional link in the international specie-flow mechanism. That mechanism no longer operated automatically. It operated only if the Federal Reserve chose to let it do so, and the Federal Reserve did not so choose; it took certain measures that prevented gold inflows from producing a corresponding expansion in the money supply. The United Kingdom had recurring difficulties in retaining its gold. It followed a restrictive monetary policy, but, because of rigidities in prices and particularly in wages, the result was unemployment rather than a lowering of prices. Unemployment reduced imports and stimulated exports, thus preventing gold losses. But this was not a tenable long-term position, as a lower price level might have been. Most other countries adopted a gold-exchange standard. Everywhere, central banks took scattered measures to loosen the connection between changes in the money supply and inflows or outflows of gold.If the Great Depression had not occurred, this system might have grown and matured and improved. But the Depression brought the managed gold standards to a quick end. It originated in the United States, spread to all the countries linked by the gold exchange standard, and then reverberated back to the United States. Britain was the first major country to cut the link, leaving the gold standard in 1931. The United States followed in March 1933, restoring a fixed but higher dollar price for gold in January 1934, at $35 an ounce.The dollar standard The world’s monetary system operated on a dollar standard from the end of World War II until 1971, when, in an attempt to control inflation, the United States unilaterally severed the connection between the dollar and gold. Under the dollar standard, the dollar was widely used in international trade, even in trade between countries other than the United States. It was the unit in terms of which the exchange rates of other currencies were expressed. Other countries maintained their official exchange rates by buying and selling U.S. dollars and held dollars as their primary reserve currency for that purpose. The existence of a dollar standard did not mean that other countries could not change their exchange rates as Germany and France did in 1969 just as the gold standard did not mean that they could not devalue or appreciate in terms of gold. What it did mean was that the United States could not determine its own exchange rate or its balance of payments position. It also meant that U.S. monetary policy had a major effect on the world economy.Since 1971 the world’s monetary system has consisted of a collection of national fiat currencies linked by floating exchange rates set in the market. Frequent government interventions to affect exchange rates have been effective at most only temporarily. None of the numerous proposals to reform the system has come close to acceptance.Modern monetary systems Monetary systems are today very much alike in all the major countries of the world. They consist of three levels: (1) the holders of money (the public ) individuals, businesses, governmental units; (2) commercial banks (privately or governmentally owned), which borrow from the public and make loans to individuals, firms, or governments; and (3) central banks, which have a monopoly on the issue of certain types of money, serve as the bankers for the central government and the commercial banks, and have the power to determine the quantity of money.Public money holdings The public holds its money as: (1) currency (including coin) and (2) bank depositsPublic money holdings Currency In most countries the bulk of the currency consists of notes issued by the central bank. In the United Kingdom these are Bank of England Notes; in the United States, Federal Reserve Notes; and so on. It is hard to say precisely what issued by the central bank means. In the United States, for example, the currency bears the words Federal Reserve Note, but these notes are not obligations of the Federal Reserve Banks in any meaningful sense. The holder who presents them to a Federal Reserve Bank has no right to anything except other pieces of paper adding up to the same face value. The situation is much the same in most other countries.The other major item of currency held by the public is coin. In almost all countries this is token coin, worth as metal much less than its face value.Bank deposits Bank deposits are counted also as part of the money holdings of the public. In the 19th century most economists regarded only currency and coin as money, treating deposits only as claims to money. As deposits became more and more widely held, and as a larger fraction of transactions came to be effected by check, economists started to include not the checks, but the deposits they transferred, as money on a par with currency and coin.The definition of money has been the subject of much dispute. The chief point at issue is which categories of bank deposits to call money and which to regard as near money. Many economists include as money only deposits transferable by check (demand deposits). Others include nonchecking deposits, such as time deposits or current deposits in commercial banks. Still others include deposits in other financial institutions, such as savings banks, savings and loan associations, and so on.The term deposits is highly misleading. It connotes something deposited for safekeeping, like currency in a safe-deposit box. Bank deposits are not like that. When one brings currency to a bank for deposit, the bank does not put the currency in a vault and keep it there. It may put a small fraction of the currency in the vault as reserves, but it will lend most of it to someone else or buy an investment that is, a bond or some other security. As part of the inducement to depositors to lend it money, it provides facilities for transferring demand deposits from one person to another by check.The deposits of commercial banks are assets of their holders but liabilities of the banks. The assets of the banks consist of reserves currency plus deposits at other banks and earning assets loans plus investments in the form of