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Elemental Economics

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Dr. Harry Hillman Chartrand, PhD

Cultural Economist & Publisher

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5.0 Fiscal & Monetary Policy (cont'd)

5.2 Monetary Policy

5.2.1. Money   (MKM C10 all editions)  

Money is arguably the magic of contemporary culture.   As pieces of metal, paper, plastic or electronic records it transforms itself into a car, television, computer, food or shelter.  As Joel Grey’s character in the movie Cabaret sings: “Money, money, money makes the world go round, makes the world go round, makes the world go round!” And while money won’t buy you love it can make a good down payment.  In fact, money is one of humanity’s greatest social innovations. 


i - Uses 

Money has four principal uses as:

(a) a generally accepted medium of exchange for goods and services.  The key here is ‘generally accepted’.  For example, at the campus computer store if I put down a Japanese ten thousand yen bank note it will not generally be accepted in exchange for a new hard drive, at least in Canada;

(b) a unit of account in exchange.  The key here is that while one cannot compare apples and oranges one can compare their monetary prices and add them up.  This is, of course, why a System of National Income Accounting is possible;

(c) a store of value for future exchange.  The key here is stability of value through time.  For example, until recently in Zimbabwe inflation was running at 250 million per cent per year.  This meant that if you were paid on Friday by Monday your pay check was virtually worthless; and,

(d) an income earning asset.  The key here is deferred gratification.   On the one hand, one can spend money today on goods and services to gain immediate satisfaction or utility.   On the other hand, one can save and/or invest to earn interest (the price of money) and then spend a larger sum in future.

Without money, barter is the only non-coercive means of exchange.  Barter, however, has very high transaction costs due to the problem of coincidence of interest.  If I am a farmer with milk and want bread, I must find a baker with bread who wants milk.  If the baker, however, wants carrots then I must find someone with carrots who wants milk then take the carrots to the baker to get bread, if he still has any.  In a money economy, however, I simply sell my milk to anyone who wants it and get money which the baker generally accepts.

This assumes, of course, a world of private property.  On the far Left of Economics is perfect communism where distribution idealistically occurs ‘each according to one’s needs’.  There is no private property and hence no exchange.  Alternatively, on the far Right is the idealistic concept of absolute private property with which not even the State can interfere.  In Law this is known as ‘allodial title‘ to property.


i - Forms

I  will now review the five principle forms of money: (i) Commodity; (ii) Convertible; (iii) Fiat; (iv) Deposit; and, (v) Super Money.

(a) Commodity

The first form of money was a commodity with a high value/weight ratio.  Transportation is a major transaction cost.  Precious metals, gems, rare or sacred plants or animal products (tobacco and ivory) or labour-intensive items like wampum and the giant stone wheels of Polynesia were early forms of money. 

Commodity money, however, is subject to a number of problems and complications.  The first is ‘debasement’ or corruption, e.g., lowering the quantity of precious to non-precious metal.  Is that bar of gold 24 carat or 18?  Second, anything ‘precious’ usually has an attractive alternative use, e.g., as jewellery.  Third, no matter its value/weight ratio, any commodity in quantity is bulky and heavy.

The problem of debasement was initially handled through coinage.  Thus the first coins bearing the stamp of royal authority guaranteeing its quality are attributed to King Croesus of Lydia (in what is now Turkey) and whose kingdom shortly after innovation of coinage fell to Cyrus the Great of Persia in the 6th century BCE.  It was this same King of Kings who freed the Jews from their Babylonian Captivity and allowed them to return to Israel where they finally wrote down the Torah and/or Old Testament of the Christian Bible.  Unfortunately, monarchs in financial difficulty often deliberately debased the currency themselves.  This was the form of inflation in the ancient and medieval worlds.

(b) Convertible

The next step in monetary evolution was convertible paper money.   Used first in China it was in extensive use in medieval European market towns.  Essentially, goldsmiths held large quantities of gold and silver and other valuables in well-protected vaults and safes.  A traveller to a market town would rent these facilities to deposit and safely store their valuables while they shopped.  The goldsmith would issue a paper receipt redeemable for or ‘convertible’ into these deposits.  Soon paper receipts rather than bulky deposits were physically exchanged and paper money was born.  And it was the delay between deposit and withdrawal that fostered the birth of the banking system as we know it.  This time lag allowed the goldsmith (and later the banker) to loan out deposits earning interest – money making money.  As long as they could pay back depositors on demand all was well.  The question, of course, was the trustworthiness of the goldsmith and later of deposit-taking institutions such as banks.  Trust was not, and is not, always justified.

(c) Fiat

Eventually another institutional innovation took place.  The State assumed responsibility for the convertibility of paper money that it issued.  Originally it could be converted into gold or silver – pay bearer on demand.  This was the basis of the Gold Standard which backed the American dollar until 1971.  Fiat money is simply paper currency issued by the State as a medium of exchange, unit of account, store of value and income earning asset generally accepted as ‘money’ within a given jurisdiction.  What backs fiat money is not gold or silver but rather the expectation of market players about the productive capacity and balance of payments of a country.  Paper money (and according to some coins) constitute M1 money or the monetary base.

(d) Deposit

Fourth, the most important form is deposit money.  Most individuals deposit their earnings into deposit-taking institutions like banks.  Consumers and firms pay for goods and services by transferring these deposits by cheque or other debit transaction.  The institution simply alters the books.  No currency actually changes hands.  Deposit money is the main means of settling transaction in the modern world. 

Again the delay between deposit and withdrawal allows banks to loan out deposits to earn interest – money making money.  As long as they can pay back depositors on demand all is well.  This raises the question of reserves, i.e., what percentage of deposits should be held to meet withdrawals.  Like all retail business banks learn overtime how much inventory (in this case reserves) to retain.  By loaning out depositors’ monies banks, in effect, create new money.

M1 plus all personal deposits form M2.  When non-personal (institutional) deposits are added to M2, we have M3.  There is however, no consensus on what actually constitutes M1, M2, M3 …. Mn.

(e) Super

There is, however, yet another form of money - ‘super’ money.  Super money is based on the changing market value of the stock market and other appreciating assets.  At a given point in time market valuation of a stock can be used as collateral for a bank loan or line of credit.  The next day, the value of the stock may rise or fall but the loan has been made, new money has been created.  Similarly some argue credit cards are a form of money because of deferred payment (usual 30 days).  In effect, new money is thereby created. 

iii - Liquidity (MKM C15/377; 352-54; 361-364)

Liquidity is a fundamental characteristic of money.  It refers to the time and cost associated with converting money into goods and services and vice versa.  Thus as one moves from M1 through M3 and then onwards liquidity becomes less and less.  For example I walk into a store with fiat money and it is immediately accepted.  If I write a cheque I must provide identification which may or may not be accepted.  It can be argued that all assets - financial, physical and intellectual - are forms of money with greater or lesser liquidity.  Contemporary monetary theory is in fact awash with controversy about new forms of money including securitization of assets which is arguably the root of the Great Recession.

There are, however, differing and somewhat confusing definitions of what constitutes the 'money supply'. 

In Parkin & Bade:

M1 = bills & coins, the most liquid of monies

M2 = M1 + personal deposits requiring a cheque or credit card check and taking longer

M3 = M2 + term deposits which require formalities and a penalty charge if taken out before term. 

In Wikpedia -

M0 = physical currency

M1 = M0 + demand deposits including chequing and current accounts

M2 = M1 + small time and savings deposits plus non-institutional money-market funds

M3 = M2 + large time deposits, institutional money-market funds, short-term repurchase agreements plus other larger liquid assets. 

In the Economist Glossary:

One difficulty for policymakers lies in how to measure the relevant money supply. There are several different methods, reflecting the different LIQUIDITY of various sorts of MONEY. Notes and coins are completely liquid; some BANK deposits cannot be withdrawn until after a waiting period. M3 (M4 in the UK) is known as broad money, and consists of cash, current account deposits in banks and other financial institutions, SAVINGS deposits and time-restricted deposits. M1 is known as narrow money, and consists mainly of cash in circulation and current account deposits. M0 (in the UK) is the most liquid measure, including only cash in circulation, cash in banks’ tills and banks’ operational deposits held at the Bank of England.

In another first year text, McConnell, Brue & Barbiero, it is:

M1 = currency + demand deposits

M2 = M1 + several 'near' monies (assumably non-chequing accounts at the chartered banks)

M2+ = M2 + deposits at credit unions, trust & mortgage loan companies + money market mutual funds

M2++ = M2+ plus Canada Savings Bonds + non-money market mutual funds

Nonetheless, it can be argued that, with respect to liquidity, that all assets - financial, physical and intellectual - are forms of 'money' with greater or lesser liquidity.

In Ragan & Lipsey (pp. 692-695) the money supply is:

M1 = currency + demand deposits

M2 = M1 + non-chequing accounts at the chartered banks

M2+ = M2 + deposits at credit unions, trust & mortgage loan companies + money market mutual funds

M2++ = M2+ plus Canada Savings Bonds + non-money market funds



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