bonds and other securities. The reserves are only a small fraction of the aggregate deposits. Initially, in the history of banking, the amount of reserves held was determined by each bank separately in terms of its judgment of the likely demands on it. The growth of deposits enabled the total quantity of money (including deposits) to be larger than the total sum available to be held as reserves. A bank that received, say, $100 in gold might add $25 to its reserves and lend out $75. But the recipient of the $75 loan would spend it. Some of those who received gold this way would hold it as gold, but others would deposit it in this or in other banks. If, for example, two-thirds was redeposited, some bank or banks would find $50 added to deposits and to reserves and would repeat the process, adding $12 1/2 to its reserves and lending out $37 1/2. When this process worked itself out fully, total deposits would have increased by $200, bank reserves would have increased by $50, and $50 of the initial $100 deposited would have been retained as currency outside banks. There would be $150 more money in total than before (deposits up by $200, currency outside banks down by $50). Although no individual bank created money, the system as a whole did. This multiple expansion process lies at the heart of the modern monetary system.Central banking An important part of the monetary system is the central bank. The Bank of England was the first modern central bank, serving as the model for many others. It was established as a private bank in 1694 but quickly came to be largely an agency of the government. The Bank of France was established as a governmental institution by Napoleon in 1800. In the United States, the 12 Federal Reserve Banks, which, together with the Board of Governors in Washington, D.C., constitute the Federal Reserve System, are technically owned by their member commercial banks, but this is a pure formality. Member banks get only a fixed annual percentage dividend on their stock and have essentially no real power. To all intents and purposes, the system is a governmental agency.The notes issued by a central bank (or other governmental agency) plus deposits at the central bank are often called high-powered money, because when held as bank reserves each dollar or pound or franc may correspond to several dollars or pounds or francs of commercial bank deposits. Generally speaking, there is now no formal limit to the amount of notes and deposits that a central bank may have as liabilities.The way in which a central bank increases or decreases the total amount of high-powered money is, typically, by making loans (discounting) or by buying and selling government securities (open-market operations). If, for example, the Federal Reserve System purchases $1,000,000 of government securities, it will pay for these securities by a check on itself, adding $1,000,000 to its assets and $1,000,000 to its liabilities. The seller can take the check to a Federal Reserve Bank, which will exchange for it $1,000,000 in Federal Reserve Notes. Or the seller may deposit the check at a commercial bank, and the bank will in turn present it to a Federal Reserve Bank, which will pay the check by making a book entry increasing that bank’s deposits with it by $1,000,000. The bank may, in turn, transfer this sum to a borrower, who again will convert it into Federal Reserve Notes or deposit it.The important point is that these bookkeeping operations simply record a process whereby the central bank has created, out of thin air as it were, additional high-powered money the direct counterpart of printing Federal Reserve Notes. Similarly, if the central bank sells government securities, it destroys high-powered money. (See also government economic policy: Monetary policy.)In addition to the high-powered money of the central bank, the total quantity of money at any given time depends on the preferences of the public as to the relative amounts of money it wishes to hold as currency and as deposits and on the preferences of the banks as to the ratio they wish to maintain between their reserves and their deposits. (The reserve ratio is, of course, dominated by legal reserve requirements, where they exist, but may vary somewhat as banks think it prudent to keep a larger or smaller cushion in excess of required reserves.)It follows that, by controlling the amount of high-powered money and by other, less important means, a central bank can vary the total quantity of money as it wishes within broad limits. The major problem of modern monetary policy is how the central bank should use this power.Monetary theories The relation between money and what it will buy has always been a central issue of monetary theory. Economists have generally held that the level of prices is determined by the quantity of money. But precisely how the quantity of money affects the level of prices, and what the effects are of changes in the quantity of money, have been conceptualized in different ways at different times. For an interval of two or three decades, from the mid-1930s to the mid-1960s, there was a widespread rejection of the quantity theory by professional economists. More recently, there has been something of a counterrevolution involving a partial return to and modification of earlier views. The following discussion of monetary theory will therefore deal first with the quantity theory of money, as it developed before the 1930s, then with the Keynesian revolution, and finally with the recent counterrevolution.Conclusion No other subject in economics has been studied longer or more intensively than the subject of money. The result is a vast amount of documented experience and a well-developed body of theoretical analysis. The extent to which the students of monetary problems agree in their basic conclusions is concealed by the tendency of laymen to exaggerate their differences. But even among professional economists there remain important disagreements, centring mainly on empirical judgments about the stability and form of some of the relations between money and other economic magnitudes.